Investment Decisions for Mutually Exclusive Projects: An Options Framework

Posted: 24 Aug 1998

See all articles by Paul D. Childs

Paul D. Childs

University of Kentucky

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Alexander J. Triantis

Johns Hopkins University - Carey Business School; University of Maryland - Robert H. Smith School of Business

Abstract

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

Suggested Citation

Childs, Paul David and Ott, Steven H. and Triantis, Alexander J., Investment Decisions for Mutually Exclusive Projects: An Options Framework. Available at SSRN: https://ssrn.com/abstract=6614

Paul David Childs

University of Kentucky ( email )

College of Business & Economics
Lexington, KY 40506-0034
United States
606-257-2490 (Phone)
606-257-9688 (Fax)

Steven H. Ott (Contact Author)

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704-687-2744 (Phone)
704-687-6987 (Fax)

Alexander J. Triantis

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

University of Maryland - Robert H. Smith School of Business ( email )

Department of Finance
College Park, MD 20742-1815
United States
301-405-2246 (Phone)
301-314-9157 (Fax)

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