A Hybrid Approach to Project Valuation under Uncertainty: Integrating Decision Analysis and Real Options Analysis

Tang Shengyue

Abstract

How to properly evaluate the price of risky project has been widely discussed either in the investment industry or academia. For companies such as Venture Capital firms, the current common investment strategy is the sequential investment: Investors may not choose to put in a large amount of money at the beginning, but gradually sink the fund into the project stage by stage, contingent upon the performance of past stages. In academia, this right of investors to choose to continue investing or abandon the project in the future is called Real Options.

In this thesis, a hybrid two-phase approach to evaluate the risky investment is proposed. The features of this model include long-term real options and short term cash flows valuations, by which the need to forecast the future probability can be avoided. In addition, the short-term uncertainties comprise private risks and public risks, which can be properly managed by Decision Analysis and Binomial Lattice method respectively, so that managerial flexibility and risk rate can be properly taken into consideration.

Finally, an example is used to illustrate the proposed methodology. The results showed that the proposed methodology is practical and require minimal needs to access subjective probabilities that are difficult to obtain. Furthermore, the methodology requires only the use of standard commercial decision analysis software.