Testing the Option Value Theory of Irreversible Investment

This paper statistically tests the theory of irreversible investment under uncertainty. Using dynamic programming and contingent claims valuation alternatively, we derive the value of options to invest in capacity, where the projects are endogenous to the economic circumstances prevailing at the investment date. We then test whether capacity investment decisions made by Canadian copper mines are compatible with the theory. The result speak strongly in favor of option theory as a theory of real investment; in particular, we provide a test which rejects the Net Present Value criterion, and our model explains both investment size and timing satisfactorily from a statistical and from an economic point of view.
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