Real Options: Applications in Public Economics

Lawrence, Craig and Thomas, Mathew (2008): Real Options: Applications in Public Economics.

Abstract

This paper illustrates the use of real options principles to value prototypical resource and industryinvestment projects. It captures important competitive/strategic dimensions in a step-by-stepanalysis of investment decisions (options) under uncertainty. It compares and contrasts staticdiscounted cash flow analysis (DCF) with real options analysis using three case studies. The initialexample values a resource extraction process using static DCF and then compares the projectvaluation when future information is valued and acted upon. The second example considers a coaldevelopment and uses the binomial valuation approach to capture the option value associated withhaving the right but not the obligation to exit the development. It contrasts this valuation approachagainst static DCF and highlights that future royalty payments could be underestimated if based onthe standard DCF valuation. The third example analyses the impact of providing a subsidy forhybrid vehicle production to accelerate potential uncertain environmental benefits. Lastly, thesuitability of the standard financial and economic evaluation tools used by treasury agencies isconsidered when projects contain real options.

• Item Type: MPRA Paper
• Language: English
• Keywords: financial economics; investment decisions; public economics; externalities; subsidies; project evaluation
• Subjects: H - Public Economics > H1 - Structure and Scope of Government > H10 - General; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; H - Public Economics > H4 - Publicly Provided Goods > H43 - Project Evaluation ; Social Discount Rate; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H23 - Externalities ; Redistributive Effects ; Environmental Taxes and Subsidies; G - Financial Economics > G1 - General Financial Markets > G10 - General

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