![]() An owner will only exercise the option if the option payoff is positive. Their efforts brought about the famous Black–Scholes–Merton formula, which provides a closed-form solution to value European call options.Ī call option provides the right but not the obligation to buy a share of common stock at a predetermined price before or at a predetermined date. Groundwork for financial option pricing was laid by Black and Scholes ( Citation1973) and Merton ( Citation1973). It values financial options that give a holder the right to defer unfavourable payoffs. The theory of real options originates from financial options valuation. ![]() The real options analysis (ROA) of the last decade is advocated as a promising technique in valuing the flexibility of managerial decisions in infrastructure life cycle decisions. In the absence of market price uncertainties, ROA should be avoided DTA is to be preferred. However, in the absence of reasonable estimates of market variables, the DT approach to ROA is the best alternative. Although it is complex, ROA certainly adds value in public infrastructure decision making when market price uncertainty is prevalent. Three valuation approaches are compared: DTA, ROA and the DT approach to ROA. The uncertainty drivers are the strength of a bridge, political decisions regarding traffic flow and the price development of construction costs. This study investigates the value of managerial flexibility in a public infrastructure replacement decision. Another difficulty is that infrastructure assets are subject to other types of uncertainties, defined here as asset uncertainties. To avoid this, a simplified but not correct version of ROA is easily applied, referred to as a Decision Tree Approach (DTA) to ROA. One of the difficulties in the application of ROA is the required estimation of market variables. Despite its increasing popularity, ROA has not gained a foothold in public infrastructure decision making. The popularity of ROA is seen in a growing number of case studies on real assets. The concept of ROA is that future unfavourable payoffs can be deferred as soon as more information about market prices becomes available. Real options analysis (ROA) captures this value under uncertain market prices. Managerial flexibility in infrastructure investment and replacement decisions adds value.
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