Devaluating projects and the investment–uncertainty relationship

Abstract

Sarkar (2000. On the investment–uncertainty relationship in a real options model. Journal of Economic Dynamics and Control, 24, 219–225) analyzes the investment–uncertainty relationship in a real-options model demonstrating that the widely accepted conclusion that uncertainty harms investment can be reversed. Wong (2006. The effect of uncertainty on investment timing in a real options model. Journal of Economic Dynamics and Control, forthcoming) confirms this point showing that more uncertainty can reduce the expected time to exercise the investment option. This paper deals with such an issue and attempts to integrate both Sarkar's and Wong's analysis. For risk-neutral investors, we show that uncertainty can favor investment only if projects devaluate over time. This conclusion does not hold in a CAPM framework, where we demonstrate that the relationship uncertainty/investment can be positive (a) even when the investment threshold increases with uncertainty and (b) in the case of projects negatively correlated with the market portfolio.