The investment opportunity set and its proxies

Abstract

Myers (1977) describes the value of a firm as consisting of 2 things: assets in place and future investment options. He introduces the term 'Investment Opportunity Set' (IOS) to describe these options. In this paper, we have set out to identify the most appropriate proxy for the IOS using a range of single factor and multifactor techniques. Several recent studies do already use similar methods to examine the correlation between various proxies and an observable measure of the IOS over the following years (Kallapur and Trombley (1999), Baber, Janakiraman and Kang (1995), Adam and Goyal (2002)). The most common measure used previously for the IOS has been the future growth in the book value of the firm. This growth measures directly how the size of the firm in terms of book value increases, although it contains no information on how the market value of a firm is affected by future investments. This paper extends the existing literature by using a market-based measure for the IOS. Before starting it is important to define the IOS. Kallapur and Trombley (2001) define investment opportunities as options to invest in positive net present value (NPV) projects. They state that while some investment opportunities also result in an increase in the size of the firm, not all 'growth' opportunities have a positive NPV. Since all opportunities in the IOS have a positive NPV, investment will lead to an increase in value to shareholders, which ultimately should end up in the market value of the company.