Sequential Investment Analysis Under Uncertainty

ONE of the most important require*3 ments of a good capital budgeting ~Y procedure is that it provides an effective scheme for handling uncertainty. Most classical capital budgeting techniques do not formally incorporate uncertainty into the analysis, although some recent techniques do introduce uncertainty about the outcomes of investment opportunities presently available to the firm. But the nature of uncertainty in capital budgeting is much broader. In selecting among presently available investment opportunities the firm must also take into account the timing, number, size, and profitability of deals that may appear in the future-none of which may be known with certainty. As a consequence, most firms are faced with two conflicting desires: to have funds available for highly profitable investment opportunities that have not yet appeared on the investment horizon and at the same time to avoid tax and opportunity cost penalties for underinvestment.1 The purpose of this paper is to summarize some ways in which uncertainties about future investment opportunities may be explicitly taken into account in making investment choices so as to strike a balance between these conflicting desires. An outstanding example of this conflict is the problem faced by oil and gas operators with limited funds who attempt to discover and develop oil and gas deposits: How should an oil and gas operator with limited funds select from the stream of inside prospects and outside deals that he must review each year?2 Even if the operator has developed the best potential exploration program over areas and deals presently available to him for exploitation, he cannot be sure that he has allocated his capital in the most efficient manner possible, for as the fiscal year passes he will be required to review and accept or reject a large number of inside prospects and outside deals that he has not yet seen. Both the number of future deals or prospects that will appear and the value of each deal or prospect when it does appear are unknown to him. If he commits all of his capital to those ventures before him now, he may have difficulty raising funds for the real hot ones that may come along next month. If he holds back and does not invest the cash throwoff from his present holdings of oil and gas properties, the throwoff will be taxed at the end of the year-a penalty that might be avoided by relaxing his acceptance criteria and accepting more deals earlier in the year. One independent operator presented his quandary by saying: