The effect of uncertainty on investment timing in a real options model

Abstract

This paper examines the effect of uncertainty on investment timing in a canonical real options model. We show that the critical value of a project that triggers the exercise of the investment option exhibits a U-shaped pattern against the volatility of the project. This is due to the two countervailing risk and return factors in effect. We further show that such a U-shaped pattern is inherited by the expected time to exercise the investment option. Thus, for relatively safe projects, greater uncertainty shortens the expected exercise time and thus enhances investment. This is in sharp contrast to the negative investment–uncertainty relationship commonly found in the extant literature. Finally, we show that the positive investment–uncertainty relationship is more likely for high growth projects than for low growth projects.