A Bayesian Approach to Real Options: The Case of Distinguishing between Temporary and Permanent Shocks

Abstract

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. Copyright (c) 2010 the American Finance Association.

Interfaces for enterprise valuation from a real options lens

“…Bellalah (2001), Chi (2000), Dixit (1989Dixit ( , 1992, Espinoza (2011), Frayer andUludere (2001), Gu (2002), McDonald and Siegel (1986), Nichols et al (1994), Pindyck (1988), Schneider et al (2008), Trigeorgis (1991Trigeorgis ( , 1993, Tsai (2008) Dixit (1989Dixit ( , 1992; Grenadier and Malenko (2010); McDonald and Siegel (1986), McGrath (1997), Pindyck (1988), Tsai (2008) Standard deviation in returns, or equivalent assets Bellalah (2001), Bowman and Moskowitz (2001), Dixit (1989Dixit ( , 1992, Espinoza (2011), Grenadier andMalenko (2010), Kogut and Kulatilaka (1994), McDonald andSiegel (1986), McGrath (1997), Mölls and Schild (2012), Nichols et al (1994), Pindyck (1988), Tsai (2008), Schneider et al (2008) Variance Frayer and Uludere (2001), Trigeorgis (1991) Coefficient of variation of market costs Espinoza (2011) Probability in up or down movements Trigeorgis (1993) Probability of exogenous shock Grenadier and Malenko (2010) External information Exchange rate Dixit (1989), …”

“…Bellalah (2001), Bowman and Moskowitz (2001), Chi (2000), Dixit (1989Dixit ( , 1992, Fan and Zhu (2010), Grenadier and Malenko (2010), Haenline et al (2006), Kulatilaka and Perotti (1998), Mauboussin (1999), Pindyck (1988), Schneider et al (2008), Tsai (2008), Trigeorgis (1991) Security price Trigeorgis (1993) Cost of switching locations Kogut and Kulatilaka (1994) Costs of production, operating costs Frayer and Uludere (2001) Initial value of a house Gu (2002) Project costs Espinoza (2011), Mölls and Schild (2012) Time Change in state of the world, a future period of time…”

“…Bellalah (2001), Bowman and Moskowitz (2001), Dixit (1992), Espinoza (2011), Fan andZhu (2010), Frayer and Uludere (2001), Grenadier and Malenko (2010), Haenlein et al (2006); Kulatilaka and Perotti (1998), Mauboussin (1999), McDonald and Siegel (1986), Mölls and Schild (2012), Nichols et al (1994), Schneider et al (2008), Trigeorgis (1993), Tsai (2008), van Putten and MacMillan (2004) Present values of revenues from an option to change production capacity Pindyck (1988) Option value of international expansion Dixit (1989), Kogut and Kulatilaka (1994) Value of a multi-option investment Trigeorgis (1991) Option value of acquisition or divesture Chi (2000) Value of underlying assets…”

“…Value of an equivalent market asset Bowman and Moskowitz (2001), Espinoza (2011), Frayer andUludere (2001), Gu (2002), Ross (1978), Schneider et al (2008), Trigeorgis (1991Trigeorgis ( , 1993 Industry revenues Dixit (1989) Project, market segment, or venture revenues or cash flows Bellalah (2001), Chi (2000), Dixit (1992), Grenadier and Malenko (2010), Haenlein et al (2006), Kulatilaka and Perotti (1998), Mauboussin (1999), Mölls and Schild (2012), Nichols et al (1994), Tsai (2008) Capital asset revenues Pindyck (1988), Trigeorgis (1991) Price in different locations Fan and Zhu (2010), Kogut and Kulatilaka (1994) Myers (1977) Quantity of assets held Ross (1978) Capital expenditures McDonald and Siegel (1986); Nichols et al (1994) Sunk costs: Investment level, initial investment, entry costs, or abandonment value…”

“…With more information regarding aspects of an option and its underlying asset, we find that the costs of information acquisition are additive to the discount rate (Bellalah, 2001). Information resulting from asymmetries (Tsai, 2008), or from external assessments (Fan & Zhu, 2010), as well as beliefs in the nature and intensity of events (Grenadier & Malenko, 2010) multiplier. With the model, the multiplier is a weighting factor to the cash flows of an investment opportunity, and the optimal value is found using partial differential equations.…”