Options in Mutually Exclusive Projects of Unequal Lives

Posted: 5 Nov 1998

See all articles by Christine A. Brown

Christine A. Brown

Department of Banking and Finance; Financial Research Network (FIRN)

Kevin Thomas Davis

University of Melbourne - Department of Finance; Australian Centre for Financial Studies

Abstract

Standard techniques advocated for choosing between mutually exclusive projects of unequal lives make an implicit assumption of continued project replication. While intuitively appealing, those techniques ignore the fact that project replication is one outcome of a repeated choice situation, and may not be the optimal outcome once stochastic features of the environment are taken into account. In essence, standard techniques ignore the real options relating to the subsequent choices inherent in each decision. By means of a simple example, assuming interest rate uncertainty, it is demonstrated that the standard techniques can lead to error in a stochastic environment. Because of the idiosyncratic characteristics of project comparisons and the compound nature of the options involved, neat analytical solutions and techniques are not available to replace the elegant, but inadequate, textbook models. Financial managers need to model each choice on a case by case basis, appropriately identifying the key drivers of Net Present Value and specifying the stochastic environment pertaining to each.

Suggested Citation

Brown, Christine A. and Davis, Kevin Thomas, Options in Mutually Exclusive Projects of Unequal Lives. Available at SSRN: https://ssrn.com/abstract=129408

Christine A. Brown (Contact Author)

Department of Banking and Finance ( email )

Building 11E
Clayton, Victoria 3800
Australia
+61 3 99031793 (Phone)
+61 3 99055475 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: www.firn.org.au

Kevin Thomas Davis

University of Melbourne - Department of Finance ( email )

Faculty of Business and Economics
Parkville, Victoria 3010 3010
Australia
+613 8344 5098 (Phone)
+613 8344 6914 (Fax)

Australian Centre for Financial Studies ( email )

Level 46, 525 Collins St
Melbourne, Victoria 3079
Australia

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