Sequential Investments with Stage Specific Risks and Drifts

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Abstract

We provide a generalized analytical methodology for evaluating a real sequential investment opportunity, which does not rely on a multivariate distribution function, but which allows for stage-specific risks and drifts. This model may be a useful capital budgeting and valuation tool for exploration and development projects, where risks change over the stages. We construct a stage threshold pattern whereby the final stage threshold exceeds the early stage threshold due to drift differentials between the project values at the various stages, value volatility differences, and correlation differentials, implying a rich menu of parameter values that may be suitable for a variety of projects. Governments seeking to motivate early final stage investments might lower final stage project volatility or specify project value decline over time, unless prospective owners are willing to pay the real option value (ROV) for concessions. In contrast, concession owners, more interested in ROV than thresholds that motivate early investments, may welcome final stage value escalation, or guarantees that reduce the correlation between project value and construction cost.

Bibliographical metadata

Original languageEnglish
Article numberdoi 10.1080
Pages (from-to)1150-1175
JournalEuropean Journal of Finance
Volume23
Early online date4 Apr 2016
DOIs
Publication statusPublished - Jan 2017

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