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Investment in two alternative projects with multiple switches and the exit option

Author

Listed:
  • Igor V. Kravchenko

    (IST-ID and CEMAT)

  • Cláudia Nunes

    (Universidade de Lisboa)

  • Carlos Oliveira

    (Norwegian University of Science and Technology
    Universidade de Lisboa; REM - Research in Economics and Mathematics, CEMAPRE)

Abstract

This paper uses an analytical framework to examine a firm’s investment and switching strategy under uncertainty. The context is the possibility to launch and operate two distinct projects, one at a time, with exposure to a stochastic exogenous price. We allow for multiple switches between the two projects, along with abandonment options from each. These possibilities fundamentally influence the operational strategy. We show that under some conditions, a dichotomous waiting region may arise at the investment stage. In this case we have an inaction region, for a range of prices in a certain bounded interval, where the firm does not invest and waits to have more information about the price evolution. This region vanishes for a high level of uncertainty. Additionally, the firm may operate with a negative instantaneous profit. We prove that investment in this region is never optimal. Numerical examples enable comparative statics, while extension to allow for time-to-build is included.

Suggested Citation

  • Igor V. Kravchenko & Cláudia Nunes & Carlos Oliveira, 2023. "Investment in two alternative projects with multiple switches and the exit option," Mathematics and Financial Economics, Springer, volume 17, number 1, December.
    • Handle: RePEc:spr:mathfi:v:17:y:2023:i:4:d:10.1007_s11579-023-00343-x
    DOI: 10.1007/s11579-023-00343-x
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    References listed on IDEAS

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    1. Bar-Ilan, Avner & Sulem, Agnes & Zanello, Alessandro, 2002. "Time-to-build and capacity choice," Journal of Economic Dynamics and Control, Elsevier, vol. 26(1), pages 69-98, January.
    2. Jean-Paul Décamps & Thomas Mariotti & Stéphane Villeneuve, 2006. "Irreversible investment in alternative projects," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(2), pages 425-448, June.
    3. Bobtcheff, Catherine & Villeneuve, Stéphane, 2010. "Technology choice under several uncertainty sources," European Journal of Operational Research, Elsevier, vol. 206(3), pages 586-600, November.
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    8. Dixit, Avinash, 1993. "Choosing among alternative discrete investment projects under uncertainty," Economics Letters, Elsevier, vol. 41(3), pages 265-268.
    9. Guerra, Manuel & Kort, Peter & Nunes, Cláudia & Oliveira, Carlos, 2018. "Hysteresis due to irreversible exit: Addressing the option to mothball," Journal of Economic Dynamics and Control, Elsevier, vol. 92(C), pages 69-83.
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    12. H. Dharma Kwon, 2010. "Invest or Exit? Optimal Decisions in the Face of a Declining Profit Stream," Operations Research, INFORMS, vol. 58(3), pages 638-649, June.
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