4 Real options and investment
4.1 Introduction
Contemporary microeconomic theory reflects the progress that has been made in incorporating time, expectations and uncertainty into more realistic models of decision making. In the last 20 years, the theory of investment decision-making and our understanding of the costs and benefits of investment have been revolutionised by analysis of investment timing, the value of the flexibility to delay investment, and the cost that is incurred by giving up flexibility at the point where the decision to invest is actually made. This broad class of problems in investment is addressed by the literature on real options (Guthrie, 2009a).
An important source of real option values derives from firms' flexibility regarding the timing of investment, since this allows them to “wait and see” how economic conditions evolve, for example, before committing to large irreversible investments. While real options are commonly discussed in the context of irreversible risky investments in network industries, the concept is applicable to a very wide range of situations, including those in workably competitive markets. Real options analysis may assist understanding of a wide range of choices that relate to irrecoverable expenditure.
A key insight of the literature on real options is that the total economic cost of an individual project is not just the capital expenditure involved, but also includes the reduction in the value of the firm's growth options due to investment. This manifests itself in decision-making in two equivalent ways: (i) investment is optimal only when the value of the completed project exceeds the required capital expenditure by at least the amount of the reduction in the value of the growth-option; and (ii) investment is optimal only when the internal rate of return from investment exceeds the project's weighted average cost of capital by some strictly positive premium.
While there are few explicit links between them in the published literature, real options may be understood as a key element of contractual incompleteness. For example, large projects which require and receive approval may still require the exercise of management discretion about the optimal time to invest if the return on the investment is to be maximised. In other words, and as we explain below, since the optimal timing of investment cannot be specified ex ante, the decision on exactly when to invest may be viewed as a component of contractual incompleteness. The allocation of decision rights in respect of investment timing should therefore be thought of as a response to contractual incompleteness.
In this chapter we provide a survey of the literature on real options, and consider its implications for public-sector ownership and investment. Subsequent sections provide further examples of the relevance of this approach for the choice between private and public ownership.
