International Capital Budgeting Using Option Pricing Theory

Abstract

Typically, international capital budgeting is carried out using the adjusted net present value (NPV) approach. In this article, we present an alternate method for valuing international investments; one that is based on the option pricing theory developed by Black and Scholes (1973). We show that when (a) the decision being valued involves an irreversible investment, (b) the investment decision can be postponed, and (c) uncertainty is resolved gradually over time, using the option pricing approach may be more appropriate than the NPV approach. Applying the traditional NPV approach to value investments such as the decision to enter a new market, expand production, suspend operations temporarily or liquidate operations, may lead one to underestimate their value. This is because the naive NPV criteria is a static valuation method that ignores a firm's flexibility to postpone projects, to abandon them, or to shut down operations temporarily.

Citation

Sercu, P. and Uppal, R. (1994), "International Capital Budgeting Using Option Pricing Theory", Managerial Finance, Vol. 20 No. 8, pp. 3-21. https://doi.org/10.1108/eb018483