Abstract: This paper argues that increased uncertainty, in certain
situations, may actually encourage investment. Since earlier studies
mostly base their arguments on the assumption of geometric Brownian
motion, the study extends the assumption to alternative stochastic
processes, such as mixed diffusion-jump, mean-reverting process, and
jump amplitude process. A general approach of Monte Carlo
simulation is developed to derive optimal investment trigger for the
situation that the closed-form solution could not be readily obtained
under the assumption of alternative process. The main finding is that
the overall effect of uncertainty on investment is interpreted by the
probability of investing, and the relationship appears to be an invested
U-shaped curve between uncertainty and investment. The implication
is that uncertainty does not always discourage investment even under
several sources of uncertainty. Furthermore, high-risk projects are not
always dominated by low-risk projects because the high-risk projects
may have a positive realization effect on encouraging investment.
Abstract: Real options theory suggests that managerial flexibility embedded within irreversible investments can account for a significant value in project valuation. Although the argument has become the dominant focus of capital investment theory over decades, yet recent survey literature in capital budgeting indicates that corporate practitioners still do not explicitly apply real options in investment decisions. In this paper, we explore how real options decision criteria can be transformed into equivalent capital budgeting criteria under the consideration of uncertainty, assuming that underlying stochastic process follows a geometric Brownian motion (GBM), a mixed diffusion-jump (MX), or a mean-reverting process (MR). These equivalent valuation techniques can be readily decomposed into conventional investment rules and “option impacts", the latter of which describe the impacts on optimal investment rules with the option value considered. Based on numerical analysis and Monte Carlo simulation, three major findings are derived. First, it is shown that real options could be successfully integrated into the mindset of conventional capital budgeting. Second, the inclusion of option impacts tends to delay investment. It is indicated that the delay effect is the most significant under a GBM process and the least significant under a MR process. Third, it is optimal to adopt the new capital budgeting criteria in investment decision-making and adopting a suboptimal investment rule without considering real options could lead to a substantial loss in value.