The Implications of Option Pricing Theory on United Kingdom Development Policy

Cerny, Keith (1997). The Implications of Option Pricing Theory on United Kingdom Development Policy. PhD thesis The Open University.

Abstract

Investment policy makers have consistently sought to promote inward investment through investment incentives of various kinds (e.g. capital grants, depreciation allowances). In applying these instruments, governments seek to influence companies as they apply a traditional investment decision making approach known as Net Present Value (NPV) analysis. Each of the government investment incentives influences some aspect of the NPV calculation.

Relatively recent research by McDonald Siegel (1986) has show n that for certain classes of investments, the NPV approach is inaccurate, often by a factor of two or more. This is because the NPV approach neglects the value of the option gained w hen a company chooses not to invest; by waiting a year or more, a company gains insight into macroeconomic and industry factors. If a company chooses to invest today, it must be sure that the return is sufficient to justify giving up the value of this additional information.

The value of this option can be quantified, based upon the underlying volatility and trend of the investment, and the company's cost of capital. This research creates an explicit linkage between traditional NPV analysis and the option valuation approach, before considering a whole new set of policy instruments designed to increase a company's likelihood to invest. The research develops several potential new instruments, screens them for the desired behaviour, and selects the most promising instrument. The new instrument is then validated by using an investment case example adapted from the public domain and a large computer model.

The research also discusses several related areas. It describes the effect of overlaying Poisson type events on an investment decision (i.e. a sudden shift in the value of the investment), and draws the implications of this thinking on the policy approaches that should be taken by incumbent and opposition regional policy makers. Lastly, the research includes a review of the U.K.'s regional policy objectives and an analysis of different approaches to corporate investment decision making.

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