Option pricing for project evaluation: An introduction. Final report
- Incentives Research, Inc., Boston, MA (United States)
An option is a contract that gives the holder the right to buy (or sell) an asset at a predetermined price on or before a specified date. Since it is a right rather than an obligation, the holder will exercise an option only if it is profitable to do so. Many characteristics of investment projects are analogous to option contracts. A power plant that can burn two types of fuel provides a fuel switching option, for example, since the manager can choose to burn the alternate fuel if it is more profitable (less costly) to do so. In the context of investment projects, an option is the flexibility to revise an investment or operating plan as new information becomes available. The options embedded in investment projects can be important sources of value. However, discounted cash flow (DCF) analysis, which is the technique traditionally used for valuation purposes in utility planning, is ill-suited to the valuation of options. Fortunately, the theory and methods developed to price options in financial markets can be exploited to value the options embedded in investment projects too. This report provides an introduction to option pricing theory and methods from a project evaluation perspective. It also illustrates these valuation techniques by application to a set of electric utility planning problems. In contrast to conventional DCF analysis, option pricing provides insight into optimal management policy as well as project value.
- Research Organization:
- Electric Power Research Inst., Palo Alto, CA (United States); Incentives Research, Inc., Boston, MA (United States)
- Sponsoring Organization:
- Electric Power Research Inst., Palo Alto, CA (United States)
- OSTI ID:
- 34381
- Report Number(s):
- EPRI-TR--104755
- Country of Publication:
- United States
- Language:
- English
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