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Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment



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    • Ilan Cooper is with the Department of Financial Economics, Norwegian School of Management. This paper is based on a chapter of my doctoral dissertation at the Graduate School of Business of the University of Chicago. I am grateful to my advisors John Heaton, Owen Lamont, Toby Moskowitz, and especially George Constantinides and Steve Davis for their guidance and encouragement. I have benefited immensely from the comments and suggestions of Simon Benninga, Bruno Gerard, Leonid Kogan, Lior Menzly, Richard Priestley and Nahid Rahman. I owe special thanks to Rick Green (the editor) and an anonymous referee, whose insightful comments helped me improve the paper greatly. I am also grateful to John Cochrane, Adlai Fisher, Boyan Jovanovic, Marco Lyrio, Bernt-Arne Odegaard, and seminar participants at the University of Chicago, Federal Reserve Bank of Boston, Free University of Amsterdam, Norwegian School of Management, Copenhagen Business School, University of Haifa, Tel-Aviv University, Hebrew University, Norwegian School of Economics and Business Administration, 2003 EFA annual meeting, University of Leuven, Tilburg University, 2004 AFA annual meeting, and Stockholm School of Economics for helpful comments and suggestions. All remaining errors are my own.


This paper derives a real options model that accounts for the value premium. If real investment is largely irreversible, the book value of assets of a distressed firm is high relative to its market value because it has idle physical capital. The firm's excess installed capital capacity enables it to fully benefit from positive aggregate shocks without undertaking costly investment. Thus, returns to equity holders of a high book-to-market firm are sensitive to aggregate conditions and its systematic risk is high. Simulations indicate that the model goes a long way toward accounting for the observed value premium.