Real Options in an Aymmetric Duopoly: Who Benefits from your Competitive Disadvantage

This paper considers the impact of investment cost asymmetry on the value and optimal real option exercise strategies of firms under imperfect competition.Both firms have an opportunity to invest in a project enhancing (ceteris paribus) the profit now.We show that three types of equilibria exist and derive critical levels of cost asymmetry separating the regions in which they prevail.The presence of strategic interactions leads to counter-intuitive results.First, depending on the level of asymmetry, a marginal increase in the investment cost of the firm with the cost disadvantage can increase this firm's own value.Second, such a cost increase can result in a decrease in value of the competitor.Moreover, we discuss the welfare implications of the optimal exercise strategies and show that the presence of identical firms can result in a socially less desirable outcome than if one of the competitors has a significant investment cost disadvantage.Finally, we prove that profit uncertainty always delays investment, even in the presence of a strategic option of becoming the first investor.options;duopoly;capital budgeting;social welfare;investment

Investment Under Uncertainty and Policy Change

Existing real options literature provides relatively little insight into the impact of structural changes of the economic environment on the investment decision of the firm.We propose a method to model the impact of a policy change on investment behavior in which, contrary to the earlier models based on Poisson processes, uncertainty concerning the moment of the change can be explicitly accounted for.Moreover, probabilities of the change depend on the state of the dynamic system, what ensures the consistency of the action of the policy maker. We model the policy change as an upward jump in the (net) investment cost, which is, for instance, caused by a reduction in the investment tax credit.The firm has an incomplete information concerning the trigger value of the process for which the jump occurs.We derive the optimal investment rule maximizing the value of the firm.It is shown that the impact of trigger value uncertainty is non-monotonic: the investment threshold decreases with the trigger value uncertainty for low levels of uncertainty, while the reverse is true for high uncertainty levels.Finally, we present policy implications for the authority that result from the firm's value-maximizing behavior.investment;uncertainty;policy

Is Investment-Cash Flow Sensitivity Caused by the Agency Costs or Asymmetric Information? Evidence from the UK

We investigate the investment-cash flow sensitivity of a large sample of the UK listed firms and confirm that investment is strongly cash flow-sensitive.Is this suboptimal investment policy the result of agency problems when managers with high discretion overinvest, or of asymmetric information when managers owning equity are underinvesting if the market (erroneously) demands too high a risk premium?We find that the observed cash flow sensitivity results mainly from the agency costs of free cash flow.The magnitude of the relationship depends on insider ownership in a nonmonotonic way.Furthermore, we obtain that outside blockholders, such as financial institutions, the government, and industrial firms (only at high control levels), reduce the cash flow sensitivity of investment via effective monitoring.Finally, financial institutions appear to play a role in mitigating informational asymmetries between firms and capital markets.We corroborate our findings by performing additional tests based on the stochastic efficient frontier approach and power indices.investment-cash flow sensitivity;ownership and control;asymmetric information;liquidity constraints;agency costs of free cash flow;large shareholder monitoring;Shapley values

Strategic Capital Budgeting: Asset Replacement Under Uncertainty

We consider a firm's decision to replace an existing production technology with a new, more cost-efficient one.Kulatilaka and Perotti [1998, Management Science] nd that, in a two-period model, increased product market uncertainty could encourage the firm to invest strategically in the new technology.This paper extends their framework to a continuous-time model which adds flexibility in timing of the investment decision.This flexibility introduces an option value of waiting which increases with uncertainty.In contrast with the two-period model, despite the existence of the strategic option of becoming a market leader due to a lower marginal cost, more uncertainty always increases the expected time to invest.Furthermore, it is shown that under increased uncertainty the probability that the firm finds it optimal to invest within a given time period always decreases for time periods longer than the optimal time to invest in a deterministic case.For smaller time periods there are contrary effects so that the overall impact of increased uncertainty on the probability of investing is in this case ambiguous.capital budgeting;uncertainty;investment;game theory

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

Household liquidity and incremental financing decisions:theory and evidence

In this paper we develop a stochastic model for household liquidity. In the model, the optimal liquidity policy takes the form of a liquidity range. Subsequently, we use the model to calibrate the upper bound of the predicted liquidity range. Equipped with knowledge about the relevant control barriers, we run a series of empirical tests on a panel data set of Dutch households covering the period 1992-2007. The results broadly validate our theoretical predictions that households (i) exhaust most of their short-term liquid assets prior to increasing net debt, and (ii) reduce outstanding net debt at the optimally selected upper liquidity barrier. However, a small minority of households appear to act sub-optimally. Poor and vulnerable households rely too frequently on expensive forms of credit (such as overdrafts) hereby incurring substantial amounts of fees and fixed borrowing costs. Elderly households and people on social benefits tend to accumulate too much liquidity. Finally, some households take on expensive short-term credit while having substantial amounts of low-yielding liquid assets

Corporate Investment under Uncertainty and Competition: A Real Options Approach.

Abstract: Corporate investment opportunities can be represented as a set of (real) options to acquire productive assets. Identification of the optimal exercise strategies for these options plays a crucial role in improving the quality of capital budgeting decisions and, as a consequence, in maximizing shareholders¿ wealth. Structural changes in the economic environment, imperfect product market competition and agency conflicts across different groups of the firm¿s stakeholders make the standard option theory alone often insufficient for analyzing real investment decisions. This thesis combines option theory with non-cooperative game theory to establish some new results concerning the impact of policy uncertainty, product market interactions, and debt financing on the firm¿s optimal investment strategy.