A model of real investment under project value and cost uncertainty, given temporal constraints

This dissertation constructs, solves and simulates a comprehensive model of irreversible investment under uncertainty, for a firm with an opportunity to defer investing in a project. The dissertation attempts to improve the existing investment models. More specifically, the perpetuity assumption is relaxed and replaced with the assumption that the project could be undertaken within a finite time period. Simultaneously, an uncertain project value and an uncertain project cost, possibly correlated with the project value, are introduced. At the same time, a new computational methodology is derived to solve for the value of the firm and to obtain an investment decision rule. The solution allows the deployment of extensive simulations that clarify the sensitivity of the investment to the factors entering the model.; The study extends the current models valuing investments under uncertainty and irreversibility when deferral is feasible and develops an investment decision rule in a finite opportunity to postpone framework. It fills a gap in the current real options literature by providing a solution to a model that was not explicitly studied before.; To derive the model, a dynamic programming technique leading to a Hamilton-Bellman-Jacobi equation is formalized in Chapter IV.; In order to study the problem in detail, a simple numerical approximation for the solution is derived in Chapter V. This original development follows the one-variable approach proposed for an American option by Barone-Adesi and Whaley (1987). A salient feature of the derivation is that it computes not only the value of the firm cum flexibility but also the ratio between the project value and the project cost at which it is optimal to invest.; In Chapter VI the solution to the investment problem resulting from the foregoing approach is used to evaluate the sensitivities of both the value of the firm cum flexibility and of the project value to project cost ratio to different parameters: project value and cost growth rates and volatilities, time constraint, discount rate and initial value to cost ratio. Moreover, the study attempts to provide a plausible explanation for the ambiguous conclusions regarding the relationship between uncertainty and investment levels reported in the current literature.