Irreversible Investment, Capacity Choice, and the Value of the Firm

Abstract

A model of capacity choice and utilization is developedconsistent with value maximization when investment is irreversibleand future demand is uncertain. Investment requires the fullvalue of a marginal unit of capacity to be at least as large asits full cost. The former includes the value of the firms optionnot to utilize the unit, and the latter includes the opportunitycost of exercising the investment option. We show that formoderate amounts of uncertainty, the firm's optimal capacity ismuch smaller than it would be if investment were reversible, and alarge fraction of the firm's value is due to the possibility offuture growth. We also characterize the behavior of capacity andcapacity utilization, and discuss implications far the measurementof marginal cost and Tobin's q.