Applications of real options valuation

This dissertation presents three essays, each discussing an application of real options (contingent claim analysis) techniques. These applications involve equipment replacement, computable general equilibrium analysis and valuation of hedge-fund management compensation. This first essay develops and discusses a real options or contingent claim model to value military replacement investments. This model illustrates the problem of optimal replacement investment decisions when investment is "irreversible," in the sense of carrying a discrete or sunk cost. A real options model of replacement investment is developed. The general technique, and especially the numerical method used here, could be readily used for actual investment decision making once access to appropriate data is available. The second essay presents a novel application of computable general equilibrium analysis by incorporating real options effects and detailed modeling of the U.S. financial sector into a computable general equilibrium model. All previously developed computable general equilibrium models have assumed Marshallian present value criteria for modeling equilibrium conditions. In other words, they assumed that marginal costs should be equal to marginal revenues to achieve an optimal allocation in the economy. The real options literature shows that even with a moderate amount of uncertainty, investment is justified only when the current price significantly exceeds the long-run average cost, or the current rate of return on the sunk cost investment exceeds the cost of capital, usually by a large margin. The computable general equilibrium model discussed in the essay simulates the effects of market volatility change and shows that high volatility inversely affects the economy. The objective of the third essay is to provide a framework for the valuation of hedge-fund management compensation payoffs. The present value of typical hedge-fund management compensation payoffs cannot be measured using a standard NPV approach, as the cash flows are not symmetric. The valuation method suggested in the essay uses an analogy between a hedge fund's management compensation package and a portfolio of call options on the assets of the hedge fund. An illustrative numerical example of this valuation procedure is presented.