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

Stepwise Green Investment under Policy Uncertainty

We analyse how market price and policy uncertainty, in the form of random provision or retraction of a subsidy, interact to affect the optimal time of investment and the size of a renewable energy (RE) project that can be completed in either a single (lumpy investment) or multiple stages (stepwise investment). The subsidy takes the form of a fixed premium on top of the electricity price, and, therefore, investment is subject to electricity price uncertainty. We show that the risk of a permanent retraction (provision) of a subsidy increases (decreases) the incentive to invest, yet lowers (raises) the amount of installed capacity, and that this result is more pronounced as the size of the subsidy increases. Additionally, we show that increasing the number of policy interventions lowers the expected value of a subsidy and the size of the project. Furthermore, we illustrate that, although an increase in the size of a subsidy lowers the relative value of the stepwise investment strategy, the expected value of a lumpy investment strategy is still lower than that of stepwise investment

The requirement for flexibility in capital budgeting

Capital investments are always long-term commitments of capital. When considering the undertaking of these projects, managers are faced with a high level of uncertainty. To better equip firms to respond to fluctuations in influencing factors, such as changes in demand and interest rate levels, capital budgeting needs to account for the value of flexibility options. Flexibility entails the alterations that can be conducted to the investment plan or when the initial capital outlay has already been done. It can contain altering the level of operations, choice of timing or even shutting down the project. In order to make the optimal capital budgeting decision, the value of a project needs to include flexibility into calculations. This paper examines the various forms and valuation of flexibility. The importance of flexibility has been widely recognised, as the review of previous literature proves. Bringing external factors into the analysis is crucial, as they have a direct effect on the principle elements of traditional capital budgeting. One of these factors is the interest rate level, which is directly linked to the set hurdle rate, weighted average cost of capital (WACC). The WACC is used in capital budgeting as a discount rate. To further highlight the effect of interest rate fluctuations in capital budgeting, a sensitivity analysis has been conducted by altering the used hurdle rate. The chosen focus on this specific external influencer stems from the current environment of low rates. If the current situation induces prolonged assumptions of low interest rate levels, the eventual shift may expose projects to be unprofitable ex post. The methods of valuing flexibility have been researched vastly, though rarely been put to practise. The main reason behind this is the complex nature of the methods. Also, flexibility is often viewed as an added expense or a burden to capital budgeting. The motivation behind this paper is to further demonstrate the true importance of flexibility options and to critically evaluate the applicability and precision of the presented valuation methods

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

Influential Article Review - A Binomial Compound Option Approach to Modeling Sequential R&D Investments

This paper examines research and development. We present insights from a highly influential paper. Here are the highlights from this paper: In this paper, we propose a binomial approach to modeling sequential R&D investments. More specifically, we present a compound real options approach, simplifying the existing valuation methodology. Based upon the same set of assumptions as prior models, we show that the number of computational steps for valuing any compound option can be reduced to a single step. We demonstrate the applicability of our approach using the real-world example of valuing a new drug application. Overall, our work provides a heuristic framework for fostering the adoption of binomial compound option valuation techniques in R&D management. For our overseas readers, we then present the insights from this paper in Spanish, French, Portuguese, and German

Asset sale, debt restructuring, and liquidation

This paper considers a dynamic model in which shareholders of a firm in distress have a choice of whether to proceed to debt restructuring or direct liquidation at an arbitrary time. In the model, we show the following results. Fewer asset sales, lower financing, debt renegotiation, and running costs, a lower premium to the debt holders, a lower cash flow volatility, and a higher initial coupon increase the shareholders’ incentive to choose debt restructuring to avoid full liquidation. In the debt renegotiation process, the shareholders arrange the coupon reduction and use equity financing to retire a part of the debt value to the debt holders. The timing of debt restructuring always coincides with that of liquidation without debt renegotiation. Most notably, the shareholders do not prefer asset sale in debt restructuring even if they face high financing costs. The possibility of debt renegotiation in the future increases the initial leverage ratio in the optimal capital structure

A Model of Investment under Uncertainty with Time to Build, Market Incompleteness and Risk Aversion

In this paper I develop a theoretical framework of irreversible investment under uncertainty in which there is time to build (TTB). The novel aspects of this framework, compared with TTB models in the extant literature, are that the market is incomplete in that not all the uncertainty associated with investing can be diversified away by trading an appropriate spanning asset, and the decision-maker, who acts in the interest of an organisation, is risk averse. I show that models of investment under uncertainty with a TTB, and models of investment under uncertainty with market incompleteness and risk aversion, ought not to be mutually exclusive as they have been in research to date because the recognised results of market incompleteness and risk aversion on the optimal investment strategy are challenged when we incorporate a TTB feature. Conversely, there are also implications on the effect of a TTB when we incorporate market incompleteness and risk aversion. The framework I develop in this paper provides a robust and parsimonious means of facilitating this