Abstract
The paper highlights the encountered problems in implementing real options under
more realistic assumptions such as business cycle risk and normally distributed cash
flows. The problems considered include (i) estimating empirical distribution of cash
flows from real option investments; (ii) investment decisions across business cycles,
and (iii) calculating the probability of investing with the above stated rich features.
To this end, we estimate operating cash flows of US corporate firms using a Markov
chain model under both geometric and arithmetic Brownian motions assumptions for
cash flows and develop a valuation model of real option with normally distributed
cash flows. Associated investment valuation models incorporating these estimates
reveal that critical cash flow levels significantly differ across models and regimes.
Publisher
International Econometric Review