The Real Options Solution To A Cost-Of-Capital Dilemma
<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="color: #0d0d0d; font-size: 10pt; mso-themecolor: text1; mso-themetint: 242;"><span style="font-family: Times New Roman;">The required rate of return should equal the average expected return in the market for the same level of risk.<span style="mso-spacerun: yes;"> </span>However, firms should only accept such projects with expected returns that <span style="text-decoration: underline;">exceed</span> this required rate of return.<span style="mso-spacerun: yes;"> </span>This contradicts our first statement that the required rate of return <span style="text-decoration: underline;">equals</span> this average expected return for the market.<span style="mso-spacerun: yes;"> </span>We study this possible paradox in the context of a stochastic general-equilibrium model with endogenous prices.<span style="mso-spacerun: yes;"> </span>We find that the capitalization of the real options involved in this model explains away this contradiction or paradox.</span></span></p>