SIMPLE APPROACH FOR DECIDING: Introduction 3

In both cases, the rules that are derived have the advantage that they provide an unambiguous relation between an easily observable variable and firm investment. This is important from an empirical standpoint because the fact that no such relation had been identified hampered the ability to test the theory. For instance, the ambiguous effect of change in interest rates on investment is often cited at an important implication of the theory. What this paper does is provide a particular interest rate — the mortgage rate — that is unambiguously related to investment. Similarly, a decrease in the time value of the firm’s stock options increases the likelihood of undertaking an expansion. Thus far, the literature on real options has emphasized the ambiguous nature of how macroeconomic policy changes might affect investment. The time value of the firm’s options can be used as an unambiguous measure of the theoretical effect of a policy change. Since this time value can be measured on the firm level for different time horizons, this research opens the possibility of not only assessing the effect of a policy change on the economy as a whole, but also assessing the differential effect across sectors and time horizons.
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The class of investment decisions that are the focus of this paper have been analyzed before. Ingersoll and Ross (1992) have derived the appropriate rule for deciding when to invest in projects with riskless cash flows (a subclass of the first class) in the presence of interest rate uncertainty. Their solution relies on the fact that the option to wait can be valued as an option on interest rates. It therefore depends on the model of interest rates that is used. Since the value of this option must be calculated explicitly, the solution also lacks the principal advantage of standard NPV analysis — simplicity. Although it is not clear what fraction of investment decisions are delayable, it would be hard to argue that this fraction is insignificant.

Ingersoll and Ross (1992, p. 27) therefore conclude that to correctly make a non-trivial fraction of corporate financing decisions, corporate decision makers should not use the simple NPV rule. The implication is that corporate managers would not only need to have a knowledge of finance far beyond the level that is currently standard but would also have to take a stand on what model of interest rates is “correct.” By showing that the hurdle rate derived in that paper corresponds to the yield on a actively traded bond, a mortgage backed security, we demonstrate how both of these difficulties can be avoided.

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