Uncertainty and the Likelihood of Entry: An Empirical Assessment of the Moderating. Role of Irreversibility

Tim Folta, Douglas R. Johnson and Jonathon O Brien

Purdue University Economics Working Papers from Purdue University, Department of Economics

Abstract: Real options models have emerged as a compelling tool for understanding market entry decisions involving sunkness, or irreversibility. In contrast to neoclassical models of investment, real options models consider that uncertainty has a direct effect on the willingness to invest, and that the effect of uncertainty is intensified as the irreversibility of investment increases. Although the effect of uncertainty on investment has been documented, the theoretical interaction between uncertainty and irreversibility has not been empirically demonstrated because the existing literature has tended to assume that all investments are equally irreversible. Our paper addresses this issue and advances the literature on real options theory in the following three ways. First, we empirically validate the proposition that uncertainty is moderated by the irreversibility of the required investment. Second, we relate the irreversibility of the entry decision to a firm s corporate strategy, and demonstrate that the effect of uncertainty is moderated by how related that industry is to the firm s current portfolio of business segments. Finally, our results provide evidence regarding the tradeoff between the option to grow and the option to wait the effect of uncertainty on entry varies in the presence of growth options.

Pages: 44 pages
Date: 2001-05
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Persistent link: https://EconPapers.repec.org/RePEc:pur:prukra:1143

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