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Solving the Capacity Optimization Problem under Demand Uncertainty

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  • Jan Vlachý

    ()
    (Czech Technical University, Prague and City University of Seattle)

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    Abstract

    This paper provides theoretical and practical insight into the solution of the investment project optimization problem under uncertainty. A case study recommends the use of statistical simulation, which is shown to be a powerful, practical, flexible and comprehensive tool for managerial decision-making purposes, even as it takes into account exogeneous uncertainty, as well as endogeneous processes structurally vested in the project. Results show that excess capacity may have a value exceeding its cost, which can be assessed either through comparison of available variants, or by carrying out a full optimization. From the theoretical point of view, the relationship of the problem to real-option analysis is investigated in more detail. Even though it obviously does contain real options, in principle, as various project alternatives differ in terms of their flexibility to alter operating scale, the proposed solution clearly surmounts some of the limitations of prevalent realoption models.

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    Bibliographic Info

    Article provided by Department of International Business and Economics from the Academy of Economic Studies Bucharest in its journal Romanian Economic Journal.

    Volume (Year): 12 (2009)
    Issue (Month): 34 ((4))
    Pages: 97-116

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    Handle: RePEc:rej:journl:v:12:y:2009:i:34:p:97-116

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    Related research

    Keywords: capital budgeting; capacity optimization; real options; statistical simulation;

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    References

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    1. Henry, Claude, 1974. "Investment Decisions Under Uncertainty: The "Irreversibility Effect."," American Economic Review, American Economic Association, vol. 64(6), pages 1006-12, December.
    2. Robert S. Pindyck, 1986. "Irreversible Investment, Capacity Choice, and the Value of the Firm," NBER Working Papers 1980, National Bureau of Economic Research, Inc.
    3. Boyle, Phelim P., 1977. "Options: A Monte Carlo approach," Journal of Financial Economics, Elsevier, vol. 4(3), pages 323-338, May.
    4. Rendleman, Richard J, Jr & Bartter, Brit J, 1979. "Two-State Option Pricing," Journal of Finance, American Finance Association, vol. 34(5), pages 1093-1110, December.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    6. Lenos Trigeorgis, 1993. "Real Options and Interactions With Financial Flexibility," Financial Management, Financial Management Association, vol. 22(3), Fall.
    7. A. Charnes & W. W. Cooper, 1959. "Chance-Constrained Programming," Management Science, INFORMS, vol. 6(1), pages 73-79, October.
    8. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    9. Hadar, Josef & Russell, William R, 1969. "Rules for Ordering Uncertain Prospects," American Economic Review, American Economic Association, vol. 59(1), pages 25-34, March.
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