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An investment model with switching costs and the option to abandon

Author

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  • Mihail Zervos

    (London School of Economics)

  • Carlos Oliveira

    (Universidade de Lisboa)

  • Kate Duckworth

    (London School of Economics)

Abstract

We develop a complete analysis of a general entry–exit–scrapping model. In particular, we consider an investment project that operates within a random environment and yields a payoff rate that is a function of a stochastic economic indicator such as the price of or the demand for the project’s output commodity. We assume that the investment project can operate in two modes, an “open” one and a “closed” one. The transitions from one operating mode to the other one are costly and immediate, and form a sequence of decisions made by the project’s management. We also assume that the project can be permanently abandoned at a discretionary time and at a constant sunk cost. The objective of the project’s management is to maximise the expected discounted payoff resulting from the project’s management over all switching and abandonment strategies. We derive the explicit solution to this stochastic control problem that involves impulse control as well as discretionary stopping. It turns out that this has a rather rich structure and the optimal strategy can take eight qualitatively different forms, depending on the problems data.

Suggested Citation

  • Mihail Zervos & Carlos Oliveira & Kate Duckworth, 2018. "An investment model with switching costs and the option to abandon," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 88(3), pages 417-443, December.
    • Handle: RePEc:spr:mathme:v:88:y:2018:i:3:d:10.1007_s00186-018-0641-5
    DOI: 10.1007/s00186-018-0641-5
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    References listed on IDEAS

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