![]() ![]() Factors such as budget constraints, status of design completion, anticipated risks and project difficulties, construction schedule, and certainty of costs and time impact how the parties select and negotiate contract provisions regarding pricing. Different pricing methods may be utilized. One of the most fundamental provisions of any construction contract is the price to be paid for work performed. Thank you for reading CFI’s explanation of Real Options.Second in a series of articles addressing ten key provisions in construction contracts. Using the variables above, we can easily use the methods used for pricing financial options such as binomial model, Black-Scholes model, and Monte Carlo simulation to price real options. In order to use the techniques for pricing financial options for real options, we should define the relevant variables.Įxpenditure required to acquire asset/Upfront investment As for example, the option to expand can be viewed as a call option, while the option to abandon can be viewed as a put option. Some real options behave similarly to calls some behave similarly to puts. However, in a real-life setting, the NPV approach can be hard to perform correctly.įortunately, the pricing of financial options approaches can be applied to price the real options. We will use the option if the NPV is positive and dismiss it if the NPV is negative. For example, for an option to expand the business operation, we can forecast the future cash flows of this project and discount them to the present value at the opportunity cost. The NPV method is the most straightforward approach to real options pricing. ![]()
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