On Irreversible Investment and Discounting: An Arbitrage Pricing Approach
23 Pages Posted: 28 Jan 2008 Last revised: 31 Mar 2008
This paper presents a unified approach to valuing investment projects under uncertainty, based on stochastic discount factors, by linking optimal stopping theory to the no-arbitrage principle in asset pricing. An investment threshold for the case where the discount factor and the project's cash-flow both follow a geometric Brownian motion is derived. Comparative statics of the investment trigger are obtained adding to and clarifying on the uncertainty - investment debate. Finally, three different ways are illustrated to obtain discount factors: no-arbitrage, CAPM, and representative agent analysis. The link between the characteristics of these different approaches and the optimal investment policy is studied.
Keywords: Real options, Discount factors
JEL Classification: G31
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