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Irreversible capital accumulation under interest rate uncertainty

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  • Luis Alvarez

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Abstract

We consider the optimal sequential irreversible investment policy of a value maximizing firm facing decreasing returns to scale and interest rate uncertainty. We characterize the optimal accumulation policy and its value for a broad class of diffusion models of the short interest rate by focusing on the marginal investment decision and deriving the marginal value of capital explicitly. We also state a set of conditions under which there is a maximal capital stock above which the option to expand productive capacity further in the future becomes valueless. Hence, our results indicate that interest rate uncertainty may limit the size of an optimally investing firm. Copyright Springer-Verlag 2010

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Bibliographic Info

Article provided by Springer in its journal Mathematical Methods of Operations Research.

Volume (Year): 72 (2010)
Issue (Month): 2 (October)
Pages: 249-271

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Handle: RePEc:spr:compst:v:72:y:2010:i:2:p:249-271

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Related research

Keywords: Interest rate uncertainty; Irreversible investment; Incremental capital accumulation; G31; G11; E22;

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References

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  1. Merton, Robert C., 1973. "An asymptotic theory of growth under uncertainty," Working papers 673-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Luis H. R. Alvarez & Erkki Koskela, 2001. "Wicksellian Theory of Forest Rotation under Interest Rate Variability," CESifo Working Paper Series 606, CESifo Group Munich.
  3. Russell Cooper & Joao Ejarque, 2003. "Financial Frictions and Investment: Requiem in Q," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 710-728, October.
  4. Luis H. R. Alvarez & Erkki Koskela, 2006. "Irreversible Investment under Interest Rate Variability: Some Generalizations," The Journal of Business, University of Chicago Press, vol. 79(2), pages 623-644, March.
  5. Caballero, R.J., 1996. "Fixed Costs: The Demise of Marginal q," Working papers 96-14, Massachusetts Institute of Technology (MIT), Department of Economics.
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  8. Dixit, Avinash, 1995. "Irreversible investment with uncertainty and scale economies," Journal of Economic Dynamics and Control, Elsevier, vol. 19(1-2), pages 327-350.
  9. Nickell, Stephen J, 1974. "On Expectations, Government Policy and the Rate of Investment," Economica, London School of Economics and Political Science, vol. 41(163), pages 241-55, August.
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  11. 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.
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  15. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
  16. Alvarez, Luis H.R. & Koskela, Erkki, 2003. "On Forest Rotation Under Interest Rate Variability," Discussion Papers 840, The Research Institute of the Finnish Economy.
  17. Baldwin, Carliss Y, 1982. " Optimal Sequential Investment When Capital Is Not Readily Reversible," Journal of Finance, American Finance Association, vol. 37(3), pages 763-82, June.
  18. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1980. " An Analysis of Variable Rate Loan Contracts," Journal of Finance, American Finance Association, vol. 35(2), pages 389-403, May.
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