Contrasts Between Types of Assets in Fixed Investment Equations as a Way of Testing Real Options Theory

Abstract

This paper tests the power of real options theory to explain investment under uncertainty, exploiting differences in the degree of irreversibility between machinery and buildings. It reports estimates of investment equations for each asset class using a large sample of UK manufacturing industries, with results that are consistent with the predictions of real options theory. Additionally, using a specially constructed industryspecific measure of irreversibility for machinery investment, the paper provides further confirmation of the empirical relevance of real options.

Extent and intensity of investment with multiple capital goods

“…A plausible interpretation of these is that assets have differential degrees of irreversibility with Vehicles emerging as the asset type with the highest degree of reversibility and Buildings with the lowest. Evidence for differential irreversibility across capital goods has also been documented in previous studies (Guiso and Parigi 1999;Ram 1999, 2001;Bulan 2005;Drakos 2006;Driver et al 2006). Table 1 about here------ Table 2 reports the sample distribution of the extensive by year and industry.…”

Irreversible investment under uncertainty: the message in Leasing Expenditures

“…In particular, the ratio of disposals (selling capital) to acquisitions (capital purchases) is used as an indicator of the activity of second-hand markets and, consequently, of reversibility. Clearly, the ratio will be low, or approaching zero, if second hand markets were thin or non-existent (Driver et al, 2006).…”

“…Finally, some researchers have proposed an indirect indicator for the degree of irreversibility by resorting to an ad hoc ordering of irreversibility, where the researcher a priori orders capital goods based on their underlying characteristics, and therefore, depending on the user's exposure to each asset type, one may infer the degree of irreversibility (Guiso and Parigi, 1999;Ram, 1999, 2001;Butzen et al, 2002;Driver et al, 2006;Bulan, 2005;Drakos, 2006). …”

How Asset Irreversibility Influences the Investment‐uncertainty Relationship

“…Only few prior studies control for irreversibility at the asset‐level of a firm, see, e.g., Guiso and Parigi () and Driver et al . (). Guiso and Parigi (), for instance, differentiate between investments in structures, machineries and equipments, and vehicles to account for heterogeneity across investments.…”