A practical analytical model for valuing early stage investments using real options

In this work, we build on a previous real options approach that utilises managerial cash‐flow estimates to value early stage project investments. Through a simplifying assumption, where we assume that the managerial cash‐flow estimates are normally distributed, we derive a closed‐form solution to the real option problem. The model is developed through the introduction of a market sector indicator, which is assumed to be correlated to a tradeable market index and drives the project's cash‐flow estimates. In this way we can model a cash‐flow process that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash‐flow in a financially consistent manner under the risk‐neutral minimum martingale measure. The method requires minimal subjective input of model parameters and is very easy to implement.