A LATTICE CLAIMS MODEL FOR CAPITAL-BUDGETING

Techniques of Contingent Claims Analysis (CCA), extend current capital budgeting practices in two specific ways, First, by explicitly accoun ting for project uncertainty and second, by quantifying the flexibilit y value afforded due to the presence of real options. When applied app ropriately, CCA techniques can provide a powerful and robust valuation approach and are particularly useful in providing insight to key stra tegic factors that affect project value, These advantages, however, co me at some expense as most applications of CCA to project valuation re sult in complex partial differential equations which cannot be solved for simple analytic formulas, This, combined with the intricate mathem atical structure of these methods often make it difficult for an intui tive grasping and may result in implementation problems. The purpose o f this article is to provide a prefatory perspective on the use of CCA techniques as applied to engineering, production, mining, and manufac turing projects. To that end, by using efficient numerical techniques this article formulates a simple and unified CCA framework for valuing a large class of projects that contain real options. The approach is straightforward, readily implementable, and computationally efficient. The framework presented in this paper also provides an important intr oduction to the use of CCA methods and the quantification of flexibili ty value in the management of operations.