Optimal investment decision under regulatory and environmental risks

Abstract

This paper investigates the decision-making of a firm that has an option to invest from among multiple alternative projects. This type of option is called a max-option, and the nature of a max-option has been investigated in several papers. I extend the previous analysis to a model that allows the random occurrence and disappearance of alternative projects in which to invest. The occurrence and disappearance of investment opportunities will be caused by changes in regulation, exits and entries of rival firms, technological innovation, political risk, catastrophes, etc. By proving the properties of the options, this paper suggests how a firm should deal with regulatory and environmental risks. Specifically, I demonstrate that the prospective future occurrence of an alternative (e.g. as a result of deregulation) has the significant effect of increasing the option value and deferring the investment decision. The results help better understand investment decisions with regulatory and environmental uncertainty.

Keywords:

• finance
• investment analysis
• decision analysis
• real option
• regulatory risk

Acknowledgements

The author would like to thank an anonymous referee for helpful comments. This work was supported by KAKENHI 22710142 and 23310103.

Notes

^1. The European type was originally investigated by (Johnson, 1987) and (Stulz, 1982), whereas American type was originally investigated by (Broadie and Detemple, 1997) and (Villeneuve, 1999).

^2. An alternative approach is the game-theoretic approach. Strategic interactions among several firms have been investigated in (Grenadier, 1996), (Huisman and Kort, 2004), (Kong and Kwok, 2007), (Nishihara and Fukushima, 2008), and (Nishihara and Shibata, 2010b). Refer to (Chevalier-Roignant et al., 2011) for an overview.

^3. Refer to (Dixit and Pindyck, 1994) for the economic rationale for this assumption.

^4. When the maturity is infinite, I have only to replace 1_{τ ≤ T} with 1_{τ < ∞}.

^5. This paper dose not specify how to finance the project, while some papers, including (Nishihara and Shibata, 2010a), (Nishihara and Shibata, 2013), and (Shibata and Nishihara, 2012), focused on the effects of financing constraints and the costs of investment timing problems.

^6. (Nishihara, 2009) models rival preemption for the max-option endogenously, and derives the equilibrium of the preemption game.

^7. This problem is the same as the max-option problem (12) with X ₂(t) replaced by the killed process.

^8. In contrast, in a model based on the discontinuous stochastic process the jump size must be exogenously presumed.

^9. These parameter values are similar to those of previous studies. I carried out many computations with varying parameter values and distilled robust results into this section.