In sequential decision processes, there has been an increasing awareness that the flexibility to pursue newly emergent investment opportunities is an important property of decision alternatives which describes the future availability of invested funds. However, the methods to measure effectively the flexibility have not yet been developed, and the flexibility has not been regarded as a decision factor distinct from the profit and the risk factors for evaluating proposals. The information on the future availability of invested funds provides a decision maker with additional insight into the characteristics of alternatives.
Payback period and unrecovered project balance as measures of flexibility are compared with negative project balance. The negative project balance at each point in time provides the information on the shape of the time-dependent cash flow pattern and the rate at which the uncertainty about the recovery of the initial investment cost is resolved through time. The shortcomings of the previous approach utilizing the negative project balance as a basis to measure flexibility are pointed out. A method is developed for measuring the flexibility, using the concept of the negative project balance with project abandonment option.
The investment decision with consideration of flexibility and profitability results more wealth accumulation than the decision without considering flexibility does in sequential investment processes. To utilize the information on the flexibility under certainty, the PV/FI decision model is developed. Under risk, the multiobjective decision model is developed as a method to assess the worth of proposals that have probabilistic outcomes in sequential capital allocation processes under capital rationing. This model includes the idea of flexibility along with the profit and the risk measures accepted well in the traditional investment decision models. The effectiveness of this model is compared with the expected present value and the mean-semivariance models by simulation.