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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:
mskandel@mscc.huji.ac.il, Graduate School of Business and Department of Economics, Hebrew University, Mount Scopus, Jerusalem, Israel
Neil D. Pearson
Affiliation:
pearson2@uiuc.edu, University of Illinois, Department of Finance, 1206 South Sixth Street, Champaign, IL 61820.
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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

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