Most investment expenditures have two important characteristics:
First, they are largely irreversible; the firm cannot disinvest, so the
expenditures are sunk costs. Second, they can be delayed, allowing the firm
to wait for new information about prices, costs, and other market conditions
before committing resources. An emerging literature has shown that this has
important implications for investment decisions, and for the determinants of
investment spending. Irreversible investment is especially sensitive to
risk, whether with respect to future cash flows, interest rates, or the
ultimate cost of the investment. Thus if a policy goal is to stimulate
investment, stability and credibility may be more important than tax
incentives or interest rates.
This paper presents some simple models of irreversible investment, and
shows how optimal investment rules and the valuation of projects and firms
can be obtained from contingent claims analysis, or alternatively from
dynamic programming. It demonstrates some strengths and limitations of the
methodology, and shows how the resulting investment rules depend on various
parameters that come from the market environment. It also reviews a number
of results and insights that have appeared in the literature recently, and
discusses possible policy implications.
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