Revenue-Enhancing Pre-Investment Activities Under Uncertainty
44 Pages Posted: 26 Jun 2018
Date Written: June 11, 2018
Models of investment under uncertainty mostly concern the firm's stochastic environment as exogenously given and subject to constant characteristics. We consider a firm that can sequentially invest to alter the growth rate of a project through a revenue-enhancing pre-investment activity prior to entering a new market, both when the change is fixed and when the magnitude of the change can be optimally chosen by the firm. We find that this incentivises the firm to invest early in revenue-enhancing activities, and then wait to invest to enter the market. There is both an option value of waiting that delays investment in revenue-enhancing activities, as well as an accelerating effect from the change in growth rate. The overall effect on the investment thresholds from increased uncertainty is ambiguous. Which effect dominates is dependent on both the cost parameters and the magnitude of the change in the rate of growth. When the firm can optimally choose the amount of the revenue-enhancing activity, we find that the firm invests more in these activities when uncertainty is higher, but the effect of uncertainty can still be ambiguous. When the marginal cost of the activity increases, the firm both delays the investment and undertakes less revenue-enhancement, but the overall amount spent increases. We conclude that increasing the drift through revenue-enhancing pre-investments is very attractive for the firm, and that this affects the firm's optimal investment.
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Keywords: Sequential Investment, Real Options, Endogenous Uncertainty, Optimal Control
JEL Classification: G00, G10, G11
Suggested Citation: Suggested Citation