Options, the Value of Capital, and Investment

Rodney L. White Center for Financial Research Working Paper No. 15-95

Posted: 24 Aug 1998  

Andrew B. Abel

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Avinash Dixit

Princeton University - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Janice C. Eberly

Northwestern University - Kellogg School of Management

Robert S. Pindyck

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

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Abstract

Capital investment decisions must recognize the limitations on the firm's ability to later sell off or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how this valuation relates to the q-theory of investment, and how these options affect the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options interact to determine the effect of uncertainty on investment, how these option values change in response to shifts of the distribution of future profitability, and how the q-theory and option pricing approaches to investment are related.

JEL Classification: E22

Suggested Citation

Abel, Andrew B. and Dixit, Avinash and Eberly, Janice C. and Pindyck, Robert S., Options, the Value of Capital, and Investment. Rodney L. White Center for Financial Research Working Paper No. 15-95. Available at SSRN: https://ssrn.com/abstract=6586

Andrew B. Abel (Contact Author)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania - Finance Department ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-898-4801 (Phone)
215-573-7244 (Fax)

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

Avinash K. Dixit

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States
609-258-4013 (Phone)
609-258-6419 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Janice C. Eberly

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-467-1840 (Phone)
847-491-5719 (Fax)

Robert S. Pindyck

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02139
United States
617-253-6641 (Phone)
617-258-6855 (Fax)

HOME PAGE: http://web.mit.edu/rpindyck/www/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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