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Real investment decision under CRRA utility: The flow payoff case

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  • Yin, Xiaoqing
  • Wang, Haijun

Abstract

This paper explores how payoff volatility (idiosyncratic volatility), time preference and investment-wealth ratio affect an entrepreneur's real investment decision in a constant relative risk aversion (CRRA) framework, when the investment project generates a flow payoff. We find that time preference has an important effect on the optimal investment threshold, which comes from wealth effects on the implied project value and the implied option value. Particularly, we discover that the optimal investment threshold is convex in time discount rate. At most cases, a larger payoff volatility increases the optimal investment threshold and makes the entrepreneur invest later. However, if the entrepreneur has lower risk aversion and more sufficient patience, a larger payoff volatility may decrease the optimal investment threshold and makes the entrepreneur invest earlier. Moreover, a higher investment-wealth ratio makes the entrepreneur invest later.

Suggested Citation

  • Yin, Xiaoqing & Wang, Haijun, 2025. "Real investment decision under CRRA utility: The flow payoff case," Journal of Economic Dynamics and Control, Elsevier, vol. 177(C).
    • Handle: RePEc:eee:dyncon:v:177:y:2025:i:c:s016518892500096x
    DOI: 10.1016/j.jedc.2025.105130
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    Keywords

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    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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