Reading books about making strategic decisions in the workplace sometimes makes me feel better ‐ only very few make me think better. Dr David Luenberger has written a book which teaches how to think better. It is intended to inform well‐educated practitioners and MBA students of the various problems associated with investment decision making. It is a patiently written book written for a diverse audience with varied needs, but I like the book because of my interests in capital budgeting and option pricing theory. In it I find clear and simple explanations of how and why options which trade on exchanges are priced and the connection of option pricing to capital budgeting. Luenberger’s clear and simple explanations about these matters are in short supply in finance; so Luenberger’s effort is an unusual achievement. There are not many other places one can go to learn about these topics without having either very specialized preparation as a prerequisite, or the courage to read for page after page without understanding in the desperate hope that the light will come on before the end of the chapter comes.
Indeed, academics and their MBA students prize this text as a gateway which permits decision makers to move from an elementary grasp of investment analysis to an advanced one more practical in its use. It is a teaching book, moving the reader from the show‐and‐tell treatment of plugging data into a model and getting an answer, to a higher plane where the more honest but more difficult questions about the quality of a model and the decision it produces are evaluated.
Luenberger’s book is a clear treatment of traditional investment theory and the recent improvements to this theory. Traditional methods such as the Discounted Cash Flow Model for Capital Budgeting, the Bond Model, the Capital Asset Pricing Model, the Arbitrage Pricing Theory, both the Black‐Scholes and Binomial Option Pricing Models are treated in sufficient detail and with great clarity. Moreover, the examples used throughout the text are not trivial but yet simple enough to be easily followed by the reader who wishes to see specific applications which serve to reinforce concepts already taught, and also rich enough in their details to be of practical interest to the reader, apart from their pedagogical advantages. Of the traditional topics, most corporate decision makers will have little professional interest in utility theory, although academics will appreciate Luenberger’s demonstrations which link this theory with other pricing models, both single‐ and multi‐period. However, corporate practitioners will almost certainly appreciate an application of utility theory which is found in Luenberger: the notion of optimal growth. Log‐optimal portfolios are weighted (levered) in such a way as to maximize the long‐run rate of return on investment. Luenberger’s explanation of how this can be done and why and when such a solution is optimal is an extraordinary piece of expository writing.
Readers in the workplace will find from this book important work which they are unfamiliar with. Log‐optimal strategies and the rest represent ideas which make a difference to the survival and future of corporate organizations. Recent insights into investment decision making, laid down for the reader by Luenberger with pains‐taking care, go far past the issue of what the discount rate should be in a particular Net Present Value (NPV), problem. These new results are enormously important to corporate decision makers as they think about capital investment as a tool which can make their firms more adaptable to rapidly changing market conditions for both inputs and outputs.
These new insights suggest that a traditional view of NPV, which always neglects the value of flexibility inherent in some investments, overstates the cost of capital for those investment opportunities which if pursued provide the firm with an ability to alter the mix of either its outputs or its inputs in response to changing market conditions.
Luenberger’s book is an unparalleled resource for corporate decision makers who have been away from university studies long enough to be unaware of the decision‐making tools now available to value what are termed by academics to be real options. Real options value the degree of operational flexibility inherent in strategic and tactical investment opportunities. Capital budgeting decisions which are evaluated with traditional NPV models impute a zero value for flexibility. Decision makers using the traditional NPV tools learned in B‐schools ignore the value of operational flexibility.
However, a warning is in order ‐ although it is the most accessible of any text that I have read concerning the nature and evaluation of these real options in particular, and that of the improvements in investment theory in general, it is not a book that can be read by any practitioner without regard for his or her background. Easy reading requires a B‐school or engineering background. The successful reader is familiar with the notion of NPV and is willing to work with mathematical notation familiar to anyone who has taken courses in algebra, statistics, and business finance. For those who can afford this price of admission, it is a truly useful book.
