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.
|Number of pages||9|
|Journal||Quarterly Review of Economics and Finance|
|Issue number||3 Part.1|
|Publication status||Published - 1 Dec 1998|