In this thesis, the real options approach is used to analyze the optimal entry and exit strategies of an investment project. The value of a project under stochastic cash flows and the value of the option to invest are computed. The investment decision model assumes, if the firm invests, it obtains a project that produces fixed number of units of product, which can be sold at a fixed cost. The demand of the product is assumed to be stochastic. The production may be in excess and the surplus can be sold at a lower scrap price. The firm incurs an upfront cost to invest; and while the project has been activated, another sunk cost is required for abandonment. The model attempts to derive the threshold value of demand at which the firm should optimally exercise the option to invest. Once the...[ Read more ]

In this thesis, the real options approach is used to analyze the optimal entry and exit strategies of an investment project. The value of a project under stochastic cash flows and the value of the option to invest are computed. The investment decision model assumes, if the firm invests, it obtains a project that produces fixed number of units of product, which can be sold at a fixed cost. The demand of the product is assumed to be stochastic. The production may be in excess and the surplus can be sold at a lower scrap price. The firm incurs an upfront cost to invest; and while the project has been activated, another sunk cost is required for abandonment. The model attempts to derive the threshold value of demand at which the firm should optimally exercise the option to invest. Once the project has been activated, we also determine the threshold value at which it optimally abandons the project. Since there are lower and higher caps on the stochastic cash flows associated with the project, the right to invest and the right to abandon are rendered useless when it is too costly to invest and exit, respectively. The finite time horizon version of the investment decision model is also analyzed. This optimal entry and exit investment decision model can be visualized as a compound American option since the payoff upon exercising the entry right is another option with the exit right.