Option value, uncertainty, and the investment decision

Eugene Kandel, Neil D. Pearson

Research output: Contribution to journalArticlepeer-review

33 Scopus citations

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.

Original languageAmerican English
Pages (from-to)341-374
Number of pages34
JournalJournal of Financial and Quantitative Analysis
Volume37
Issue number3
DOIs
StatePublished - 2002

Bibliographical note

Funding Information:
Kandel, [email protected], Graduate School of Business and Department of Economics, Hebrew University, Mount Scopus, Jerusalem, Israel; and Pearson, [email protected], University of Illinois, Department of Finance, 1206 South Sixth Street, Champaign, IL 61820. We thank Andrew Abel, Janice Eberly, Craig Holden, Yishay Maoz, Robert Pindyck, and seminar participants at Hebrew University, Tel Aviv University, University of Arizona, University of Texas at Austin, and the Indiana University/University of Illinois joint seminar for helpful comments. Kandel thanks the Krueger Center for Finance Research at Hebrew University for financial support.

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