Capital Budgeting with Uncertain Future Opportunities: A Markovian Approach

The importance of an explicit consideration of uncertainty in evaluating the economic desirability of investment propositions is generally recognized in contemporary literature on capital budgeting. The emphasis has been on analyzing the effects of uncertainty of future cash-flows which result from an investment on the economic desirability of that investment. However, although future cash-flows are one important source of uncertainty, it should be recognized that other factors may contribute to uncertainty in a significant way. Uncertainty regarding alternate future investment opportunities is of obvious importance in the capital budgeting context. Thus, an investor who makes the best possible investment decision at a given point in time may deplore such a decision a short time afterward simply because his commitment prevents him from exploiting a better opportunity. While it might be assumed implicitly that an investor, in considering his alternatives, ought to include in such deliberations all the courses of action that may become available in the future, this aspect seems important enough to warrant explicit attention.