Ship Investment under Uncertainty: Valuing a Real Option on the Maximum of Several Strategies

This paper demonstrates the use of real option analysis to value the flexibility available to management decision making in introducing an express liner service using a new technology. The ship operator’s decision is framed as an option to exchange the risky income stream of one strategy (asset) for the maximum of several alternatives as uncertainty is resolved over time. Copeland’s and Antikarov’s Marketable Asset Disclaimer is invoked; the intrinsic values of the underlying assets and their volatilities and correlations are modelled using traditional discounted cash flow techniques. The option is valued numerically in a multinomial tree. The result is the value of flexibility and is added to the present value of the original strategy to derive the present value of the flexible strategy. A sensitivity analysis is performed to examine the value of the flexible strategy as both the levels of uncertain factors and their volatilities change. © 2005 Palgrave Macmillan Ltd. All rights reserved.