Payback period and Internal Rate of Return in Real Options Analysis

We propose a new method to compute payback period (PBP) and internal rate of return (IRR) in the presence of real options. We extend the Kulatilaka–Trigeorgis general model of real options to derive the expected value of these two decision rules in the presence of the options to wait, to mothball, and to abandon. This new method is applied to a numerical example in shipping finance.We quantify the value enhancing and downside risk decreasing properties of real options with respect to IRR and PBP. We show how the choice of independent projects with these decision rules— but without real options—may induce respectively underinvestment and overinvestment, while their figures are consistent with expanded NPV if computed in the presence of real options. Finally, we gain some insight into the actual dynamic programming behavior endogenous to real options valuation.