Investment under uncertainty and the threat of nationalization

Abstract

This paper considers the case of a multinational corporation who holds the option to invest in a foreign country. The company incurs the investment cost and gains access to a volatile profit flow once the project becomes operational. The cost is entirely sunk so the investor must account, not only for uncertain market conditions, but also for the threat of nationalization by the local government. By employing a dynamic model that incorporates both market uncertainty and political risk we determine the optimal timing for investment and nationalization, as well as the appropriate scale of the investment. We show that a reduction in the nationalization cost induces earlier but also smaller investment and also earlier nationalization. Our findings provide a theoretical explanation for the empirical observation that investors do not necessarily avoid industries susceptible to nationalization. We argue that the threat of nationalization leads to premature and undersized investments, rather than deterring them entirely.

Keywords: Nationalization, Investment analysis, Capacity Investment, Nash bargaining, Real options

JEL Classification: C7, D8, K3, F2, O3