Options in mutually exclusive projects of unequal lives

Christine Brown, Kevin Davis

Research output: Contribution to journalArticleResearchpeer-review

4 Citations (Scopus)

Abstract

Standard techniques advocated for choosing between mutually exclusive projects of unequal lives make an implicit assumption of continued project replication. While intuitively appealing, those techniques ignore the fact that project replication is one outcome of a repeated choice situation, and may not be the optimal outcome once stochastic features of the environment are taken into account. In essence, standard techniques ignore the real options relating to the subsequent choices inherent in each decision. By means of a simple example, assuming interest rate uncertainty, it is demonstrated that the standard techniques can lead to errors in a stochastic environment. Because of the idiosyncratic characteristics of project comparisons and the compound nature of the options involved, neat analytical solutions and techniques are not available to replace the elegant, but inadequate, textbook models. Financial managers need to model each choice on a case by case basis, appropriately identifying the key drivers of Net Present Value and specifying the stochastic environment pertaining to each.

Original languageEnglish
Pages (from-to)569-577
Number of pages9
JournalQuarterly Review of Economics and Finance
Volume38
Issue number3 Part.1
Publication statusPublished - 1 Dec 1998

Cite this

@article{33b4f42099b042caacab98d6ef93fb28,
title = "Options in mutually exclusive projects of unequal lives",
abstract = "Standard techniques advocated for choosing between mutually exclusive projects of unequal lives make an implicit assumption of continued project replication. While intuitively appealing, those techniques ignore the fact that project replication is one outcome of a repeated choice situation, and may not be the optimal outcome once stochastic features of the environment are taken into account. In essence, standard techniques ignore the real options relating to the subsequent choices inherent in each decision. By means of a simple example, assuming interest rate uncertainty, it is demonstrated that the standard techniques can lead to errors in a stochastic environment. Because of the idiosyncratic characteristics of project comparisons and the compound nature of the options involved, neat analytical solutions and techniques are not available to replace the elegant, but inadequate, textbook models. Financial managers need to model each choice on a case by case basis, appropriately identifying the key drivers of Net Present Value and specifying the stochastic environment pertaining to each.",
author = "Christine Brown and Kevin Davis",
year = "1998",
month = "12",
day = "1",
language = "English",
volume = "38",
pages = "569--577",
journal = "Quarterly Review of Economics and Finance",
issn = "1062-9769",
publisher = "Elsevier",
number = "3 Part.1",

}

Options in mutually exclusive projects of unequal lives. / Brown, Christine; Davis, Kevin.

In: Quarterly Review of Economics and Finance, Vol. 38, No. 3 Part.1, 01.12.1998, p. 569-577.

Research output: Contribution to journalArticleResearchpeer-review

TY - JOUR

T1 - Options in mutually exclusive projects of unequal lives

AU - Brown, Christine

AU - Davis, Kevin

PY - 1998/12/1

Y1 - 1998/12/1

N2 - Standard techniques advocated for choosing between mutually exclusive projects of unequal lives make an implicit assumption of continued project replication. While intuitively appealing, those techniques ignore the fact that project replication is one outcome of a repeated choice situation, and may not be the optimal outcome once stochastic features of the environment are taken into account. In essence, standard techniques ignore the real options relating to the subsequent choices inherent in each decision. By means of a simple example, assuming interest rate uncertainty, it is demonstrated that the standard techniques can lead to errors in a stochastic environment. Because of the idiosyncratic characteristics of project comparisons and the compound nature of the options involved, neat analytical solutions and techniques are not available to replace the elegant, but inadequate, textbook models. Financial managers need to model each choice on a case by case basis, appropriately identifying the key drivers of Net Present Value and specifying the stochastic environment pertaining to each.

AB - Standard techniques advocated for choosing between mutually exclusive projects of unequal lives make an implicit assumption of continued project replication. While intuitively appealing, those techniques ignore the fact that project replication is one outcome of a repeated choice situation, and may not be the optimal outcome once stochastic features of the environment are taken into account. In essence, standard techniques ignore the real options relating to the subsequent choices inherent in each decision. By means of a simple example, assuming interest rate uncertainty, it is demonstrated that the standard techniques can lead to errors in a stochastic environment. Because of the idiosyncratic characteristics of project comparisons and the compound nature of the options involved, neat analytical solutions and techniques are not available to replace the elegant, but inadequate, textbook models. Financial managers need to model each choice on a case by case basis, appropriately identifying the key drivers of Net Present Value and specifying the stochastic environment pertaining to each.

UR - http://www.scopus.com/inward/record.url?scp=0032324957&partnerID=8YFLogxK

M3 - Article

VL - 38

SP - 569

EP - 577

JO - Quarterly Review of Economics and Finance

JF - Quarterly Review of Economics and Finance

SN - 1062-9769

IS - 3 Part.1

ER -