Investment, Uncertainty, and the Impact of Real Options

This paper estimates the responsiveness of irreversible investment to uncertainty using financial data for a sample of 320 U.S. manufacturing firms over the period from 1996 to 2009. The introduction of uncertainty to the investment problem implies that the valuation of capital should be a positive multiple of the acquisition cost which, in effect, compensates the firm for expending the option value of its decision. The valuation of capital is formed with estimates from the first stage estimation of a production function. Uncertainty is considered using the implied long term volatility from firm specific equity options contracts. The firm specific measure is also averaged by industry and time period to form an industry average measure. The second stage estimation is a log linear investment equation in which firm capital expenditure is regressed on the valuation of capital and the option multiple. For both the firm specific and industry average measures, the responsiveness of investment to valuation is found to be fully proportional. The responsiveness of investment to uncertainty, however, is found to be negative and proportional for industry average uncertainty but negative and less than proportional for the firm specific measures. These findings support the real options model of irreversible investment.