Track: Financial Engineering

Abstract

This study considers a firm's optimal investment timing problem when investment opportunities arrive in a random sequence and are irreversible. I analytically derive the project value and the investment threshold. The solutions converge to those of the real option value (ROV) method as the arrival rate of investment opportunities is higher, whereas the solutions converge to those of the net present value (NPV) method as the arrival rate of investment opportunities is lower. Further, I extend the results to a case with two project types, namely good and bad types. I analytically derive the condition under which the firm always forgoes bad-type projects. A notable result is that the firm accepts a bad-type project for a low arrival rate and a high state variable. The results reveal the effects of illiquidity on the real option valuation and build a bridge between the NPV and ROV methods.