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Does uncertainty resolution matter?

I wish to discuss the problem of uncertainty resolution in investment analysis and valuation. I believe that under the assumption of constant investment opportunities, the pattern of uncertainty resolution (early resolution of uncertainty vs. remote resolution of uncertainty) does not matter when we consider the choice between assets with identical expected discounted return and identical risk characteristics. But, if we assume changing future investment opportunities, the question is no more clear.
Why entrepreneurs prefer projects with early payback to projects with longer payback?
What is your own preferences?

I provide an abstact of the following paper from which to depart a discussion.

The Resolution of Investment Uncertainty Through Time
Harold Bierman, Jr., Warren H. Hausman
Cornell University
Massachusetts Institute of Technology
Investments in operating assets with identical expected discounted return and identical risk characteristics (i.e., variances and higher moments) when measured at the outset may have significantly different patterns of uncertainty resolution over their lives. The concept of uncertainty resolution, although ambiguous, is a potentially important characteristic of an investment alternative. This paper explores the usefulness and limitations of the concept of uncertainty resolution in the evaluation of both single risky investments and in portfolios of risky investments. In cases where future investment opportunities are completely known the concept does not seem useful; however, in a more realistic setting where future investment alternatives are ill defined at present, the concept may prove useful. Further research is needed to explore fully the questions raised here.
MANAGEMENT SCIENCE
Vol. 18, No. 12, August 1972, pp. B-654-B-662

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Replies to This Discussion

Permalink Reply by Mike Adhikari on March 11, 2010 at 1:28pm: Sergei: Interesting topic. I never thought about it before. I agree entrepreneurs prefer shorter payback over longer payback. I think that is because future is more uncertain. My clients prefer a business with more predictable cash flow over less. The more one takes away the risk, the higher the valuation.; ▶ Reply to This

Permalink Reply by sergei on March 12, 2010 at 5:43am: In fact, I say about investment projects with the same risk at the outset. Suppose that we have two projects with 10 year lives. The difference is that in the first project much of the uncertainty is resolved during 3 first years, whereas in the second project uncertainty maintains until the 7 years and start to resolve quickly from year 7 onward. What are the advantages of early uncertainty resolution as in the case of project 1.

Another problem if we have two projects with the same NPV, but different lives. Say, project A is implemented in 5 years, while project B does in 7 years. Let us assume that increasing uncertainty as we move far into the future is accounted properly when we calculate NPV. What project is preferable now and why?; ▶ Reply to This

Permalink Reply by Mike Adhikari on March 12, 2010 at 11:49pm: The discount rate is different each years depending on the risk of future CF in each year. Assuming NPV is same, 3 and 7 years, the 3 year project will be preferred, because even though discount rate is may be higher for the 7 year project, there remains a risk, how do I know what is the right discount rate?

Between A and B, A is preferred. Again, the discount rate itself has uncertainty. How does one know what is the right one. Human beings go for the shorter risk-reduction option because, even though the math of NPV is correct, there is risk in discount rate assumptions.; ▶ Reply to This

Permalink Reply by sergei on March 13, 2010 at 4:50am: To some extent I agree with you. However, apart from this, we need considering additional considerations about preferences for early uncertainty resolution.
To my mind, after the uncertainty is resolved, the risk diminishes and the firm improves credit standing. This may be regarded as one of the advantages, even if we assume that risks are accounted for properly. The second consideration is about abandoning a project, contracting or expansion after its perspectives are clear. This will be modeled through real options.
Project A is preferred, because we can invest elsewhere after year 5. Within the scope of NPV framework we usully assume that other investent opportunities provide only 0 NPV. But if we have the posibbility to invest in projects with positive NPV, then projects with earlier lives are preferable. What do you think about this?; ▶ Reply to This

Permalink Reply by Mike Adhikari on March 13, 2010 at 8:32pm: Optiona A: A 10% IRR project over 5 years.
Option B: A 10% IRR project of 1 year. Ability to invest in newer projects after that.
Both with same NPV over 5 years.
I may prefer A, if the risk of finding subsequent newer projects with IRR = > 10% is high.; ▶ Reply to This

Permalink Reply by sergei on March 16, 2010 at 6:27am: The projects with equal IRRs may differ in risk. You should use 'IRR-CoE' spread to come at equal NPVs.; ▶ Reply to This

Permalink Reply by Brent Wheeler on March 16, 2010 at 3:38am: The key to answering your question lies here. NPV is not the end of the story. There is also implicit (unstated) option value at work here. The option the reinvest in year five is more valuable than the option to reinvest in year seven.... so we prefer the shorter time horizon even if NPV and all other elements are identical.; ▶ Reply to This

Permalink Reply by sergei on March 16, 2010 at 6:25am: I agree. But... may be there are also other advantages or considerations?; ▶ Reply to This

Permalink Reply by Brent Wheeler on March 16, 2010 at 6:33am: Possibly, but I think you are right the way you set the question up.... not all comments have stuck rigorously to the requirement that all moments of all risk variables are equivalent in the problem!!!

Once everything but time is held constant, its difficult to see anything other than option value - if we assume that any errors are, on average distributed equally in both projects (which we must).

The other assumptions (perhaps hidden are):

- fully diversified portfolios
- identical transaction costs between projects
- no arbitrage

But these are standard - and even if not always valid, any deviation applies to both projects.... so its quite a water tight case.; ▶ Reply to This

Permalink Reply by sergei on March 17, 2010 at 1:39pm: I also encountered the notion of "anxiety aversion". Can this be a significant consideration to prefer earlier uncertaity resolution?

See the following paper for details:
http://faculty.chicagobooth.edu/george.wu/research/papers/temporal_...; ▶ Reply to This

Permalink Reply by Brent Wheeler on March 17, 2010 at 2:15pm: Interesting paper. There are potentially a large number of behavioural effects going on. I suppose it comes down to how well the NPV calculation is capable of capturing these..... I guess it underlines the fact that the discount rate will actually differ from period to period depending on resolution - whereas we tend to model things with one rate which must be an average.

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