An investment theory with lags and adjustment costs

Abstract

We propose a stochastic control model to study corporate investment with generalized investment frictions, including investment lags and various of adjustment costs. We find that the dominance of the ``good news principle'' or ``bad news principle'' is determined by the joint effect of investment lags and adjustment costs, reconciling the results in Bernanke (1983) and Bar-Ilan and Strange (1996). Meanwhile, we resolve disputes between the net present value rule and the real option method of making investment decisions, and we find that the accuracy of the NPV rule depends on both investment lags and the opportunity cost of adjustment. Moreover, we calibrate our model with aggregated firm data and show that the co-existence of investment lags and the opportunity cost of adjustment is the key to explaining the correlation between investment and lagged profit.

Keywords: Bad News Principle, Investment Lags, Adjustment Costs, NPV Method, Real Option

JEL Classification: D21, E22, E32