Uncertainty and Stepwise Investment

26 Pages Posted: 2 Mar 2007 Last revised: 20 Dec 2009

Peter M. Kort

Tilburg University - Department of Econometrics & Operations Research; Tilburg University - Center for Economic Research (CentER)

Pauli Murto

Helsinki School of Economics & Business Administration

Grzegorz Pawlina

Lancaster University - Department of Accounting and Finance

Date Written: May 21, 2009

Abstract

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

Suggested Citation

Kort, Peter M. and Murto, Pauli and Pawlina, Grzegorz, Uncertainty and Stepwise Investment (May 21, 2009). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=967434 or http://dx.doi.org/10.2139/ssrn.967434

Peter Kort

Tilburg University - Department of Econometrics & Operations Research ( email )

Tilburg, 5000 LE
Netherlands
+31 13 466 2062 (Phone)
+31 13 466 3072 (Fax)

HOME PAGE: http://center.uvt.nl/staff/kort/

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2062 (Phone)
+31 13 466 3072 (Fax)

Pauli Murto

Helsinki School of Economics & Business Administration ( email )

P.O. Box 21210
Helsinki 00100, 00101
Finland

Grzegorz Pawlina (Contact Author)

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+ 44 1524 592834 (Phone)
+ 44 1524 847321 (Fax)

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