Practical guide to real options in discrete time II

This paper is an extended version of the paper 'Practical Guide to Real Options in Discrete Time' (http://econwpa.wustl.edu:80/eps/fin/papers/0405/0405016.pdf), where a general, computationally simple approach to real options in discrete time was suggested. We explicitly formulate conditions of the general theorems for basic types of real options, and explain our method in detail for the case of transition density given by exponential functions on each half-axis. To demonstrate that the discrete time approach can be more analytically tractable than the continuous time one, we consider timing of investment with lags, and a model of gradual capital expansion. We obtain simple formulas for the expected values of capital stock in every time period; in continuous time models, a much more sophisticated technique is needed.