Real Options, Irreversible Investment and Firm Uncertainty: New Evidence from U.S. Firms

45 Pages Posted: 15 Sep 2005 Last revised: 20 Nov 2009

Date Written: March 2005

Abstract

This paper investigates real options behavior in capital budgeting decisions using a firm-level panel data set of U.S. companies in the manufacturing sector. Specifically, this paper looks are the relationship between the firm's investment to capital ratio and total firm uncertainty, measured as the volatility of the firm's equity returns. Total firm uncertainty is decomposed into its market, industry and firm-specific components. Given that the irreversibility of capital is derived from asset-specificity at the industry level, increased industry uncertainty displays a pronounced negative effect on firm investment consistent with real options behavior. Increased firm-specific uncertainty is also found to depress firm investment - a result that can be attributed to real options behavior and not just managerial risk aversion. The results are robust to various specifications that control for the firm's investment opportunities that are captured by Tobin's q, cash flow, marginal profitability of capital and firm leverage.

Keywords: Real Options, Irreversible Investment, Uncertainty

JEL Classification: G31, D81, E22

Suggested Citation

Bulan, Laarni Tobia, Real Options, Irreversible Investment and Firm Uncertainty: New Evidence from U.S. Firms (March 2005). Review of Financial Economics, Special Issue on Real Options,Vol.14, pp. 255-279, 2005, Available at SSRN: https://ssrn.com/abstract=800534 or http://dx.doi.org/10.2139/ssrn.293152

Laarni Tobia Bulan (Contact Author)

Cornerstone Research ( email )

Boston, MA
United States

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