Options, the Value of Capital, and Investment
Andrew B. Abel
University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)
Princeton University - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)
Janice C. Eberly
Northwestern University - Kellogg School of Management
Robert S. Pindyck
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
Rodney L. White Center for Financial Research Working Paper No. 15-95
Capital investment decisions must recognize the limitations on the firm's ability to later sell off or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how this valuation relates to the q-theory of investment, and how these options affect the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options interact to determine the effect of uncertainty on investment, how these option values change in response to shifts of the distribution of future profitability, and how the q-theory and option pricing approaches to investment are related.
JEL Classification: E22
Date posted: August 24, 1998
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