An Investment Criterion Incorporating Real Options

Hirofumi Suto, James Alleman and Paul Rappoport
Additional contact information
Hirofumi Suto: NTT East, Hokkaido, JAPAN

Communications & Strategies, 2008, vol. 1, issue 70, 45-66

Abstract: Investment in infrastructure such as the information and communication technology sector requires large, substantial amounts, most of which are sunk or irreversible. Uncertainty of market demand, competition, costs and public policy complicates the investment decision process. This paper provides an investment decisionmaking criterion under uncertainty using (deferred) real options methodology to evaluate if an investment should be made immediately, cautiously, deferred (wait-and-watch), or foregone. A decision-making index d is developed, which is equal to the expectation of net present value (NPV) normalized by its standard deviation. Under a lognormal assumption of the distribution of NPV discounted by risk-free rate, we find the "break-even point" at which the NPV equals the real option value (ROV): d = D* = 0.276. Using the absolute value of D*, one can make sophisticated decisions considering opportunity losses. This new decision index, d, provides a criterion to make investment decisions to capture underlying uncertainty. When making a decision, a manager only has to observe three parameters: expectation of future cash flow, its uncertainty as measured by its standard deviation, and the magnitude of investment. We discuss examples using this criterion and show its value. The criterion is particularly useful when NPV lies near zero or uncertainty is large.

Keywords: Real Options, Decision, Investment, Economic Methodology; Statistical Decision Theory, Criteria for Decision-Making under Risk and Uncertainty. (search for similar items in EconPapers)
JEL-codes: B41 C1 D81 E22 (search for similar items in EconPapers)
Date: 2008
References: View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
http://repec.idate.org/RePEc/idt/journl/CS7003/CS70_SUTO_et_al.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:idt:journl:cs7003

Access Statistics for this article

More articles in Communications & Strategies from IDATE, Com&Strat dept. Contact information at EDIRC.
Bibliographic data for series maintained by BLAVIER Thomas ( this e-mail address is bad, please contact ).