The Real Options Solution To A Cost-Of-Capital Dilemma
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Keywords
cost of capital, real options, capital budgeting, general equilibrium financial theory, expected returns, rate-of-return paradox
Abstract
The required rate of return should equal the average expected return in the market for the same level of risk. However, firms should only accept such projects with expected returns that exceed this required rate of return. This contradicts our first statement that the required rate of return equals this average expected return for the market. We study this possible paradox in the context of a stochastic general-equilibrium model with endogenous prices. We find that the capitalization of the real options involved in this model explains away this contradiction or paradox.