An Exact Soultion for the Investment and Market Value of a Firm Facing Uncertainty, Adjustment Costs, and Irreversibility

26 Pages Posted: 27 Dec 2006 Last revised: 26 Jul 2010

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: July 1993

Abstract

This paper derives closed-form solutions for the investment and market value, under uncertainty, of competitive firms with constant returns to scale production and convex costs of adjustment. Solutions are derived for the case of irreversible investment as well as for reversible investment. Optimal investment is a non-decreasing function of q, the shadow value of capital. The conditions of optimality imply that q cannot contain a bubble; thus, optimal investment depends only on fundamentals. However, the value of the firm may contain a bubble that does not affect investment behavior. Relative to the case of reversible investment, the introduction of irreversibility does not affect q, but it reduces the fundamental market value of the firm.

Suggested Citation

Abel, Andrew B. and Eberly, Janice C., An Exact Soultion for the Investment and Market Value of a Firm Facing Uncertainty, Adjustment Costs, and Irreversibility (July 1993). NBER Working Paper No. w4412, Available at SSRN: https://ssrn.com/abstract=480229

Andrew B. Abel (Contact Author)

University of Pennsylvania - Finance Department ( email )

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

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Janice C. Eberly

Northwestern University - Kellogg School of Management ( email )

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United States
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847-491-5719 (Fax)

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