Uncertainty and Stepwise Investment
26 Pages Posted: 2 Mar 2007 Last revised: 20 Dec 2009
Date Written: May 21, 2009
We analyze the optimal investment strategy of a firm that can complete a project either in one stage at a single freely chosen time point or in incremental steps at distinct time points. The presence of economies of scale gives rise to the following trade-off: lumpy investment has a lower total cost, but stepwise investment gives more flexibility by letting the firm choose the timing individually for each stage. Our main question is how uncertainty in market development affects this tradeoff. The answer is unambiguous and in contrast with a conventional real-options intuition: higher uncertainty makes the single-stage investment more attractive relative to the more flexible stepwise investment strategy.
Keywords: Investment analysis, real options, capital budgeting, project flexibility, dynamic programming
JEL Classification: C61, D81, G31
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