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Unformatted text preview: kland, 1992). The following section
reviews the industry and decision theory literature on option theory.
5.6 OPTION THEORY
The application of option theory to investment appraisal was motivated by a
recognition that the standard DCF approach does not capture all sources of value
associated with a given project. Specifically, writers such as Dixit and Pindyck
(1994) argue that two aspects of extra value or economic desirability are inadequately
captured by a standard NPV analysis. First, the operating flexibility available within
a single project, which enables management to make or revise decisions at a future
time. The traditional NPV method, they believe, is static in the sense that operating
decisions are viewed as being fixed in advance. In reality, Buckley (2000 p422)
argues, good managers are frequently good because they pursue policies that maintain
flexibility on as many fronts as possible and they maintain options that promise
upside potential. Following such an observation Dixit and Pindyck (1994 p6) write:
“…the ability to delay an irreversible investment expenditure can profoundly
affect the decision to invest. It also undermines the simple net present value
rule, and hence the theoretical foundation of standard neoclassical investment
They go on to conclude:
“…as a result the NPV rule … must be modified.” (Dixit and Pindyck, 1994
Secondly, they believe that the “strategic” option value of a project, which results
from its interdependence with future and follow-up investments, is not accounted for
in the conventional NPV method (Dixit and Pindyck, 1998 and 1994). Therefore,
Myers (1984) and Kester (1984) suggest that the practice of capital budgeting should 111 be extended by the use of option valuation techniques to deal with real investment
Option theory, sometimes called “option pricing”, “contingent claims analysis” or
“derivative asset evaluation”, comes from the world of finance (Lohrenz and Dickens,
1993). In its most common form, option theory uses the Black-Scholes model for
spot prices and expresses the value of the project as a stochastic differential equation
(Galli et al., 1999). In this section, by reviewing the finance literature, the development of option theory will be traced. The popularity and success of option
theory algorithms has led to wide interest in analogous application to evaluation of oil
and gas assets (Lohrenz and Dickens, 1993). This literature will also be reviewed.
In the 1970s, the financial world began developing contracts called puts and calls.
These give the owner the right, for a fee, to buy an option, which is the right (but not
the obligation) to buy or sell a financial security, such as a share, at a specified time in
the figure at a fixed price (Bailey et al., in press). If the transaction has to take place
on that date or never, the options are called European; otherwise they are called
American (this does not refer to where the transaction takes place!) (Galli et al.,
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This document was uploaded on 03/30/2014.
- Summer '14
- The Land