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Investment Under Uncertainty and Time-Inconsistent Preferences

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  • Steven R. Grenadier
  • Neng Wang

Abstract

The real options framework has been used extensively to analyze the timing of investment under uncertainty. While standard real options models assume that agents possess a constant rate of time preference, there is substantial evidence that agents are very impatient about choices in the short-term, but are quite patient when choosing between long-term alternatives. We extend the real options framework to model the investment timing decisions of entrepreneurs with such time-inconsistent preferences. Two opposing forces determine investment timing: while evolving uncertainty induces entrepreneurs to defer investment in order to take advantage of the option to wait, their time-inconsistent preferences motivate them to invest earlier in order to avoid the time-inconsistent behavior they will display in the future. We find that the precise trade-off between these two forces depends on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding their future time-inconsistent behavior, as well as whether the payoff from investment occurs all at once or over time. We extend the model to consider equilibrium investment behavior for an industry comprised of time-inconsistent entrepreneurs. Such an equilibrium involves the dual problem of entrepreneurs playing dynamic games against competitors as well as against their own future selves.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12042.

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Date of creation: Feb 2006
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Publication status: published as Grenadier, Steven and Neng Wang. “Investment under uncertainty and time-inconsistent preferences.’’ Journal of Financial Economics 84, 1 (2007): 2-39.
Handle: RePEc:nbr:nberwo:12042

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Cited by:
  1. Basak, Suleyman & Chabakauri, Georgy, 2009. "Dynamic Mean-Variance Asset Allocation," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7256, C.E.P.R. Discussion Papers.
  2. Hsiaw, Alice, 2013. "Goal-setting and self-control," Journal of Economic Theory, Elsevier, Elsevier, vol. 148(2), pages 601-626.
  3. Salois, Matthew J. & Moss, Charles B., 2011. "A direct test of hyperbolic discounting using market asset data," Economics Letters, Elsevier, Elsevier, vol. 112(3), pages 290-292, September.
  4. E. Agliardi & R. Andergassen, 2006. "Last Resort Gambles, Risky Debt and Liquidation Policy," Working Papers 577, Dipartimento Scienze Economiche, Universita' di Bologna.
  5. Jianjun Miao, 2008. "Option exercise with temptation," Economic Theory, Springer, Springer, vol. 34(3), pages 473-501, March.
  6. Wennberg, Karl & Wiklund, Johan & DeTienne, Dawn & Cardon, Melissa, 2009. "Reconceptualizing Entrepreneurial Exit: Divergent Exit Routes and Their Drivers," Working Paper Series in Business Administration, Stockholm School of Economics 2009:10, Stockholm School of Economics.
  7. Di Corato, Luca, 2011. "Optimal Conservation Policy under Imperfect Intergenerational Altruism," 2011 International Congress, August 30-September 2, 2011, Zurich, Switzerland, European Association of Agricultural Economists 114440, European Association of Agricultural Economists.
  8. Strebulaev, Ilya A. & Whited, Toni M., 2012. "Dynamic Models and Structural Estimation in Corporate Finance," Foundations and Trends(R) in Finance, now publishers, vol. 6(1–2), pages 1-163, November.
  9. Marín-Solano, Jesús & Navas, Jorge, 2010. "Consumption and portfolio rules for time-inconsistent investors," European Journal of Operational Research, Elsevier, Elsevier, vol. 201(3), pages 860-872, March.
  10. Tetsuya Yamada, 2010. "Accelerated Investment and Credit Risk under a Low Interest Rate Environment: A Real Options Approach," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, vol. 28, pages 181-214, November.
  11. Masaaki Kijima & Yuan Tian, 2013. "Investment and capital structure decisions under time-inconsistent preferences," KIER Working Papers 858, Kyoto University, Institute of Economic Research.
  12. Svetlana Boyarchenko & Sergei Levendorskii, 2005. "Discount factors ex post and ex ante, and discounted utility anomalies," Microeconomics, EconWPA 0510013, EconWPA, revised 17 Nov 2005.
  13. Schade, Christian & Snir, Avichai, 2012. "When the stress of quitting meets the cost of playing: An Experiment on to quit or not to quit?," Structural Change in Agriculture/Strukturwandel im Agrarsektor (SiAg) Working Papers, Humboldt University Berlin, Department of Agricultural Economics 134426, Humboldt University Berlin, Department of Agricultural Economics.

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