Academic journal article International Journal of Business

Real Options with Information Costs: A Synthesis

Academic journal article International Journal of Business

Real Options with Information Costs: A Synthesis

Article excerpt

ABSTRACT

This paper presents some new results regarding the pricing of real options in the presence of market frictions. Since the standard literature ignores the role of market frictions and the effect of incomplete information, we rely on Merton's (1987) model of capital market equilibrium with incomplete information (CAPMI) to introduce information costs in the pricing of real assets. Using this model instead of the standard CAPM of Sharpe (1964) allows computing the value of the firm and its assets in the presence of information uncertainty. In the original derivation of the Black-Scholes (1973) model, the CAPM was used. In the same context, the CAPMI model can be used. Using the methodology in Bellalah (1999, 2001, 2002) and in Paxson (2003) for the pricing of real options, we extend the standard models to account for the effects of shadow costs of incomplete information. The models can be used for the valuation of several real options, R&D projects as well as projects with several stages like joint ventures.

JEL Classification: G12, G20, G31

Keywords: Firm value; Real options; Information costs; Joint venture

I. INTRODUCTION

The standard literature on capital budgeting techniques uses the net present value as a reference criterion in investment decisions. The analysis is mainly based on the use of the cost of capital in the discounting of future cash flows. A project is accepted if its extended Net Present Value, NPV, is positive, otherwise it is rejected. The extended NPV corresponds to the standard NPV plus the flexibility in investment decisions. The standard technique for calculating the NPV has not changed much since Fisher (1907) by discounting the expected cash flow at an appropriate discount rate. The research in this area is based on the specification and estimation of the discount rate.

Over the last two decades, a body of academic research takes the methodology used in financial option pricing and applies it to real options in what is well known as real options theory. This approach recognizes the importance of flexibility in business activities. Today, options are worth more than ever because of the new realities of the actual economy: information intensity, instantaneous communications, high volatility, etc (2). The literature on real options and discounted cash flow techniques ignores the role of information uncertainty. However, these costs play a central role in financial markets and capital budgeting decisions. Financial models based on complete information might be inadequate to capture the complexity of rationality in action.

Some factors and constraints, like entry into a business are not costless and may influence the short run behaviour of asset prices. The treatment of information and its associated costs play a central role in capital markets. If an investor does not know about a trading opportunity, he will not act to implement an appropriate strategy to benefit from it. However, the investor must determine if potential gains are sufficient to warrant the costs of implementing the strategy. These costs include time and expenses required to create data base to support the strategy, to build models and to get informed about the technology. This argument applies in varying degrees to the adoption in practice of new structural models of evaluation.

This reasoning holds not only for individual investors but also for professional managers who spend resources and time in the same spirit. It is also valid for the elaboration and implementation of option pricing models.

Hence, recognition of information costs might be important in asset valuation and has the potential to explain empirical biases exhibited by prices computed from complete information models. As shown in Merton (1987), the "true" discounting rate for future risky cash flows must be coherent with his simple model of capital market equilibrium with incomplete information. …

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