Real options in irreversible investment under uncertainty: A review

Abstract

The use of real options approach to determine the optimal time to execute irreversible investment under uncertainty has been studied extensively. Several relationships between uncertainty and irreversible investment has been proposed. We review the literature with the aim of answering the following questions: (i) What is the inadequacy in the methods used to solve the optimal timing problem in real options analysis for irreversible investment? (ii) What is the relationship between uncertainty and irreversible investment? (iii) How do you choose the stochastic process to incorporate in a real options analysis of an irreversible investment? Based on our study we clarify the apparent ambiguity in the relationship between uncertainty and irreversible investment and present four fundamental relationships between uncertainty and irreversible investment. Guidelines for selecting appropriate stochastic processes to include in an empirical study of an irreversible investment are suggested and some possible future directions of research are charted.