Journal of Applied Finance & Banking

Revisiting Uncertain Investment and Financing Decisions using Entry Probability

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  • Abstract

    This paper extends the work of Chen and Chang (2010) and attempts to present a model for the optimal investment threshold and the real option value under price uncertainty from a different aspect of entry probability. I measure a financing policy by the debt ratio, a weight for the proportion of funding by debt relative to funding by equity. The weight is exogenously embedded in the stochastic optimization of an investment opportunity under price uncertainty. An entry probability, indicating the likelihood of an investment action optimally taken at a future time instant, is derived. Sensitivity analyses are performed to investigate the effects of parameters such as price volatility and price drift. The results demonstrate that price drift and price volatility might have different effects, depending on the time elapsed and on the debt ratio. In general, higher debt ratio contributes to higher investment threshold and higher real option value, confirming that financial leverage might serve as a value driver. However, as the debt ratio increases, the investment threshold might become too high to reach, indicating that waiting is the best choice. Such a circumstance is also verified by the entry probability approaching zero, which implies the far-reaching investment threshold.