Abstract

While real options are increasingly used in evaluating returns on IT projects, scholars and practitioners have started questioning the use of financial option pricing models such as Black- Scholes and Binomial models to evaluate these. We analyze this question by employing decision tree analysis to model a typical scenario involving real options – that of building a prototype before commencing an IT project. We use numerical simulation to compare the option value generated by our model with that approximated by the financial option pricing models. The main result of our paper is that the financial option pricing models consistently overestimate the value of a real option compared to the true value over a range of parameter values. This suggests that managers must exercise caution while evaluating options involving specific situations such as IT projects, and applying the generic financial option pricing models may not reflect the true value of the option.

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