Missed Opportunities: Optimal Investment Timing When Information is Costly
27 Pages Posted: 15 Aug 2005
Date Written: August 2005
Real options analysis typically assumes that projects are continuously evaluated and launched at precisely the time determined to be optimal. However, real world projects cannot be managed in this way because of the costs of formally evaluating an investment opportunity. This paper analyzes how projects should be managed in such a world. Information about a project comes in two flavors: project-specific information, which can only be observed if a fixed evaluation cost is incurred; and generic information, which can be observed without cost. If sufficiently good generic information is observed during the period immediately after a project evaluation, the firm will invest without any further evaluation. Beyond this period, the firm will always reevaluate the project before investment. The availability of information and project evaluation costs affect the firm's optimal behavior in different ways: a higher evaluation cost means that the firm evaluates the project later (that is, sets a higher evaluation threshold) but invests sooner (that is, sets a lower investment threshold); a bigger role for project-specific information also induces the firm to set a lower investment threshold, but it actually encourages the firm to evaluate the project sooner. The value of waiting is lower when more information is project-specific and when project evaluations are more costly. Standard real option models may therefore overestimate the value of investment timing flexibility. This misvaluation is especially severe when the value of the completed project is strongly mean reverting, because then precision in investment timing is particularly important.
Keywords: real options, incomplete information, capital budgeting
JEL Classification: G31, D81
Suggested Citation: Suggested Citation