The Relationship between the Magnitude of Growth Opportunities and the Duration of Equity
Posted: 8 Dec 1999
Abstract
Conventional wisdom holds that since cash flows from growth opportunities occur later in time relative to cash flows from existing projects, firms that can be characterized as growth firms, have a higher duration. In this paper, we adopt the real options approach to the valuation of growth opportunities and show that under certain circumstances, the opposite can be true; equity duration can be lower for growth firms. Further, we show that the relation between equity duration and the magnitude of growth opportunities depends on (i) the magnitude of the duration of assets in place, (ii) the market share of the firm in its industry, (iii) the magnitude of R&D expenditures, and (iv) the volatility of future cash flows generated by the investment project underlying the growth opportunity. We find empirical support for our predictions for firms in the utility and banking industries.
JEL Classification: G31, G32
Suggested Citation: Suggested Citation