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Capital Investment as Real Options: A Note on Dixit-Pindyck Model.

Termos, Ali (2008): Capital Investment as Real Options: A Note on Dixit-Pindyck Model.

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Abstract

Abstract This paper applies Contingent Claims model a la Dixit and Pindyck (1994), on bank investment. Banks are indifferent between investing their assets on their own and extending loans to investors. The critical decision faced by the banker is the timing of the investment decision and its uncertainty. When banks make an irreversible investment decision they exercise the option to invest and give up the opportunity of waiting for new information to arrive. This lost option value is incorporated in the investment cost. Therefore, the value of the project must exceed the investment cost by the value of keeping the investment option alive. Using a third-moment mean-reversion process of the investment’s volatility, the model shows that a higher mean-reversion parameter reduces both the value of the option to invest and the critical value at which the project deems feasible.

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