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Missed Opportunities: Optimal Investment Timing when Information is Costly

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  • Guthrie, Graeme

Abstract

Real options analysis typically assumes that projects are continuously evaluated and launched at precisely the time determined to be optimal. However real world projects cannot be managed in this way because of the costs of formally evaluating an investment opportunity. This paper analyzes how projects should be managed in such a world. Information about a project comes in two flavors: project-specific information which can only be observed if a fixed evaluation cost is incurred; and generic information which can be observed without cost. If sufficiently good generic information is observed during the period immediately after a project evaluation the firm will invest without any further evaluation. Beyond this period the firm will always reevaluate the project before investment. The availability of information and project evaluation costs affect the firm's optimal behavior in different ways: a higher evaluation cost means that the firm evaluates the project later (that is sets a higher evaluation threshold) but invests sooner (that is sets a lower investment threshold); a bigger role for project-specific information also induces the firm to set a lower investment threshold but it actually encourages the firm to evaluate the project sooner. The value of waiting is lower when more information is project-specific and when project evaluations are more costly. Standard real option models may therefore overestimate the value of investment timing flexibility. This misvaluation is especially severe when the value of the completed project is strongly mean reverting because then precision in investment timing is particularly important.

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  • Guthrie, Graeme, 2005. "Missed Opportunities: Optimal Investment Timing when Information is Costly," Working Paper Series 3990, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
  • Handle: RePEc:vuw:vuwcsr:3990
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    File URL: http://researcharchive.vuw.ac.nz/handle/10063/3990
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    References listed on IDEAS

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    1. Merton, Robert C, 1998. "Applications of Option-Pricing Theory: Twenty-Five Years Later," American Economic Review, American Economic Association, vol. 88(3), pages 323-349, June.
    2. Grenadier, Steven R. & Wang, Neng, 2005. "Investment timing, agency, and information," Journal of Financial Economics, Elsevier, vol. 75(3), pages 493-533, March.
    3. Tarun Sabarwal, 2005. "The non-neutrality of debt in investment timing: a new NPV rule," Annals of Finance, Springer, vol. 1(4), pages 433-445, October.
    4. Sarkar, Sudipto, 2003. "The effect of mean reversion on investment under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 377-396, November.
    5. Steven R. Grenadier, 2002. "Option Exercise Games: An Application to the Equilibrium Investment Strategies of Firms," Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 691-721.
    6. Paul Childs & Steven Ott & Timothy Riddiough, 2001. "Valuation and Information Acquisition Policy for Claims Written on Noisy Real Assets," Financial Management, Financial Management Association, vol. 30(2), Summer.
    7. Glenn W. Boyle & Graeme A. Guthrie, 2003. "Investment, Uncertainty, and Liquidity," Journal of Finance, American Finance Association, vol. 58(5), pages 2143-2166, October.
    8. John Conlisk, 1996. "Why Bounded Rationality?," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 669-700, June.
    9. Metcalf, Gilbert E. & Hassett, Kevin A., 1995. "Investment under alternative return assumptions Comparing random walks and mean reversion," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1471-1488, November.
    10. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
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