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Irreversible investment, capacity choice, and the value of the firm

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  • Pindyck, Robert S.

Abstract

A model of capacity choice and utilization is developed consistent with value maximization when investment is irreversible and future demand is uncertain. Investment requires the full value of a marginal unit of capacity to be at least as large as its full cost. The former includes the value of the firms option not to utilize the unit, and the latter includes the opportunity cost of exercising the investment option. We show that for moderate amounts of uncertainty, the firm's optimal capacity is much smaller than it would be if investment were reversible, and a large fraction of the firm's value is due to the possibility of future growth. We also characterize the behavior of capacity and capacity utilization, and discuss implications far the measurement of marginal cost and Tobin's q.

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File URL: http://hdl.handle.net/1721.1/2147
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Bibliographic Info

Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 1802-86..

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Date of creation: 1986
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Handle: RePEc:mit:sloanp:2147

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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
Phone: 617-253-2659
Web page: http://mitsloan.mit.edu/
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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

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Keywords: HD28 .M414 no.1802-; 86;

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  1. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
  2. Cukierman, Alex, 1980. "The Effects of Uncertainty on Investment under Risk Neutrality with Endogenous Information," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(3), pages 462-75, June.
  3. Andrew B. Abel & Olivier J. Blanchard, 1983. "The Present Value of Profits and Cyclical Movements in Investment," NBER Working Papers 1122, National Bureau of Economic Research, Inc.
  4. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 101(4), pages 707-27, November.
  5. Bernanke, Ben S, 1983. "Irreversibility, Uncertainty, and Cyclical Investment," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 98(1), pages 85-106, February.
  6. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, Elsevier, vol. 5(2), pages 258-266, October.
  7. Saman Majd & Robert S. Pindyck, 1985. "Time to Build, Option Value, and Investment Decisions," NBER Working Papers 1654, National Bureau of Economic Research, Inc.
  8. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
  9. Hall, Robert E, 1988. "The Relation between Price and Marginal Cost in U.S. Industry," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 96(5), pages 921-47, October.
  10. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 241-249, November.
  11. Baldwin, Carliss Y, 1982. " Optimal Sequential Investment When Capital Is Not Readily Reversible," Journal of Finance, American Finance Association, American Finance Association, vol. 37(3), pages 763-82, June.
  12. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 73(1), pages 228-33, March.
  13. Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 103(3), pages 479-508, August.
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