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A Model For The Long-Term Optimal Capacity Level Of An Investment Project


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    (Department of Mathematics, Columbia House, London School of Economics, Houghton Street, London WC2A 2AE, UK)


    (Department of Mathematics, Columbia House, London School of Economics, Houghton Street, London WC2A 2AE, UK)

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    We consider an investment project that produces a single commodity. The project's operation yields payoff at a rate that depends on the project's installed capacity level and on an underlying economic indicator such as the output commodity's price or demand, which we model by an ergodic, one-dimensional Itô diffusion. The project's capacity level can be increased dynamically over time. The objective is to determine a capacity expansion strategy that maximizes the ergodic or long-term average payoff resulting from the project's management. We prove that it is optimal to increase the project's capacity level to a certain value and then take no further actions. The optimal capacity level depends on both the long-term average and the volatility of the underlying diffusion.

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    Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

    Volume (Year): 14 (2011)
    Issue (Month): 02 ()
    Pages: 187-196

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    Handle: RePEc:wsi:ijtafx:v:14:y:2011:i:02:p:187-196

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    Keywords: Capacity expansion; stochastic payoff; irreversible investment; singular control; ergodic optimization; Itô diffusion;


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