Irreversible Investment, Capacity Choice, and the Value of the Firm
AbstractA model of capacity choice and utilization is developed consistent with value maximization when investment is irreversible and future demand is uncertain. Investment requires the full value of a marginal unit of capacity to be at least as large as its full cost. The former includes the value of the firms option not to utilize the unit, and the latter includes the opportunity cost of exercising the investment option. We show that for moderate amounts of uncertainty, the firm's optimal capacity is much smaller than it would be if investment were reversible, and a large fraction of the firm's value is due to the possibility of future growth. We also characterize the behavior of capacity and capacity utilization, and discuss implications far the measurement of marginal cost and Tobin's q.
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Bibliographic InfoArticle provided by American Economic Association in its journal American Economic Review.
Volume (Year): 78 (1988)
Issue (Month): 5 (December)
Other versions of this item:
- Pindyck, Robert S., 1986. "Irreversible investment, capacity choice, and the value of the firm," Working papers 1802-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Robert S. Pindyck, 1986. "Irreversible Investment, Capacity Choice, and the Value of the Firm," NBER Working Papers 1980, National Bureau of Economic Research, Inc.
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