The existing literature on investment flexibility assumes the cost and the process of technology innovation as exogenous with respect to the firm's business needs. I tackle a question that breaks the exogeneity assumption: How valuable is investment technology innovation in the form of sunk cost flexibility that kicks in by the time the status-quo sunk cost reaches a certain level of unattractiveness? The fair value of expenditures in sunk cost flexibility is derived as a function of the desired level of flexibility and of the project's characteristics (present value, risk, discount rate, and operating cash flows as a fraction of the present value). This is achieved via a novel use of barrier contingent claims analysis.
The premium for switching investment technology when business conditions worsen
SBUELZ, Alessandro
2004-01-01
Abstract
The existing literature on investment flexibility assumes the cost and the process of technology innovation as exogenous with respect to the firm's business needs. I tackle a question that breaks the exogeneity assumption: How valuable is investment technology innovation in the form of sunk cost flexibility that kicks in by the time the status-quo sunk cost reaches a certain level of unattractiveness? The fair value of expenditures in sunk cost flexibility is derived as a function of the desired level of flexibility and of the project's characteristics (present value, risk, discount rate, and operating cash flows as a fraction of the present value). This is achieved via a novel use of barrier contingent claims analysis.
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