In this article, we apply real options theory and modern capital budgeting to the problem of valuing an Internet company. We formulate the model in continuous time, form a discrete time approximation, estimate the model parameters, solve the model by simulation, and then perform sensitivity analysis. Depending on the parameters chosen, we find that the value of an Internet stock may be rational given high enough growth rates in revenues. Even with a very real chance that a firm may go bankrupt, if the initial growth rates are sufficiently high, and if there is enough volatility in this growth rate over time, then valuations can be what would otherwise appear to be dramatically high.
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