SUMMARY

Some investment decisions are exposed to uncertainty over their implementation phase apart from the underlying economic uncertainty. We provide a general way of introducing implementation uncertainty, which includes prior research as a special case. The generality of our treatment stems from the fact that implementation uncertainty is allowed to affect both the level and the timing of project profitability. In a case explicitly addressed, implementation uncertainty might even cause earlier investment if the probability of uncertainty resolution exceeds the opportunity cost of delaying investment. Investment will be earlier, the higher the effect of uncertainty resolution on project profitability.

3.1 INTRODUCTION

When a firm is contemplating entry into a new market or investment in a research project, its decision must be made in an uncertain environment and in most cases it entails costs, which are at least partly irreversible. Uncertainty arises from the stochastic nature of the economic value of the investment. Since the return to a new product design or production process is derived from product market profitability, the value of the investment is affected by fluctuations in expected cash flows or market demand. On the other hand, R&D or investment expenditures may be sunk costs either because of the specificity of their nature in a particular firm/industry or because of what is termed the lemons effect (see Akerlof, 1970).

A growing line of research known as real options , by exploiting the analogy between real and financial investment decisions, has stressed the fact that uncertainty...