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

Andrew Abel and Janice Eberly

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: 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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Working Paper: An Exact Soultion for the Investment and Market Value of a Firm Facing Uncertainty, Adjustment Costs, and Irreversibility (1993)
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