An Analytical Theory of Project Investment: A Comparison with Real Option Theory
15 Pages Posted: 11 Nov 2002
Date Written: June 2003
Abstract
The real option theory offers great insights about project investment by capturing its analogy with financial options. However, at present, most articles on this subject either use stylized numerical examples or adopt a purely conceptual approach to describe how option pricing can be used in capital budgeting. In this work, we observe a fundamental difference between the problems of project investment and financial option, that project investment is a forward problem while option pricing is a backward problem. From this simple observation, we develop an analytical theory of project investment, which, for the first time in economic literature, provides an analytic formula that explicitly represents the relation among fixed costs, variable costs, uncertainty of the environment and the duration of a project, which is the core concern in most business projects and other economic decisions. While empirical research has lagged considerably behind the conceptual and theoretical contributions in the real option framework, this analytical theory captures the universal empirical regularity uncovered in many different fields.
Note: Previously Entitled: An Analytical Theory of Project Investment
Keywords: analytical theory, project investment, real option
JEL Classification: C00
Suggested Citation: Suggested Citation
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