This paper investigates real options behavior in capital budgeting decisions using a firm-level panel data set of U.S. companies in the manufacturing sector. Specifically, this paper looks are the relationship between the firm's investment to capital ratio and total firm uncertainty, measured as the volatility of the firm's equity returns. Total firm uncertainty is decomposed into its market, industry and firm-specific components. Given that the irreversibility of capital is derived from asset-specificity at the industry level, increased industry uncertainty displays a pronounced negative effect on firm investment consistent with real options behavior. Increased firm-specific uncertainty is also found to depress firm investment -a result that can be attributed to real options behavior and not just managerial risk aversion. The results are robust to various specifications that control for the firm's investment opportunities that are captured by Tobin's q, cash flow, marginal profitability of capital and firm leverage. 1 McDonald and Siegel (1986) present a tractable solution to the valuation of an option to invest in an irreversible project. Similar problems are also investigated in Baldwin (1982), Bernanke (1983) and McDonald and Siegel (1985). Titman (1985) specifically focuses on the valuation of land while Brennan and Schwartz (1985) evaluate investments in natural resource projects.2 See McDonald and Siegel (1986), Pindyck (1988) and Dixit and Pindyck (1994). Homogeneous capital goods that are not industry or firm-specific (such as office equipment) are still partially irreversible because of the lemons problem. Abel andEberly (1994, 1996) and Abel, Dixit, Eberly and Pindyck (1996) define partial irreversibility (or costly reversibility) as the case when the purchase price of capital is greater than its resale price.2

We examine the extent to which uncertainty delays investment and the effect of competition on this relationship using a sample of 1,214 condominium developments in Vancouver, Canada built from 1979-1998. We find that increases in both idiosyncratic and systematic risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the return volatility reduces the probability of investment by 13 percent, equivalent to a 9 percent decline in real prices. Increases in the number of potential competitors located near a project negate the negative relationship between idiosyncratic risk and development. These results support models in which competition erodes option values and provide clear evidence for the real options framework over alternatives such as simple risk aversion.-1-

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This paper investigates real options behavior in capital budgeting decisions using a firm-level panel data set of U.S. companies in the manufacturing sector. Specifically, this paper looks are the relationship between the firm's investment to capital ratio and total firm uncertainty, measured as the volatility of the firm's equity returns. Total firm uncertainty is decomposed into its market, industry and firm-specific components. Given that the irreversibility of capital is derived from asset-specificity at the industry level, increased industry uncertainty displays a pronounced negative effect on firm investment consistent with real options behavior. Increased firm-specific uncertainty is also found to depress firm investment -a result that can be attributed to real options behavior and not just managerial risk aversion. The results are robust to various specifications that control for the firm's investment opportunities that are captured by Tobin's q, cash flow, marginal profitability of capital and firm leverage. 1 McDonald and Siegel (1986) present a tractable solution to the valuation of an option to invest in an irreversible project. Similar problems are also investigated in Baldwin (1982), Bernanke (1983) and McDonald and Siegel (1985). Titman (1985) specifically focuses on the valuation of land while Brennan and Schwartz (1985) evaluate investments in natural resource projects.2 See McDonald and Siegel (1986), Pindyck (1988) and Dixit and Pindyck (1994). Homogeneous capital goods that are not industry or firm-specific (such as office equipment) are still partially irreversible because of the lemons problem. Abel andEberly (1994, 1996) and Abel, Dixit, Eberly and Pindyck (1996) define partial irreversibility (or costly reversibility) as the case when the purchase price of capital is greater than its resale price.2

No abstract