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Time to Build, Option Value, and Investment Decisions

32 Pages Posted: 27 Apr 2000  

Saman Majd

University of Pennsylvania Wharton School

Robert S. Pindyck

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Date Written: June 1985

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.

Suggested Citation

Majd, Saman and Pindyck, Robert S., Time to Build, Option Value, and Investment Decisions (June 1985). NBER Working Paper No. w1654. Available at SSRN: https://ssrn.com/abstract=227193

Saman Majd (Contact Author)

University of Pennsylvania Wharton School

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Robert S. Pindyck

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02139
United States
617-253-6641 (Phone)
617-258-6855 (Fax)

HOME PAGE: http://web.mit.edu/rpindyck/www/

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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