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An Exact Soultion for the Investment and Market Value of a Firm Facing Uncertainty, Adjustment Costs, and Irreversibility

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  • Andrew B. Abel
  • Janice C. Eberly

Abstract

This paper derives closed-form solutions for the investment and market value, under uncertainty, of competitive firms with constant returns to scale production and convex costs of adjustment. Solutions are derived for the case of irreversible investment as well as for reversible investment. Optimal investment is a non-decreasing function of q, the shadow value of capital. The conditions of optimality imply that q cannot contain a bubble; thus, optimal investment depends only on fundamentals. However, the value of the firm may contain a bubble that does not affect investment behavior. Relative to the case of reversible investment, the introduction of irreversibility does not affect q, but it reduces the fundamental market value of the firm.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4412.

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Date of creation: Jul 1993
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Publication status: published as Journal of Economic Dynamics and Control, Vol. 21 (1997): 831-852.
Handle: RePEc:nbr:nberwo:4412

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  1. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers, Princeton, Department of Economics - Financial Research Center 91, Princeton, Department of Economics - Financial Research Center.
  2. Lucas, Robert E, Jr & Prescott, Edward C, 1971. "Investment Under Uncertainty," Econometrica, Econometric Society, Econometric Society, vol. 39(5), pages 659-81, September.
  3. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, Econometric Society, vol. 50(1), pages 213-24, January.
  4. Robert E. Lucas & Jr., 1967. "Adjustment Costs and the Theory of Supply," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 75, pages 321.
  5. Abel, Andrew B & Eberly, Janice C, 1994. "A Unified Model of Investment under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 84(5), pages 1369-84, December.
  6. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, American Economic Association, vol. 78(5), pages 969-85, December.
  7. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, Elsevier, vol. 52(1), pages 3-37, March.
  8. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 73(1), pages 228-33, March.
  9. 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.
  10. Abel, Andrew B, 1985. "A Stochastic Model of Investment, Marginal q and the Market Value of the Firm," 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 305-22, June.
  11. Pindyck, Robert S, 1993. "A Note on Competitive Investment under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 83(1), pages 273-77, March.
  12. Pindyck, Robert, 1989. "Irreversibility, uncertainty, and investment," Policy Research Working Paper Series 294, The World Bank.
  13. Mussa, Michael L, 1977. "External and Internal Adjustment Costs and the Theory of Aggregate and Firm Investment," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 44(174), pages 163-78, May.
  14. Dixit, Avinash, 1991. "Irreversible Investment with Price Ceilings," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 99(3), pages 541-57, June.
  15. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  16. Treadway, Arthur B, 1969. "On Rational Entrepreneurial Behaviour and the Demand for Investment," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 36(106), pages 227-39, April.
  17. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, American Economic Association, vol. 81(1), pages 279-88, March.
  18. 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.
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Cited by:
  1. Junning Cai, 2003. "Asset Prices and Monetary Policy: Some Notes," Macroeconomics, EconWPA 0305006, EconWPA, revised 13 May 2003.
  2. Richard W. Kopcke, 1995. "Tobin's Q, economic rents, and the optimal stock of capital," Working Papers, Federal Reserve Bank of Boston 95-4, Federal Reserve Bank of Boston.
  3. Andrew B. Abel & Janice C. Eberly, 1995. "The Effects of Irreversibility and Uncertainty on Capital Accumulation," NBER Working Papers 5363, National Bureau of Economic Research, Inc.
  4. Hjalmar Böhm & Michael Funke & Nikolaus A. Siegfried, 1999. "Discovering the Link between Uncertainty and Investment - Microeconometric Evidence from Germany," Quantitative Macroeconomics Working Papers, Hamburg University, Department of Economics 19906, Hamburg University, Department of Economics.
  5. Luisa Affuso & David Newbery, 2002. "The Impact of Structural and Contractual Arrangements on a Vertically Separated Railway," The Economic and Social Review, Economic and Social Studies, Economic and Social Studies, vol. 33(1), pages 83-92.
  6. Affuso, Luisa & Newbery, David M G, 2000. "Investment, Reprocurement and Franchise Contract Length in the British Railway Industry," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2619, C.E.P.R. Discussion Papers.
  7. Junning Cai, 2004. "Baby Boom, Asset Market Meltdown and Liquidity Trap," Macroeconomics, EconWPA 0401002, EconWPA.
  8. Junning Cai, 2003. "Fundamental Paper Wealth and Monetary Policy," Macroeconomics, EconWPA 0309001, EconWPA.

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