Technical Note: Waiting Cost Models for Real Options

Abstract

When real options are used to estimate the value of delaying an engineering project, it is necessary to consider the cash flows or project benefits that are lost due to the delay. This note describes various models of these cash flows and surveys previous TEE articles to see which are used and how often delay costs are ignored. The first model considered is based on the lost dividends Black-Scholes model for financial options, which is one of the most common models used in real options even though it does not explicitly consider cash flows. More realistic scenarios include the loss of initial cash flows, delays in starting to receive the same number of cash flows, loss of cash flows at the project horizon, and permanent loss of market share. The outcomes are compared with the often unrealistic case of omitting these delay costs. We assert that the common omission of waiting costs is rarely appropriate and offer models that better capture the costs of delaying real projects.