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The Effects of Misspecification of Stochastic Processes on Investment Appraisal

Authors: George Yungchih Wang


For decades financial economists have been attempted to determine the optimal investment policy by recognizing the option value embedded in irreversible investment whose project value evolves as a geometric Brownian motion (GBM). This paper aims to examine the effects of the optimal investment trigger and of the misspecification of stochastic processes on investment in real options applications. Specifically, the former explores the consequence of adopting optimal investment rules on the distributions of corporate value under the correct assumption of stochastic process while the latter analyzes the influence on the distributions of corporate value as a result of the misspecification of stochastic processes, i.e., mistaking an alternative process as a GBM. It is found that adopting the correct optimal investment policy may increase corporate value by shifting the value distribution rightward, and the misspecification effect may decrease corporate value by shifting the value distribution leftward. The adoption of the optimal investment trigger has a major impact on investment to such an extent that the downside risk of investment is truncated at the project value of zero, thereby moving the value distributions rightward. The analytical framework is also extended to situations where collection lags are in place, and the result indicates that collection lags reduce the effects of investment trigger and misspecification on investment in an opposite way.

Keywords: real options, GBM, misspecification, investment trigger, collection lags

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