Investment Decisions for Mutually Exclusive Projects: An Options Framework
Posted: 24 Aug 1998
This paper uses an option pricing framework to determine the optimal investment policy for a firm that can select from multiple projects with mutually exclusive payoffs. We develop a multi-period model in which a firm may invest in the early development phases of several projects, and then select a single project. Such a situation is typical for firms in R&D-intensive industries. The optimal investment policy involves a choice between two strategies, sequential development and parallel development. For sequential development the firm identifies primary and secondary projects. The primary project is developed first. Upon completion of the development stage of the first project, a development decision is made on the secondary project. Alternatively, for parallel development, the firm simultaneously develops both projects, then chooses the best project to implement. In both cases, resolution of uncertainty about the values of the projects takes place through project development. We find that parallel development is optimal for projects that have uncorrelated benefits, high levels of uncertainty, are low in cost, require long periods of development, and are likely to generate high cash flows when implemented. Sequential development is optimal for projects with highly positively or highly negatively correlated benefits since investment in one project can provide valuable information about the uncompleted projects and aid in further investment decisions. Sequential development is also desirable for projects that require a large commitment of capital to begin development and are short-term in nature. We also show that the optimal ordering of sequential projects does not always begin with the most profitable project.
JEL Classification: G31
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