Real options maximizing survival probability under incomplete markets

Abstract

By integrating the survival problem into the theory of real option valuation under incomplete markets, we analyze an entrepreneurial firm s optimal survival probability and the joint decisions of business investments and portfolio choices when the business investment opportunity has undiversifiable idiosyncratic risks. Based on the theory of stochastic control, we derive the semi-closed-form solutions for the firm s optimal survival probability, its investment thresholds and the implied option value. The results show that the goal of maximizing the survival probability greatly changes the entrepreneur s business investment strategies, the pattern of asset allocation and the correlation between the option value and the project risks. The comparative statics analysis shows that public authorities should subsidize entrepreneurs and maintain stabile financial markets in order to encourage entrepreneurship.