Working Paper: CEPR ID: DP16023
Authors: Rutgerjan Lange; Coen Teulings
Abstract: The standard model of irreversible investment under uncertainty considers only the level of the cashflow that could be obtained through the investment. We present a general model that includes asstate variables both the level and the growth rate of the cash flow, while the timing and size of the onetimeinvestment are discretionary. As an illustration, we consider an investor with the exclusive rightto develop a vacant piece of land, where the timing of the investment and the scale of the propertyare chosen optimally. We demonstrate that construction is optimally postponed when prospects aregloomy, but also when they are bright. Indeed, under sufficiently high growth it is, perversely, neveroptimal to invest. Under a cost-of-capital argument, the rational response to predictable growthcombined with flexible investment conditions is to keep land vacant for extended periods, which mayexplain why construction in superstar cities often appears sluggish. Our proposed model can be usedin all investment decisions, irrespective of sector, where the assumptions of predictable growth anda one-off, flexible but otherwise irreversible investment are met.
Keywords: Real Options; Mean-Reverting Growth; Irreversible Investment; Real Estate; Construction; Urban Growth
JEL Codes: D81; R14; R31; R51; C41; C61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative growth expectations (D84) | delayed investment (G31) |
| high anticipated growth (O00) | delayed investment (G31) |
| cash flow growth rate (D25) | timing of investment (G11) |
| cost of capital (G31) | delayed investment (G31) |