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Traditional real options models demonstrate the importance of the “option to wait” due to uncertainty over future shocks to project cash flows. However, there is often another important source of uncertainty: uncertainty over the permanence of past shocks. Adding Bayesian uncertainty over the permanence of past shocks augments the traditional option to wait with an additional “option to learn.” The implied investment behavior differs significantly from that in standard models. For example, investment may occur at a time of stable or decreasing cash flows, respond sluggishly to cash flow shocks, and depend on the timing of project cash flows. DURING THE PAST TWO DECADES the real options approach to valuation of irreversible investment opportunities has become part of the mainstream literature in financial economics. The central idea is that the opportunity to invest is equivalent to an American call option on the underlying investment project. As a consequence, the problem of optimal investment timing is analogous to the optimal exercise decision for an American option. Applications of the real options approach are now numerous. 1 One feature that is common to virtually all real options models is that the underlying uncertainty pertains only to future shocks. Since future cash flows are uncertain, there is an important opportunity cost of investing today: the value of the asset might go up so that tomorrow will be an even better time to invest. This opportunity cost is often referred to in the literature as the “option |
