Optimal Investment, Growth Options and Security Returns

Posted: 2 Oct 1996

See all articles by Jonathan Berk

Jonathan Berk

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business

Vasant Naik

Lehman Brothers International, Europe

Multiple version iconThere are 3 versions of this paper

Date Written: November 1995

Abstract

We develop a dynamic model of investment at the firm level in order to better understand the behavior of equity returns. Each period the firm has an option to invest. Past investment decisions account for the firm's existing asset base, which is assumed to depreciate. The value of a firm is then derived as the value of its existing assets plus the present value of a series of options to invest in such assets in the future, the firm's growth opportunities. As a consequence of its investment decisions, the firm's asset base and its relative systematic risk change in predictable ways. In addition, the value of future growth options depends on interest rates. Together, these effects govern the predictable variation in returns through time, and determine the cross section of expected returns at a given point in time. An explicit and testable expression for the firm's expected return is derived. Expected returns in the model are linear in book-to-market, consistent with existing evidence regarding their cross sectional properties. They also accommodate the contrarian patterns and dependence on current interest rates that have been documented in time series.

JEL Classification: G12, G31 E22

Suggested Citation

Berk, Jonathan B. and Green, Richard C. and Naik, Vasant, Optimal Investment, Growth Options and Security Returns (November 1995). Available at SSRN: https://ssrn.com/abstract=7776

Jonathan B. Berk (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Richard C. Green

Carnegie Mellon University - David A. Tepper School of Business ( email )

315B Schenley Park
Pittsburgh, PA 15213-3890
United States
412-268-2302 (Phone)
412-268-7064 (Fax)

Vasant Naik

Lehman Brothers International, Europe ( email )

25 Bank Street
30th Floor
London E14 5LE
England

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