Growth Option Valuation Models: An Integrated Approach of Human Information Processing Methods and Simulation

Abstract

Growing literature about budget capital decisions reflect the fact that financial managers are aware of the existence of shadow growth options in many of their decisions about the financing and assessment of investment projects, although they might not know the specific valuation models. Analytical models for valuing complex real options projects use, nevertheless, simplified assumptions about the decisional investment process, as well as, in the calculation process of other factors, like the cost of capital or the volatility of the underlying asset. Investor contingent decisions during the life of the project and changes in the market situation, imply that the project risk, as well as the value the other factors (i.e., cost of capital, volatility) are hardly constant. The analytical complexity of the use of changing interest rates and volatilities in valuing real options, make the use of simulation techniques, for the valuation of the project or the underlying asset, a very useful instrument, under those circumstances. The aim of this paper will be therefore, to integrate two main lines of research: Human Information Processing (HIP) and simulation techniques, which are presently being used separately in the valuation of real options, to asses the process of investment decision in modern corporations. First, we will develop a methodology for the valuation of investment projects, under varying interest rates and stochastic volatility, as real options. Second, based on this proposed simulation model, we will establish an empirical research methodology to asses the valuation patterns and validity of the model, as well as the level of acceptance of the proposed growing real option valuation model among investors, comparing the process and results obtained, with those actually being used by financial managers.

Keywords: Growth options, Strategic Flexibility, Simulation, Ito's Lemma, Human Information Processing