Investment, Valuation, and Growth Options

We develop a model in which the opportunity for a firm to upgrade its technology to the frontier (at a cost) leads to growth options in the value of the firm; that is, a firm's value is the sum of value generated by its current technology plus the value of the option to upgrade. Variation in the technological frontier leads to variation in firm value that is unrelated to current cash flow and investment, though variation in firm value anticipates future upgrades and investment. We simulate this model and show that in situations in which growth options are important, regressions of investment on Tobin's Q and cash flow yield small positive coefficients on Q and larger coefficients on cash flow, consistent with the empirical literature. We also show that when growth options are important, the volatility of firm value can substantially exceed the volatility of cash flow, as empirically documented by Shiller (1981) and West (1988).