Introducing a real option framework for EVA/MVA analysis

Abstract

The importance of including real option analysis (ROA) in traditional net present value (NPV) analysis has been demonstrated in the literature: ROA values the flexibility to defer, expand, contract, or abandon an investment project, allowing for dynamic decision making. However, methods to apply ROA for firms that utilize economic value added (EVA) and market value added (MVA) for project valuation purposes are not available. This article presents a novel framework that allows for an EVA/MVA analysis to be incorporated into a binomial tree option pricing model. This new EVA/MVA-embedded binomial tree framework not only allows for the consideration of real managerial options within EVA/MVA analysis but also demonstrates its equivalence to the traditional ROA used to adjust NPV. The benefits of this development are that EVA/MVA with an embedded binomial tree is deemed to be an equally valid and robust technique to traditional NPV analysis as opposed to simply being viewed as an alternative or competing measure of project value. This further validates the choice of some firms’ use of EVA/MVA and shows that strategic ROA can be incorporated into corporate decision making.

Acknowledgement

This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors. We thank the editor and anonymous referees for helpful comments.

Additional information

Notes on contributors

Tom Arnold

Tom Arnold has a Ph.D. from the University of Georgia and is the Joseph A. Jennings Chair in Business at the University of Richmond. He currently teaches corporate finance topics and investment topics at the undergraduate and MBA levels. He researches in the areas of real options, derivative securities, finance pedagogy, and retirement planning.

Timothy Falcon Crack

Timothy Falcon Crack is a Professor Emeritus at Otago University. He previously taught undergraduate, MBA, and Ph.D. courses at Indiana University’s Kelley School of Business. He did Ph.D. coursework at MIT and Harvard and graduated with a Ph.D. in Financial Economics from MIT. He has worked as an independent consultant to the New York Stock Exchange and as the head of quantitative active equity research for the UK and Continental Europe in the London office of what was the world’s largest institutional asset manager.

Cassandra D. Marshall

Cassandra Marshall is an Associate Professor of Finance at the Robins School of Business at the University of Richmond. She received a Ph.D. and M.B. in Finance from Indiana University’s Kelley School of Business. She also holds a B.S. with majors in Finance and Economics from Western Kentucky University. She currently teaches courses in Corporate Finance to undergraduates and MBA students at the University of Richmond.

Adam Schwartz

Adam Schwartz was the Holmes Professor of Management at the Freeman College of Management prior to his untimely passing in 2020. He has a Ph.D. from the University of Georgia and held academic positions at the University of Miami, University of Mississippi, and Washington and Lee University. His research and teaching were primarily focused in the areas of derivative securities and portfolio management.