How to Deal with Risky Investment Projects
Valuing the option to irreversibly invest in a risky project is greatly significant for firms, as their capital budgeting prospects typically involve real options. The firm must decide whether or not to enter the project, and when. The existing literature on real options usually requires the risk-adjusted growth rate of the project value to be lower than the rate used by the firm to discount future risk-adjusted cash-flows. This assumption serves the purpose of avoiding an explosive value for the option to invest in the perpetual case (i.e. when the option has no finite maturity).
In their article Real Options with a Double Continuation Region (forthcoming in Quantitative Finance, doi: 10.1080/14697688.2010.484024), Anna Battauz (Department of Finance), Marzia De Donno (Department of Decision Sciences) and Alessandro Sbuelz (Catholic University) argue that removing such a restrictive assumption leads to unexplored but practical cases that are associated with novel and interesting investment policies. They model a time-varying (and possibly stochastic) cost of entering the project and consider the realistic case in which the firm's discount rate is dominated by the growth rate of the project value and the latter is dominated by the growth rate of the cost. Under such a hierarchy for the discount/growth rates, the value of the investment option does not explode even in the presence of an infinite maturity.
The nuclear energy sector may provide a good example. The business is extremely lucrative, but the overall cost of entering it is likely to increase markedly in the future, both because uranium is a scarce resource, and because of the increasing demand for safety. This may cause the cost of a nuclear energy project to grow at a higher average rate than the value of the project itself. Battauz, De Donno andSbuelz find that, in such situations, it is optimal to delay immediate investment if the project's current value is insufficiently above the current cost as well as if the value is comfortably above the cost: Optimal continuation of the option to invest applies in two distinct value-cost regions (the double continuation region). While the first region is standard in the existing literature, the second region is not. Its unearthing is the key contribution of the authors. They show that, if the cost is sufficiently overwhelmed by the value, the deeply profitable option to invest is going to appreciate on average in the near future albeit the cost will eventually catch up via the strength of its growth rate. Hence, it is worth holding the option rather than exercising it immediately. Battauz, De Donno andSbuelz provide a rigorous and explicit description of the firm's optimal decision in such uncharted but plausible circumstances.
The authors are currently exploring the features of the double continuation region with finite maturity and in the presence of big-impact news about the project's cost and value.