Hostname: page-component-586b7cd67f-t8hqh Total loading time: 0 Render date: 2024-11-26T04:02:40.776Z Has data issue: false hasContentIssue false
  • English
  • Français

Option Value, Uncertainty, and the Investment Decision

Published online by Cambridge University Press:  06 April 2009

Eugene Kandel  and
Neil D. Pearson
Eugene Kandel
Affiliation:
[email protected], Graduate School of Business and Department of Economics, Hebrew University, Mount Scopus, Jerusalem, Israel
Neil D. Pearson
Affiliation:
[email protected], University of Illinois, Department of Finance, 1206 South Sixth Street, Champaign, IL 61820.
Get access Rights & Permissions [Opens in a new window]

Abstract

The options-based approach to studying irreversible investment under uncertainty emphasizes that the opportunity cost of investment includes the value of the option to wait that is extinguished when an investment is undertaken. Thus, the investment decision is affected by the determinants of the value of this option. We extend and generalize a standard model of irreversible investment by introducing a second fully reversible technology, and also incorporate partial reversibility by allowing capital to be abandoned at a cost. As in the existing literature, we find that the threshold value of the “underlying asset” (in our case, demand) at which investment takes place is increasing in the uncertainty of demand. We also find that the value of the option and thus the threshold value of the option value multiple at which investment takes place may be either increasing or decreasing in the uncertainty of demand. In addition, we find that for the case in which capital is used to replace the reversible technology, the threshold value of the option value multiple is insensitive to the degree of reversibility of capital.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 37 , Issue 3 , September 2002 , pp. 341 - 374
Copyright
Copyright © School of Business Administration, University of Washington 2002

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Abel, A. B.; Dixit, A. K.; Eberly, J. C.; and Pindyck, R. S.. “Options, the Value of Capital, and Investment.” Quarterly Journal of Economics, 111 (1996), 755–777.CrossRefGoogle Scholar
Abel, A. B., and Eberly, J. C.. “Optimal Investment with Costly Reversibility.” Review of Economic Studies, 63 (1996), 581–593.CrossRefGoogle Scholar
Bar-Ilan, A., and Strange, W. C.. “Investment Lags.” American Economic Review, 86 (1996), 610–621.Google Scholar
Abel, A. B., and Strange, W. C.. “A Model of Sequential Investment.” Journal of Economic Dynamics and Control, 22 (1998), 437–463.Google Scholar
Berger, P. G.; Ofek, E.; and Swary, I.. “Investor Valuation of the Abandonment Option.” Journal of Financial Economics, 42 (1996), 257–287.CrossRefGoogle Scholar
Bodie, Z., and Rosansky, V.. “Risk and Return in Commodity Futures.” Financial Analysts Journal, 36 (1980), 27–40.CrossRefGoogle Scholar
Brealey, R., and Myers, S. C.. Principles of Corporate Finance. 4th ed. New York, NY: McGraw-Hill (1991).Google Scholar
Brennan, M., and Schwartz, E.. “Evaluating Natural Resource Investments.” Journal of Business, 58 (1985), 135–157.CrossRefGoogle Scholar
Caballero, R. J., and Pindyck, R. S.. “Uncertainty, Investment, and Industry Evolution.” International Economic Review, 37 (1996), 641–662.CrossRefGoogle Scholar
Dixit, A. K., and Pindyck, R. S.. Investment under Uncertainty. Princeton, NJ: Princeton Univ. Press (1994).CrossRefGoogle Scholar
Farzin, Y. H.; Huisman, K. J. M.; and Kort, P. M.. “Optimal Timing of Technology Adoption.” Journal of Economic Dynamics and Control, 22 (1998), 779–799.CrossRefGoogle Scholar
Ghosal, V., and Loungani, P.. “Product Market Competition and the Impact of Price Uncertainty on Investment: Some Evidence from U.S. Manufacturing Industries.” Journal of Industrial Economics, 44 (1996), 217–228.CrossRefGoogle Scholar
Hubbard, G. “Investment under Uncertainty.” Journal of Economic Literature, 32 (1994), 1816–1831.Google Scholar
Ingersoll, J., and Ross, S. A.. “Waiting to Invest: Investment and Uncertainty.” Journal of Business, 65 (1992), 1–29.CrossRefGoogle Scholar
Kandel, E., and Pearson, N. D.. “Flexibility versus Commitment in Personnel Management.” Journal of the Japanese and International Economies, 15 (2001), 515–556.CrossRefGoogle Scholar
Leahy, J. V., and Whited, T. M.. “The Effect of Uncertainty on Investment: Some Stylized Facts.” Journal of Money, Credit, and Banking, 28 (1996), 64–83.CrossRefGoogle Scholar
McDonald, R., and Siegel, D.. “Investment and the Valuation of Firms when There is an Option to Shut Down.” International Economic Review, 26 (1985), 331–349.CrossRefGoogle Scholar
McDonald, R., and Siegel, D.. “The Value of Waiting to Invest.” Quarterly Journal of Economics, 101 (1986), 707–727.CrossRefGoogle Scholar
Majd, S., and Pindyck, R.. “Time to Build, Option Value, and Investment Decisions.” Journal of Financial Economics, 18 (1987), 7–27.CrossRefGoogle Scholar
Maoz, Y. “A Comment on Investment Lags.” Working Paper, Hebrew Univ. of Jerusalem (1998).Google Scholar
Merton, R. C. “An Intertemporal Capital Asset Pricing Model.” Econometrica, 41 (1973), 867–887.CrossRefGoogle Scholar
Myers, S. C., and Majd, S.. “Abandonment Value and Project Life.” Advances in Futures and Options Research, 4 (1990), 1–21.Google Scholar
Pindyck, R. “Irreversible Investment, Capacity Choice and the Value of the Firm.” American Economic Review, 78 (1988), 969–985.Google Scholar
Pindyck, R. “Irreversibility, Uncertainty, and Investment.” Journal of Economic Literature, 29 (1991), 1110–1148.Google Scholar
Pindyck, R. S., and Solimano, A.. “Economic Instability and Aggregate Investment.” National Bureau of Economic Research Macroeconomic Annual, 8 (1993), 259–302.Google Scholar
Titman, S. “Land Prices under Uncertainty.” American Economic Review, 75 (1985), 505–514.Google Scholar
Trigeorgis, L. “Real Options and Interactions with Financial Flexibility.” Financial Management, 22 (1993), 202–224.CrossRefGoogle Scholar
Trigeorgis, L.Real Options: Managerial Strategy and Flexibility in Resource Allocation. Cambridge, MA: MIT Press (1996).Google Scholar