The Timing and Scale of Investment Under Uncertainty
AbstractThis paper studies optimal investment in sunk assets for a firm facing uncertain future demand and costs. The investment problem is decomposed into decisions over scale and timing which are influenced by convex adjustment costs and the feasibility of delaying investment. The value of the resulting real option to delay behaves as expected in response to increases in demand and cost uncertainty but has new timing and scale interpretations. The larger is the option value, the more capital would be installed if delay were not profitable. The timing of investment, however, is controlled by the expected trajectory of capital prices relative to the firm's discount rate. The analysis also suggests an empirical model for aggregate investment which explains 96% of the variation in real annual investment for Canada over the period (1981-94) using regressors formed from only three variables: business confidence, capital prices and real interest rates.
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Bibliographic InfoPaper provided by Department of Economics, University of Victoria in its series Econometrics Working Papers with number 9906.
Length: 20 pages
Date of creation: 02 Jun 1999
Date of revision:
Note: ISSN 1485-6441
Contact details of provider:
Postal: PO Box 1700, STN CSC, Victoria, BC, Canada, V8W 2Y2
Web page: http://web.uvic.ca/econ
More information through EDIRC
Investment; timing; scale;
Find related papers by JEL classification:
- D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
- D92 - Microeconomics - - Intertemporal Choice - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
This paper has been announced in the following NEP Reports:
- NEP-ALL-1999-07-28 (All new papers)
- NEP-FIN-1999-07-28 (Finance)
- NEP-MIC-1999-07-28 (Microeconomics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Andrew B. Abel & Avinash Dixit & Janice C. Eberly & Robert S. Pindyck, 1996.
"Options, the Value of Capital, and Investment,"
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- Abel, Andrew B., 1952-, 1995. "Options, the value of capital, and investment," Working papers 3843-95., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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- Majd, Saman & Pindyck, Robert S., 1987.
"Time to build, option value, and investment decisions,"
Journal of Financial Economics,
Elsevier, vol. 18(1), pages 7-27, March.
- Saman Majd & Robert S. Pindyck, 1985. "Time to Build, Option Value, and Investment Decisions," NBER Working Papers 1654, National Bureau of Economic Research, Inc.
- McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
- Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
- John P. Small & Henry Ergas, 1999. "The Rental Cost of Sunk and Regulated Capital," Econometrics Working Papers 9908, Department of Economics, University of Victoria.
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