Replacement Analysis of Mutually Exclusive Projects of Unequal Lives Using Kelly Specific Real Option Criterion

This paper presents a model to address the uncertainty inherent in replacement problems, whereby a firm must select between mutually exclusive projects of unequal lifespans by applying the Kelly criterion (which is not well known to the engineering economics community) within a binomial lattice option-pricing environment. Assuming that only the interest rate, among many factors, is uncertain, Brown and Davis performed an economic analysis of this problem by employing a real option-pricing method and argued that their model yields results opposite to those yielded by the traditional approach. However, the results yielded by the model proposed herein are consistent with those by the traditional approach, unlike Brown and Davis’s model. The conclusion is that since the investment time horizon is infinite, a firm rationale pertaining to the selection of the best method for the investment problem of such types does not exist.

The Sunk Cost and the Real Option Pricing Model

Although the academic literature on real options has grown enormously over the past three decades, hitherto an accurate real option pricing model has not been developed for investment decision analyses. In this paper, we propose a real option pricing model based on sunk cost characteristics, which can estimate the value of real options more accurately. First, we explore the distinctive features that distinguish real options from financial options. The study shows that the distinguishing feature of the real options is the sunk cost, which does not exist in the financial options. Based on the sunk cost characteristic of real options, we find that the exercise conditions of real and financial options are different. Second, we introduce the sunk cost into the intrinsic value function of real options and establish a new real option pricing model. Finally, this paper also discusses the properties of the intrinsic value function and pricing model of real options. We find that the application of the Black–Scholes option pricing model will overestimate the value of real options.

Pricing lease agreements incorporating tenant’s downscaling option

PurposeThe purpose of this paper is to analyse the problem that arises when a tenant’s space needs will likely change in the future, but the property owner would prefer to continue renting the initial space to the same tenant. The study builds upon ideas on structuring option values into initial rent and proposes a method for evaluating the value of adaptability for both the tenants and the owners.Design/methodology/approachThe methodology is based on real option pricing, and it includes key variables of building adaptability, lease agreement terms and property market information. The methodology explains the importance of understanding the concept of volatility related to space needs and how it affects the tenant’s decision to either remain or vacate the rented premises. Real option pricing theory highlights the problem of using linearly growing expectations for physical assets and the obvious problems that arise with that assumption.FindingsThis paper suggests that the principles of option pricing could be used in valuing building adaptability to find the optimal initial rent from both the owner’s and the tenant’s perspective. It is pointed that the volatility of the tenant’s future space requirements should drive the effective rent paid by the tenant. The paper argues as to why the owner is better off if the tenant can downscale (with building adaptability) their current space rather than vacate the whole space. Additionally, this paper presents the reasons for why the tenant should pay more for a space that has such a downscaling option. Eventually, both the owner and the tenant are better off because, from the tenant’s perspective, unnecessary relocating costs can be avoided, and from the owner’s perspective, unnecessary re-renting costs can be avoided.Practical implicationsThe paper demonstrates how the downscaling option creates value for both the owner and the tenant. The owner benefits from higher average occupancy rates, and during lease break points, only part of the premises has to be re-rented rather than the entire premises. When these higher occupancy rates are transferred into cash flows with relevant market parameters, it is evident how the rates create extra value for the property owner and for the tenant, subject to lease terms.Originality/valueThe owner benefits from the higher rent, even though there might be more lease break points where parts of the building must be rented out. If these kinds of option values can be communicated transparently, it should be possible for the owner and the tenant to agree on such terms.

Fuzzy Optimization of Option Pricing Model and Its Application in Land Expropriation

Option pricing is irreversible, fuzzy, and flexible. The fuzzy measure which is used for real option pricing is a useful supplement to the traditional real option pricing method. Based on the review of the concepts of the mean and variance of trapezoidal fuzzy number and the combination with the Carlsson-Fuller model, the trapezoidal fuzzy variable can be used to represent the current price of land expropriation and the sale price of land on the option day. Fuzzy Black-Scholes option pricing model can be constructed under fuzzy environment and problems also can be solved and discussed through numerical examples.