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IRREVERSIBILITY

This example demonstrates the role irreversibility plays a role in real options logic.8 Irreversibility refers to the inability to recover part or all of an investment if conditions change. The oil field, for example, can be considered at least partly irreversible since firms cannot recoup all of the expenditures associated with field purchase should oil prices decline below profitable levels. If one's investments were completely reversible, one would not need to consider option investing since poor decisions could be costlessly corrected. One should note that irreversibility will vary by option. For example, a new alliance contract may be terminated at minimal cost9 although failed entry into new markets can have devastating consequences for firms. Obviously, assessing degrees of irreversibility is essential for determining values of real options.

UNCERTAINTY

Uncertainty obviously plays an important role in determining the value of the oil field option. Option management is unnecessary in the absence of uncertainty since complete knowledge (and rationality) allows one to consistently select the optimal investment strategy. In the presence of complete knowledge, one knows exactly what course to pursue. Obviously, such conditions are rarely met. Therefore, option values often (but not always) increase with increasing uncertainty.10 In the case of the oil field, an investor cannot easily recoup her/his loss if economic conditions move downward (leading to declines in oil prices), or if alternative means of energy production develop (leading to decline in oil demand).

We should note, however, that the effects of uncertainty on option value are multifaceted. For example, some scholars 11 distinguish between economic uncertainty (i.e., that which is due to general macro-economic movements) and technical uncertainty (i.e., that which can be reduced via experimentation), which demonstrate countervailing effects on investment decisions.12 For example, economic uncertainty reflected in highly volatile oil prices compels one to wait to invest (e.g., pursue development of an oil field) in order to gather more information about long-term project profitability. Such uncertainty is "exogenous" since firm actions can in no way reduce this uncertainty.13 In contrast, technical uncertainty or the lack of understanding of how to effectively extract the oil is "endogenous" (since firm activities can reduce it) to the decision process and therefore can be reduced via investment. Iterative development (e.g., drilling a number of wells before deciding which to pursue for further oil extraction, using various drilling technologies before deciding which is most effective) will inform the firm of potential oil in the field, viability of extraction methods, etc. The important point here is that whereas economic uncertainty in the real options literature forestalls investment (e.g., wait and see how events unfold), technical uncertainty compels (at least in a limited manner) investment (e.g., investment reveals more information on which to base subsequent investment).

Furthermore, some research indicates that a single type of uncertainty can have a nonlinear effect on investment.14 For example, uncertainty may precipitate conditions where increases in (potential) returns to a unit of investment exceed the cost of that unit. Such conditions can occur when exogenous uncertainty creates considerable ignorance about future business conditions and thus, provides considerable upside potential while depressing input prices.15 For example, consider a manufacturing firm in an industry facing considerable market uncertainty. This uncertainty may lead to reduced input prices as producers curtail further production. However, reduced production may also attract new entrants into the industry. Some incumbents may be able to forestall entry by investing in a new plant while offsetting some of this investment with lower input prices the industry.16 In such cases, uncertainty about demand and potential entrant abilities may compel rather than dissuade investment in the plant.

 
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