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Capital Budgeting for Interrelated Projects: A Real Options Approach

Published online by Cambridge University Press:  06 April 2009

Paul D. Childs ,
Steven H. Ott  and
Alexander J. Triantis
Paul D. Childs
Affiliation:
University of Kentucky, Gatton College of Business and Economics, Lexington, KY 40506
Steven H. Ott
Affiliation:
University of Kentucky, Gatton College of Business and Economics, Lexington, KY 40506
Alexander J. Triantis
Affiliation:
University of Maryland at College Park, College of Business and Management, Van Munching Hall, College Park, MD 20742.
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Abstract

This paper explores the effect of project interrelationships on investment decisions and project values in a real options framework. We examine in detail the mutually exclusive case where a firm may invest in the development stage of two projects and then may select only a single project to implement. The firm can develop the projects in parallel or in sequence. The choice of development policy depends on the relative values of the embedded options for each strategy. Sequential development is shown to be superior to parallel development when projects have highly correlated values, and when they require a large commitment of capital for development, are short term in nature, and have relatively low volatility. We also show that the optimal ordering of sequential projects does not always begin with the most profitable project.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 33 , Issue 3 , September 1998 , pp. 305 - 334
Copyright
Copyright © School of Business Administration, University of Washington 1998

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