An Investment Criterion Incorporating Real Options

Communications and Strategies, No. 70, 2008

22 Pages Posted: 6 Mar 2009

See all articles by Hirofumi Suto

Hirofumi Suto

affiliation not provided to SSRN

James Alleman

University of Colorado at Boulder - College of Engineering and Applied Science

Paul Rappoport

Temple University - Department of Economics

Date Written: March 6, 2009

Abstract

Investment in infrastructure such as the information and communication technology sector requires large, substantial amounts, most of which are sunk or irreversible. Uncertainty of market demand, competition, costs and public policy complicates the investment decision process. This paper provides an investment decision-making criterion under uncertainty using (deferred) real options methodology to evaluate if an investment should be made immediately, cautiously, deferred (wait-and-watch), or foregone. A decision-making index d is developed, which is equal to the expectation of net present value (NPV) normalized by its standard deviation. Under a lognormal assumption of the distribution of NPV discounted by risk-free rate, we find the "break-even point" at which the NPV equals the real option value (ROV): d = D* = 0.276. Using the absolute value of D*, one can make sophisticated decisions considering opportunity losses. This new decision index, d, provides a criterion to make investment decisions to capture underlying uncertainty. When making a decision, a manager only has to observe three parameters: expectation of future cash flow, its uncertainty as measured by its standard deviation, and the magnitude of investment. We discuss examples using this criterion and show its value. The criterion is particularly useful when NPV lies near zero or uncertainty is large.

Keywords: Real Options, Decision, Investment, Economic Methodology; Statistical Decision Theory, Criteria for Decision-Making under Risk and Uncertainty.

JEL Classification: B41,C1,D81,E22

Suggested Citation

Suto, Hirofumi and Alleman, James H. and Rappoport, Paul, An Investment Criterion Incorporating Real Options (March 6, 2009). Communications and Strategies, No. 70, 2008. Available at SSRN: https://ssrn.com/abstract=1354570

Hirofumi Suto

affiliation not provided to SSRN

James H. Alleman (Contact Author)

University of Colorado at Boulder - College of Engineering and Applied Science ( email )

CO
United States

Paul Rappoport

Temple University - Department of Economics ( email )

Philadelphia, PA 19122
United States

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