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Incentives and the Communication Role of a Real Option

By Brian Mittendorf

Abstract

In the face of uncertainty, firms often place a premium on flexibility. By keeping their options open, firms are able to adjust decisions as uncertainty is resolved. Valuing this benefit of flexible projects is the focus of the real options approach to capital budgeting. This paper presents an incentive consideration in the real option valuation approach. Flexibility not only allows a firm to change course in response to new information, but it also allows interested observers to make inferences based on the change in course. Conveying information through real options can distort observers' incentives and thus alter the value of having flexibility in the first place.

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