Embedding a net present value analysis into a binomial tree with a real option analysis

A net present value (NPV) analysis with associated financial statements is embedded into a binomial tree that allows the analysis to evolve through time and, at any given moment in time, to vary with different states of the world. The modeling of the cash flows within the binomial tree requires a variable component based on relationships with a specifically defined random variable and a component that is fixed at a given moment in time. Although after‐tax operating cash flows are used in this treatment with a real options example, the binomial tree method can be applied to other definitions of project cash flows.