Associate Professor of Finance, Harvard University, Graduate School of Business Administration, Soldiers Field, Boston, MA 02163. I thank Donald Lessard for initially suggesting the problem and Susan Geller for many helpful discussions through several formulations of the model. I also thank Richard Ruback, Richard Schmalensee, Michael Spence, J. Ingersoll, and the Editor of this Journal for extensive comments on earlier drafts of this paper. Versions of this paper were presented in seminars at MIT, Harvard, Stanford, and the University of California, Berkeley and I thank the participants for their comments and insights. I alone am responsible for any mistakes or ambiguities remaining in the paper.
Optimal Sequential Investment When Capital is Not Readily Reversible
Article first published online: 30 APR 2012
1982 The American Finance Association
The Journal of Finance
Volume 37, Issue 3, pages 763–782, June 1982
How to Cite
BALDWIN, C. Y. (1982), Optimal Sequential Investment When Capital is Not Readily Reversible. The Journal of Finance, 37: 763–782. doi: 10.1111/j.1540-6261.1982.tb02222.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
When investment opportunities arrive one at a time and are reviewed sequentially, a corporation's optimal policy differs from a standard net present value rule if the corporation exercises control over an industry state variable and control is costly. The first condition presupposes a degree of market power for the firm; the second occurs if corporate investment decisions are imperfectly reversible.
To address the problem of optimal investment in this context, a firm's investment decisions are modeled as a Markov reward process. The causes of economic irreversibility are discussed and general propositions concerning the optimal investment policy are derived. These propositions are then applied to the optimization of an exploration program by an oligopolistic firm (a price leader). Under particular demand and distributional assumptions, solutions for the optimal decision rule and the value of the exploration program are obtained and their properties examined.