Academic journal article International Journal of Business

Evaluation of Real Options with Information Costs

Academic journal article International Journal of Business

Evaluation of Real Options with Information Costs

Article excerpt

ABSTRACT

This paper presents a simple framework for the analysis, valuation and simulation of several real options in the presence of shadow costs of incomplete information. Information costs can be viewed as sunk costs in the spirit of Merton's (1987) model of capital market equilibrium with incomplete information. We incorporate these sunk costs in standard discounted cash flow techniques and present the basic concepts of real options. The justification of information costs in real projects is based on the observation that R&D needs to be done before investment decisions. These costs account for all the expenses needed to be informed about an investment opportunity and the management of projects. This analysis extends the models in Bellalah (1999, 2001) for the valuation of real options within information uncertainty. We present valuation procedures and simulations for the values of common real options in the presence of shadow costs of incomplete information.

JEL Classification: G12; G13; G14; G31

Keywords: Asset pricing; Option pricing; Information and market efficiency; Capital budgeting; Investment policy

I. INTRODUCTION

A company's value creation is determined by resource allocation and the proper evaluation of investment alternatives. Managers make capital investments to create future growth for shareholders. Investments lead to patents or technologies, which open up new growth possibilities. In general, managers use the basic investment techniques as the capital asset pricing model (CAPM), the cost of capital and the discount cash flow techniques, DCF. In investment valuation, organisations also use quantitative approaches such as net present value (NPV), decision tree analysis (DTA), payback time, or scenario/simulation which do not account for intangible factors such as future competitive advantage, future opportunities, managerial flexibility, the strategic value of the investment, etc. This is because the expected outcomes are not easy to forecast and the variability of investment returns may be extremely high. New techniques for capital budgeting incorporate real options, active management, and strategic interactions between investment and financing decisions. (1)

Information plays a central role in the capital budgeting process and in investment and financing decisions. Edwards and Wagner (1999) study the role of information in capturing the research advantage and how to incorporate information into the decision process of active investment management. They show that implementation costs make sense only when weighed against the benefit of enhanced performance. They recognise that the most valuable commodity in the market is information that reduces uncertainty. In this spirit, trading cost information is part of the research that gives a manager active advantage. Edwards and Wagner (1999) show that managers must measure and develop confidence in the value of their research and then incorporate feedback from the market.

Merton (1987) adopts most of the assumptions of the original CAPM and relaxes the assumption of equal information across investors. He assumes that investors only hold securities of which they are aware. In his model, the expected returns increase with systematic risk, firm-specific risk, and relative market value. The expected returns decrease, however, with relative size of the firm's investor base, referred to in Merton's model as the "degree of investor recognition". The intuition behind Merton's model is that investors consider only a part of the opportunity set, that full diversification is not possible, and that firm specific risk is priced in equilibrium. The main distinction between Merton's model and the standard CAPM is that investors invest only in the securities about which they are "aware". This assumption is referred to as incomplete information. The more general implication is that securities markets are segmented. …

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