Working Paper: NBER ID: w1019
Authors: Robert L. McDonald; Daniel Siegel
Abstract: This paper studies the optimal timing of investment in an irreversible project where the benefits from the project and the investment cost follow continuous-time stochastic processes. The optimal time to invest and an explicit formula for the value of the option to invest are derived. The rule "invest if benefits exceed costs" does not properly account for the option value of waiting.Simulations show that this option value can be significant, and that for surprisingly reasonable parameter values it may be optimal to wait until benefits are twice the investment cost. Finally, we perform comparative static analysis on the valuation formula and on the rule for when to invest.
Keywords: investment timing; option value; stochastic processes; irreversible projects
JEL Codes: D81; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| present value of benefits (v) (J17) | investment decision (G11) |
| fixed investment cost (f) (G31) | investment decision (G11) |
| variance of future benefits = 0 (J32) | traditional investment rule validity (G11) |
| expected growth rate extremely negative (O40) | traditional investment rule validity (G11) |
| present value of benefits (v) = 2 * fixed investment cost (f) (G31) | timing of investment (G11) |
| variability of future benefits (J32) | value of investment opportunity (G11) |
| variability of future benefits (J32) | threshold for optimal investment (G11) |
| risk-free rate (G12) | value of investment opportunity (G11) |
| risk-free rate (G12) | threshold for optimal investment (G11) |
| probability of present value of benefits jumping to zero (J17) | investment decision (G11) |
| probability of present value of benefits jumping to zero (J17) | risk-free rate effect (E43) |