Corporate Finance Theory Using Real Options

Corporate Finance Theory Using Real Options is a hands-on introduction to valuing flexibility in corporate investment and financing decisions. It starts with the simple option to time an investment (McDonald and Siegel) and builds up to models of capital structure with endogenous default (Leland), the joint choice of investment timing and debt financing, and the agency costs that arise between shareholders and bondholders. It then covers binomial trees, from the replication argument behind risk-neutral pricing to the classic real options: expansion, abandonment, compound (staged) investments, and temporary shut-down and restart. Two-dimensional trees model the choice between correlated projects. Closed-form finite-horizon results (Black–Scholes–Merton, Margrabe's exchange option, and options on the maximum and minimum of two assets) serve as benchmarks. The final chapter covers switching between operating modes with switching costs and the resulting hysteresis. Every model comes with clear derivations, proofs in chapter appendices, replication tables, sensitivity analyses, and ready-to-run R code, so readers can reproduce every number and figure and adapt the models to their own problems. The book is written for graduate students, researchers and practitioners in finance and economics with a basic background in calculus and probability.