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

  • Andrew B. Abel
  • Janice C. Eberly

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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Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 12-93.

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Handle: RePEc:fth:pennfi:12-93
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  1. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  2. Pindyck, Robert S., 1986. "Irreversible investment, capacity choice, and the value of the firm," Working papers 1802-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
  4. 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, vol. 44(174), pages 163-78, May.
  5. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-38, June.
  6. Robert S. Pindyck, 1990. "Irreversibility, Uncertainty, and Investment," NBER Working Papers 3307, National Bureau of Economic Research, Inc.
  7. Abel, Andrew B & Eberly, Janice C, 1994. "A Unified Model of Investment under Uncertainty," American Economic Review, American Economic Association, vol. 84(5), pages 1369-84, December.
  8. repec:tpr:qjecon:v:98:y:1983:i:1:p:85-106 is not listed on IDEAS
  9. Lucas, Robert E, Jr & Prescott, Edward C, 1971. "Investment Under Uncertainty," Econometrica, Econometric Society, vol. 39(5), pages 659-81, September.
  10. repec:tpr:qjecon:v:101:y:1986:i:4:p:707-27 is not listed on IDEAS
  11. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
  12. 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, vol. 26(2), pages 305-22, June.
  13. Dixit, Avinash, 1991. "Irreversible Investment with Price Ceilings," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 541-57, June.
  14. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  15. Robert E. Lucas & Jr., 1967. "Adjustment Costs and the Theory of Supply," Journal of Political Economy, University of Chicago Press, vol. 75, pages 321.
  16. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
  17. Pindyck, Robert S, 1993. "A Note on Competitive Investment under Uncertainty," American Economic Review, American Economic Association, vol. 83(1), pages 273-77, March.
  18. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, vol. 50(1), pages 213-24, January.
  19. Treadway, Arthur B, 1969. "On Rational Entrepreneurial Behaviour and the Demand for Investment," Review of Economic Studies, Wiley Blackwell, vol. 36(106), pages 227-39, April.
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