Capital budgeting and policy evaluation using option pricing theory

For the past three decades analysts have relied primarily on discounted cash flow (DCF) techniques to evaluate projects and policies where cash flows were spread over time. However, recent developments point to DCF being superseded by techniques incorporating option pricing theory as the preferred project and policy appraisal technique, see Brennan and Schwartz (1985), Trigeorgis and Mason (1987), Myers (1987) and Kensinger (1987). Over the past five years option pricing theory has been applied to a broad range of valuation problems. For example, Bardsley and Cashin (1990) have valued the Australian Wheat Corporation's minimum price scheme. Seed and Anderson (1991a and 1991b) have suggested option pricing methodologies for evaluating New Zealand government primary sector policy, Trigeorgis (1990) has demonstrated how an option pricing approach may be used to value managerial flexibility, while Paddock, Seigle and Smith (1988) and Mason and Baldwin (1988) have described techniques for valuing petroleum leases and energy subsidies, respectively. Not only does this demonstrate the flexibility of the underlying theory, but it also suggests a major change has taken place in the way the rights and obligations attached to cash flows are being valued. However, while the option pricing approach has much appeal for financial theorists and academics, policy makers and officials know little or nothing about the technique. This report attempts to remedy this imbalance by outlining the strengths and weaknesses of option pricing methodologies. The report demonstrates in non technical language that the contingent claims approach may be used to value a wide range of assets, cash flows or policy programmes. However, when people think of options they usually think of options on shares which give holders the right to buy or sell them. This association is largely due to the put option transactions of the entrepreneurs of New Zealand finance in the mid to late 1980s. The recent advent of exchange traded options on ordinary shares has also contributed to options' higher profile. While a share option's actual market price depends on supply and demand for the rights attached to the option, Fisher Black and Myron Scholes, derived a theoretical model which can be used to estimate a fair option price. However, Black and Scholes also suggested their model could be used to value risky debt, shareholders' equity, and even options on options. Most initial research and applications of Black and Scholes' work concentrated on pricing share options. However, it was not long before researchers were applying the underlying theory behind option pricing to a number of other valuation problems which had option like characteristics. Broadly, the new applications were classes of contingent claims. That is, assets whose price is dependant on the price of some other asset or occurrence of some event