Optimal Investment with Costly Reversibility

54 Pages Posted: 19 Jul 2000 Last revised: 5 Apr 2008

See all articles by Andrew B. Abel

Andrew B. Abel

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Janice C. Eberly

Northwestern University - Kellogg School of Management

Date Written: April 1995

Abstract

Investment is characterized by costly reversibility when a firm can purchase capital at a given price and sell capital at a lower price. We derive an explicit analytic solution for optimal investment by a firm facing costly reversibility. In addition, we derive a local approximation to the solution which highlights the effects of the parameters of the problem on the triggers for investment. More generally, we extend the Jorgensonian concept of the user cost of capital to the case of uncertainty and define cU and cL as the user costs of capital associated with the purchase and sale of capital, respectively. Optimality requires the" firm to purchase and sell capital as needed to keep the marginal revenue product of capital in" the closed interval [cU,cL]. This prescription encompasses the case of irreversible investment as well as the standard" neoclassical case of costlessly reversible investment. Finally, quantitative analysis suggests" that even when the difference between the purchase and sale prices of capital is small user costs associated with purchasing and selling capital are closer to those applicable under" complete irreversibility than to those applicable under costless reversibility."

Suggested Citation

Abel, Andrew B. and Eberly, Janice C., Optimal Investment with Costly Reversibility (April 1995). NBER Working Paper No. w5091, Available at SSRN: https://ssrn.com/abstract=225869

Andrew B. Abel (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-898-4801 (Phone)
215-573-7244 (Fax)

HOME PAGE: http://finance.wharton.upenn.edu/~abel/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Janice C. Eberly

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-467-1840 (Phone)
847-491-5719 (Fax)

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