The effect of uncertainty on investment timing in a real options model

This paper examines the effect of uncertainty on investment timing in a canonical real options model. We show that the critical value of a project that triggers the exercise of the investment option exhibits a U-shaped pattern against the volatility of the project. This is due to the two countervailing risk and return factors in effect. We further show that such a U-shaped pattern is inherited by the expected time to exercise the investment option. Thus, for relatively safe projects, greater uncertainty shortens the expected exercise time and thus enhances investment. This is in sharp contrast to the negative investment-uncertainty relationship commonly found in the extant literature. Finally, we show that the positive investment-uncertainty relationship is more likely for high growth projects than for low growth projects. © 2006 Elsevier B.V. All rights reserved.postprin

On the Investment-Uncertainty Relationship: A Game Theoretic Real Option Approach

This paper examines the effect of uncertainty on investment timing in a game theoretical real option model. We extend the settings of Gryglewicz et al. (2008), Wong (2007), and Sarkar (2000) by a more general assumption, i.e. the investment is also influenced by the actions of a second player. The results show that a U-shaped investment-uncertainty relationship generally sustains. However, timing of an investment occurs inefficiently late. Moreover, we show that the influence of uncertainty on the associated first-mover advantage becomes ambiguous, too

Financial innovation, strategic real options and endogenous competition : theory and an application to Internet banking

Innovations in financial services continuously influence the scope of financial intermediation and the nature of competition between intermediaries. This paper examines the optimal exercise of strategic real options to invest in such an innovation, Internet banking technology, within a two-stage game, parameterized by the distribution of bank size and uncertainty over the profitability of investment, and empirically tests the results on a novel data set. Unlike traditional options, in which the distribution of the future value of the underlying asset is exogenous and the timing of exercise affects only the return to the option holder, the timing of the exercise of real options in a strategic context allows the option holder to manipulate the distribution of returns to all players. The value of the strategic investment option in our model, as a consequence, depends on both expected future profits as well as the variance of those profits. Expected profits to an entrant depend, in equilibrium, on its size, as measured by existing market share (concentration) or total assets, relative to its rivals. Conditional on the degree of uncertainty, larger banks should, as a consequence, exercise their options earlier than smaller banks, for purely strategic advantages, and act as market leaders in the provision of Internet banking services. Like ordinary options, however, the value of the strategic investment option to both large and small banks increases in uncertainty, implying that early exercise will be more likely the more information is available about potential demand. We test these hypotheses on investment in Internet banking services with data from a sample of 1,618 commercial banks in the tenth Federal Reserve District during 1999. Evidence indicates that relative bank size, as measured by either market share or asset size, positively influences the likelihood of entry into Internet banking, and trend-adjusted variation in income per person (a proxy for uncertainty of demand) negatively influences the likelihood of entry into Internet banking. In addition, market concentration of a bank's competitive rivals has a negative relationship with the likelihood of entering the market for Internet banking services. These relations are evident in both bivariate analysis and in multivariate logit regression analysis.Competition ; Internet ; Internet banking

Real options in franchising

In der vorliegenden Diplomarbeit wird der Realoptionsansatz auf Franchising übertragen. Der Realoptionsansatz, welcher seinen Ursprung in der Finanzoptionstheorie hat, beinhaltet einen essentiellen Vorteil: die Integration von Unsicherheit in das strategische Model. Hierbei ist nicht die Unsicherheit per se das wertsteigernde Element für ein Unternehmen, sondern vielmehr die Erkenntnis, dass Unsicherheit verbunden ist mit der Möglichkeit auf Flexibilität. Eine Option ist definiert als das Recht, und nicht die Pflicht, einen bestimmten Posten beziehungsweise Vermögenswert zu kaufen oder zu verkaufen, an einem oder vor einem im Voraus bestimmten Zeitpunkt, zu ex ante spezifizierten Konditionen. Der Optionsinhaber profitiert von der Möglichkeit flexibel entscheiden zu können. Die der Option zugrundeliegende Anlage stellt bei Realoptionen, im Gegensatz zu Finanzoptionen, ein potentielles physisches oder intellektuelles Investment dar. In Anlehnung an bereits durchgeführte Forschungen, Joint Ventures betreffend, wird Franchising als eine Form von sequentiellem Markeintritt gesehen, und repräsentiert somit eine Realoption zu Expandieren bzw. zu Wachsen. Die Realoptionsklausel schreibt das Recht auf die Option fest und ist ein Instrument zur Sicherung des Anspruches auf zukünftige Möglichkeiten. In Bezug auf die Realoptionstheorie repräsentieren Optionsklauseln vertraglich aufgezeichnete Vereinbarungen der beiden Franchising Partner. Das Auftreten oder Fehlen von Optionsklauseln in Franchising Verträgen könnte sowohl Hinweise auf die Absichten der Vertragspartner geben, als auch Auswirkungen auf die Motivation der Partner haben. Die Ergebnisse zeigen eine negative Beziehung zwischen der Wahrscheinlichkeit der Verwendung einer Optionsklausel und der wahrgenommenen umweltbedingten Unsicherheit. Der Realoptionsansatz scheint ein vielversprechendes Konzept zu sein, um geschäftsführende Strategien und Investment Entscheidungen zu erklären.In this thesis the real options approach is applied to franchising. Originating in financial options theory, the real options approach bares on essential advantage: the integration of uncertainty to the strategic framework. It is not the uncertainty per se, but rather the cognition that uncertainty involves the possibility of flexibility, which adds value to the firm. An option is defined as the right, but not the obligation, to buy or sell a specific asset on or before a specified point in time to ex ante précised conditions. The option holder profits from the opportunity to decide flexibly. In opposition to financial options, the underlying asset of real options represents a potential physical or intellectual investment In dependence on conducted research for joint ventures as real options, franchising is going to be assumed as a real option to expand, a real growth option. The option clause stipulates the right to the option and is an instrument for a firm to assure a claim on future opportunities. Therefore, option clauses represent the contractual recorded arrangement between the franchising partners. The occurrence or absence of such option clauses in franchising contracts might give hints to the intentions of the contractual partners, as well as have implications on partners’ incentives. The results of the empirical analysis of German franchising firms show a negative relationship between the likelihood of the usage of an option clause and perceived environmental uncertainty. The real options approach is a promising concept to explain managerial strategy and investment decisions

Uncertainty and stepwise investment

We analyze the optimal investment strategy of a firm that can complete a project either in one stage at a single freely chosen time point or in incremental steps at distinct time points. The presence of economies of scale gives rise to the following trade-off: lumpy investment has a lower total cost, but stepwise investment gives more flexibility by letting the firm choose the timing individually for each stage. Our main question is how uncertainty in market development affects this trade-off. The answer is unambiguous and in contrast with a conventional real-options intuition: higher uncertainty makes the single-stage investment more attractive relative to the more flexible stepwise investment strategy

Strategic capital budgeting: asset replacement under market uncertainty

In this paper the impact of product market uncertainty on the optimal replacement timing of a production facility is studied. The existing production facility can be replaced by a technologically more advanced and thus more cost-effective one. We take into account strategic interactions among the firms competing in the product market by analyzing the problem in a duopolistic setting. We calculate the value of each firm and show that i) a preemptive (simultaneous) replacement occurs when the associated sunk cost is low (high), ii) despite the preemption effect uncertainty always raises the expected time to replace, and iii) the relationship between the probability of optimal replacement within a given time interval and uncertainty is decreasing for long time intervals and humped for short time intervals. Furthermore it is shown that result ii) carries over to the case where firms have to decide about starting production rather than about replacing existing facilities

High speed rail transport valuation

The present paper investigates the optimal timing of investment for a high speed rail (HSR) project, in an uncertain environment, using a real options analysis (ROA) framework. It develops a continuous time framework with stochastic demand that allows for the determination of the optimal timing of investment and the value of the option to defer in the overall valuation of the project. The modelling approach used is based on the differential utility provided to railway users by the HSR service.info:eu-repo/semantics/publishedVersio

High speed rail transport valuation

The present paper investigates the optimal timing of investment for a high speed rail (HSR) project, in an uncertain environment, using a real options analysis (ROA) framework. It develops a continuous time framework with stochastic demand that allows for the determination of the optimal timing of investment and the value of the option to defer in the overall valuation of the project. The modelling approach used is based on the differential utility provided to railway users by the HSR service.info:eu-repo/semantics/publishedVersio

Real Options Valuation : an application to the portuguese real estate market

The contribution of real options analysis on the valuation of Portuguese undeveloped building sites is significant on the decision making regarding the apartment-buildings construction. Using the options model developed by Quigg (1993), and including the necessary readjustments for the Portuguese market, it was found that the scale price elasticity parameter and construction expenditures’ elasticity of scale parameter had a strong impact on building sites’ values. The empirical analysis revealed that the option to defer adds value to undeveloped building sites’ valuations. This fact cannot be ignored when deciding upon an investment’s implementation.info:eu-repo/semantics/publishedVersio

Options for Human Capital Acquisition

An \u27options\u27 view of human capital acquisition explains value creation through timedeferred, sequential, path-dependent investment choices and addresses gaps in the resourcebased theory explanation of the relationship between human resources and competitive advantage. Firms will invest in options for human capital, using alternative employment arrangements like temporary/contractual/part-time workers and internships, or by outsourcing the work, when uncertainty associated with human capital is high and investments in human capital are largely irreversible. We discuss various options for skills and employees, two interrelated components of human capital. These are flexibility options, options to wait or defer, options to abandon, learning options, and switching options. The opportunity cost of not having options is quantifiable, which makes the real options approach valuable for strategic HRM decisions