Investment Under Uncertainty and Policy Change

G. Pawlina, P.M. Kort

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Abstract

Existing real options literature provides relatively little insight into the impact of structural changes of the economic environment on the investment decision of the firm.We propose a method to model the impact of a policy change on investment behavior in which, contrary to the earlier models based on Poisson processes, uncertainty concerning the moment of the change can be explicitly accounted for.Moreover, probabilities of the change depend on the state of the dynamic system, what ensures the consistency of the action of the policy maker. We model the policy change as an upward jump in the (net) investment cost, which is, for instance, caused by a reduction in the investment tax credit.The firm has an incomplete information concerning the trigger value of the process for which the jump occurs.We derive the optimal investment rule maximizing the value of the firm.It is shown that the impact of trigger value uncertainty is non-monotonic: the investment threshold decreases with the trigger value uncertainty for low levels of uncertainty, while the reverse is true for high uncertainty levels.Finally, we present policy implications for the authority that result from the firm's value-maximizing behavior.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages23
Volume2001-5
Publication statusPublished - 2001

Publication series

NameCentER Discussion Paper
Volume2001-5

Keywords

  • investment
  • uncertainty
  • policy

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