Optimal Investment, Growth Options and Security Returns
Posted: 2 Oct 1996
Date Written: November 1995
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: Suggested Citation