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Firm investment behavior in a real options framework: Empirical evidence

Laarni Tobia Bulan, 2001
Faculty Advisor: Christopher Mayer
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Abstract

Real options models have significantly altered the way economists model investment decisions. There is a very large theoretical literature on real options, but empirical tests of irreversible investment under uncertainty have lagged behind. In this study I examine the prediction of these models that increases in uncertainty delay investment because of the option value of waiting to invest. The empirical analysis is conducted in two dimensions: at the project level and at the firm level. Using project level data on over 1,200 individual real estate developments in Vancouver, Canada between 1979 and 1998, I look at the effect of uncertainty on the timing of investment decisions. Using firm level data on U.S. manufacturing firms for the period 1964-1999, I examine whether uncertainty influences the firm's choice of the level of it's capital stock. The empirical results suggest that a firm's incentives for investing are greatly reduced during times of greater uncertainty in the firm's environment. Consistent with real options models, I find that both systematic and idiosyncratic risk matter for investment decisions. In addition, the evidence supports the view that competition erodes the value of the option to delay

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