Investment Decision Making under Uncertainty: The Impact of Risk Aversion, Operational Flexibility, and Competition

Traditional real options analysis addresses investment under uncertainty assuming a risk-neutral decision maker and complete markets. In reality, however, decision makers are often risk averse and markets are incomplete. Additionally, capital projects are seldom nowor-never investments and can be abandoned, suspended, and resumed at any time. In this thesis, we develop a utility-based framework in order to examine the impact of operational flexibility, via suspension and resumption options, on optimal investment policies and option values. Assuming a risk-averse decision maker with perpetual options to suspend and resume a project costlessly, we confirm that risk aversion lowers the probability of investment and demonstrate how this effect can be mitigated by incorporating operational flexibility. Also, we illustrate how increased risk aversion may facilitate the abandonment of a project while delaying its temporary suspension prior to permanent resumption. Besides timing, a firm may have the freedom to scale the investment’s installed capacity. We extend the traditional real options approach to investment under uncertainty with discretion over capacity by allowing for a constant relative risk aversion utility function and operational flexibility in the form of suspension and resumption options. We find that, with the option to delay investment, increased risk aversion facilitates investment and decreases the required investment threshold price by reducing the amount of installed capacity. We explore strategic aspects of decision making under uncertainty by examining how duopolistic competition affects the entry decisions