THE CONTINGENT-CLAIMS APPROACH TO INVESTMENT DECISIONS

This paper presents a contingent-claims approach to project valuation when capital expenditures are made sequentially over time. It focuses on an important facet of sequential investment projects that the firm can undertake-or pass up projects-as mote information becomes availabl e. The contingent-claims approach takes account of this important feat ure of firms' investment decision process, whereas the traditional cap ital budgeting procedure does not. Since the traditional method does n ot reflect the options nature of investment opportunities, it underest imates the value of sequential investment projects. As a result, a nai ve implementation of the traditional capital budgeting procedure could result in rejecting profitable projects. The extent of undervaluation associated with the traditional capital budgeting procedure is greate r when the correlation between the random component of the future asse t value and that of the required capital expenditure is smaller and/or when the growth rate of the required capital expenditure is higher.