The Effect of Information Streams on Captial Budgeting Decisions

In this paper a new decision rule for capital budgeting is considered. A firm has the opportunity to invest in a project of uncertain profitability. Over time, the firm receives additional information in the form of signals indicating the profitability of the project. The belief that the firm needs to have in a profitable project for investment to be optimal is calculated and analyzed. It is shown that the probability of investing in a project with low profitability is larger when the firm uses a conventional rule like the net present value rule. As a counterintuitive result it is obtained that it can be optimal to undertake the investment at a later point in time in case the expected number of signals per time unit is higher. Also an error measure is discussed that indicates the accuracy of capital budgeting rules in this stochastic environment.