This 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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Paper 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: Handle: RePEc:vic:vicewp:9906
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