A Bayesian Approach to Real Options : The Case of Distinguishing between Temporary and Permanent Shocks

Traditional real options models demonstrate the importance of the quot;option to waitquot; due to uncertainty over future shocks to project cash flows. However, there is often another important source of uncertainty: uncertainty over the permanence of past shocks. Adding Bayesian uncertainty over the permanence of past shocks augments the traditional option to wait with an additional quot;option to learn.quot; The implied investment behavior differs significantly from that in standard models. For example, investment may occur at a time of stable or decreasing cash flows, respond sluggishly to cash flow shocks, and depend on the timing of project cash flows