Working Paper: NBER ID: w1654
Authors: Saman Majd; Robert S. Pindyck
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.
Keywords: Investment Decisions; Option Value; Uncertainty; Time to Build
JEL Codes: D92; G31; O32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty (D89) | Investment Spending (G31) |
| Time to Build + Uncertainty (D84) | Investment Decisions (G11) |
| Increased Uncertainty (D89) | Delay in Investment (G31) |
| Flexibility of Investment Outlays + Increased Uncertainty (G31) | Depressive Effect on Investment Spending (E20) |
| Moderate Levels of Uncertainty (D80) | Gross Overinvestment (E22) |