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A Real Option Model with Uncertain, Sequential Investment and with Time to Build

Author

Listed:
  • Guilherme B. Martins

    (Columbia University)

  • Marcos Eugênio da Silva

    (FEA/USP)

Abstract

This article develops a real option model with uncertain and sequential investment and with time to build. The model includes options to entry and to exit the activity and addresses the maximization problem of a company in view of the investment opportunity. The differential equation of the asset is obtained by using dynamic programming and risk neutral evaluation. Particularly, for the construction period, the differential equation is partial and elliptical, which demands the use of numeric methods. The main results of the article are that (i) with uncertain and sequential investment and with time to build, the waiting value, which creates a gap between the investment decision rule based on NPV and that based on a real option model, may not very significant and (ii) the increase in uncertainty may anticipate the decision to investment.

Suggested Citation

  • Guilherme B. Martins & Marcos Eugênio da Silva, 2005. "A Real Option Model with Uncertain, Sequential Investment and with Time to Build," Brazilian Review of Finance, Brazilian Society of Finance, vol. 3(2), pages 141-172.
    • Handle: RePEc:brf:journl:v:3:y:2005:i:2:p:141-172
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    References listed on IDEAS

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    11. Avinash Dixit, 1992. "Investment and Hysteresis," Journal of Economic Perspectives, American Economic Association, vol. 6(1), pages 107-132, Winter.
    12. McDonald, Robert & Siegel, Daniel, 1984. "Option Pricing When the Underlying Asset Earns a Below-Equilibrium Rate of Return: A Note," Journal of Finance, American Finance Association, vol. 39(1), pages 261-265, March.
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    More about this item

    Keywords

    investment under uncertainty; real options; sequential investment; tme to build; elliptical partial differential equations; numercial methods;
    All these keywords.

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity

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