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The effects of irreversibility on the timing and intensity of lumpy investment

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  • Wong, Kit Pong
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    Abstract

    This paper examines how changes in irreversibility of investment affect the timing and intensity of lumpy investment. We develop a continuous-time model wherein a firm is endowed with a perpetual option to invest in a project at any time by incurring a partially reversible investment cost at that instant. The amount of the investment cost is directly related to the intensity of investment that is endogenously chosen by the firm at the instant when the investment option is exercised. We show that higher irreversibility of investment induces the firm to raise its optimal investment trigger, thereby deferring the undertaking of the project. Furthermore, we show that changes in irreversibility of investment have no impact on the firm's optimal investment intensity due to two opposing effects that exactly offset each other. Finally, we show that higher irreversibility of investment reduces the value of the investment option and, therefore, makes the firm less valuable.

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    Bibliographic Info

    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 27 (2010)
    Issue (Month): 1 (January)
    Pages: 97-102

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    Handle: RePEc:eee:ecmode:v:27:y:2010:i:1:p:97-102

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    Web page: http://www.elsevier.com/locate/inca/30411

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    Keywords: Investment intensity Investment timing Irreversibility Real options;

    References

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    1. Goldstein, Robert & Ju, Nengjiu & Leland, Hayne, 2001. "An EBIT-Based Model of Dynamic Capital Structure," The Journal of Business, University of Chicago Press, vol. 74(4), pages 483-512, October.
    2. Andrew B. Abel & Avinash K. Dixit & Janice C. Eberly & Robert S. Pindyck, 1995. "Options, the Value of Capital, and Investment," NBER Working Papers 5227, National Bureau of Economic Research, Inc.
    3. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-52, September.
    4. Capozza, Dennis & Li, Yuming, 1994. "The Intensity and Timing of Investment: The Case of Land," American Economic Review, American Economic Association, vol. 84(4), pages 889-904, September.
    5. Andrew B. Abel & Janice C. Eberly, 1993. "A Unified Model of Investment Under Uncertainty," NBER Working Papers 4296, National Bureau of Economic Research, Inc.
    6. Wong, Kit Pong, 2008. "Does market demand volatility facilitate collusion?," Economic Modelling, Elsevier, vol. 25(4), pages 696-703, July.
    7. Shakill Hassan, 2005. "Optimal timing of defections from price-setting cartels in volatile markets," Working Papers 03, Economic Research Southern Africa.
    8. Abel, Andrew B. & Eberly, Janice C., 1999. "The effects of irreversibility and uncertainty on capital accumulation," Journal of Monetary Economics, Elsevier, vol. 44(3), pages 339-377, December.
    9. Agliardi, Elettra & Agliardi, Rossella, 2008. "Progressive taxation and corporate liquidation policy," Economic Modelling, Elsevier, vol. 25(3), pages 532-541, May.
    10. Wong, Kit Pong, 2009. "The effects of abandonment options on operating leverage and investment timing," International Review of Economics & Finance, Elsevier, vol. 18(1), pages 162-171, January.
    11. Wong, Kit Pong, 2007. "The effect of uncertainty on investment timing in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2152-2167, July.
    12. Bar-Ilan, Avner & Strange, William C., 1999. "The Timing and Intensity of Investment," Journal of Macroeconomics, Elsevier, vol. 21(1), pages 57-77, January.
    13. Wong, Kit Pong, 2009. "Progressive taxation, tax exemption, and corporate liquidation policy," Economic Modelling, Elsevier, vol. 26(2), pages 295-299, March.
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    Cited by:
    1. Feil, Jan-Henning & Musshoff, Oliver, 2013. "Modelling investment and disinvestment decisions under competition, uncertainty and different market interventions," Economic Modelling, Elsevier, vol. 35(C), pages 443-452.
    2. Wong, Kit Pong, 2011. "Progressive taxation and the intensity and timing of investment," Economic Modelling, Elsevier, vol. 28(1-2), pages 100-108, January.

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