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Time to Build, Option Value, and Investment Decisions

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Author Info
Saman Majd
Robert S. Pindyck

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Abstract

Many investment projects have the following characteristics: (i) spending decisions and cash outlays occur sequentially over time, (ii) there is a maximum rate at which outlays and construction can proceed -- it takes "time to build," and (iii) the project yields no cash return until it is actually completed. Furthermore, the pattern of investment outlays is usually flexible,and can be adjusted as new information arrives. For such projects traditional discounted cash flow criteria, which treat the spending pattern as fixed, are inadequate as a guide for project evaluation. This paper develops an explicit model of investment projects with these characteristics, and uses option pricing methods to derive optimal decision rules for investment outlays over the entire construction program. Numerical solutions are used to demonstrate how time to build, opportunity cost, and uncertainty interact in affecting the investment decision. We show that with moderate levels of uncertainty over the future value of the completed project, a simple NPV rule could lead to gross over-investment. Also, we show how the contingent nature of the investment program magnifies the depressive effect of increased uncertainty on investment spending.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1654.

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Date of creation: Aug 1987
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Handle: RePEc:nbr:nberwo:1654

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Stanley Fischer & Robert C. Merton, 1985. "Macroeconomics and Finance: The Role of the Stock Market," NBER Working Papers 1291, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, vol. 5(2), pages 241-249, November. [Downloadable!] (restricted)
  3. James M. Poterba & Lawrence H. Summers, 1984. "The Persistence of Volatility and Stock Market Fluctuations," Working papers 353, Massachusetts Institute of Technology (MIT), Department of Economics.
    Other versions:
  4. Cukierman, Alex, 1980. "The Effects of Uncertainty on Investment under Risk Neutrality with Endogenous Information," Journal of Political Economy, University of Chicago Press, vol. 88(3), pages 462-75, June. [Downloadable!] (restricted)
  5. Roberts, Kevin & Weitzman, Martin L, 1981. "Funding Criteria for Research, Development, and Exploration Projects," Econometrica, Econometric Society, vol. 49(5), pages 1261-88, September. [Downloadable!] (restricted)
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  6. Myers, Stewart C. & Majd, Saman., 1983. "Calculating abandonment value using option pricing theory," Working papers 1462-83., Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
  7. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring. [Downloadable!] (restricted)
  8. Robert McDonald & Daniel R. Siegel, 1982. "Investment and the Valuation of Firms When There is an Option to Shut Down," Discussion Papers 529S, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
  9. Geske, Robert & Shastri, Kuldeep, 1985. "Valuation by Approximation: A Comparison of Alternative Option Valuation Techniques," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(01), pages 45-71, March. [Downloadable!]
  10. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166. [Downloadable!] (restricted)
  11. Brennan, Michael J. & Schwartz, Eduardo S., 1978. "Finite Difference Methods and Jump Processes Arising in the Pricing of Contingent Claims: A Synthesis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(03), pages 461-474, September. [Downloadable!]
  12. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April. [Downloadable!] (restricted)
  13. Arrow, Kenneth J & Fisher, Anthony C, 1974. "Environmental Preservation, Uncertainty, and Irreversibility," The Quarterly Journal of Economics, MIT Press, vol. 88(2), pages 312-19, May. [Downloadable!] (restricted)
  14. Martin L. Weitzman & Whitney Newey & Michael Rabin, 1981. "Sequential R&D Strategy for Synfuels," Bell Journal of Economics, The RAND Corporation, vol. 12(2), pages 574-590, Autumn. [Downloadable!] (restricted)
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