The Timing Option and the Interest Rate Sensitivity of Investment

Abstract

Employing a refinement of Irving Fisher's timber harvesting paradigm, a theoretical capital budgeting model that accounts for timing considerations is developed. To provide focus but without loss of generality, the specific decision setting of an entrepreneur planning a startup is broached. The model is then used to gauge the sensitivity of investment expenditures to interest rate changes. A rise in the interest rate is shown to have two effects. The first effect is the obvious reduction in the venture's net present value (NPV). The second effect, which refers to the interest rate–induced change in the timing of the venture's implementation, is more subtle. For highly profitable ventures, the interest rate rise induces the entrepreneur to initiate his startup sooner, whereas for less profitably ventures, the startup is postponed. Thus, due to the presence of this implementation timing option, startups and, more generally, investments that reflect a timing option are less (more) interest rate sensitive than other investment decisions where the timing option is absent if highly (less) profitable ventures predominate.