Time Horizon Effect on Real Investment Decisions

Abstract

We consider the entrepreneur’s problem of having a real investment opportunity with undiversifiable risk in a finite horizon. By explicitly characterizing the consumption and investment problem, we show that the remaining time to undertake the project has a significant impact on the characteristics of a firm’s cash flow or return dynamics. Our theory predicts that a firm with an ample time horizon to invest tends to have a cash flow or the stock return with a higher idiosyncratic volatility. Furthermore, we also extend the baseline model to the cases in which the entrepreneur has several projects that can only be sequentially exercised. In this case, a project with a lower idiosyncratic volatility will be exercised first when the investment horizon is long.