RANDOM SHOCK UNCERTAINTY AND INVESTMENT REVERSIBILITY: REAL OPTION FRAMEWORK

Xue Cui and Takashi Shibata ()

Bulletin of Economic Research, 2018, vol. 70, issue 2, 150-164

Abstract: This paper examines, in the presence of random shock, how changes in reversibility of investment affect a firm's optimal investment strategies including the investment timing (trigger) and quantity. Existing results do not consider random shock, where the quantity is independent of the degree of reversibility and the investment trigger is always decreasing with the degree of reversibility. In contrast, we show that with random shock, the quantity exhibits an inverse U†shape, and the investment trigger is not always monotonically decreasing with the degree of reversibility. Additionally, we show that the firm undertakes a smaller quantity with random shock than without random shock for any degree of reversibility. Finally, we find that the presence of random shock decreases firm value, which implies that random shock is costly for firms.

Date: 2018
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