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Optimal investment and production decisions and the value of the firm

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Abstract

We explore the effects of uncertainty on a firm that can respond by modifying its investment or production schedule (or both simultaneously) to variations in output price. Investment may increase capacity and/or reduce costs. We consider a firm with finite resources.

Our model uses option theory instead of the more traditional net present value framework. One of the early papers using this approach is Brennan and Schwartz (1985) in which an investment project to extract a finite natural resource is valued. In that paper, the value of the firm is a function of two state variables, the finite resource to be extracted (output to be produced in the future) and the commodity spot price. In order to maximize firm value, the manager can respond by modifying one control variable, the production level. In our model we handle instead three state variables (spot price, resources, accumulated investment) and two control variables (production rate and investment rate), and solve numerically.

We obtain both the value and the optimal policy of a firm that has investment projects that increase capacity and/or reduce costs and illustrate optimal policies as resources and available investments decrease over the life of the firm. Firms may start by only investing, then invest and produce, to end only producing.

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Author information

Authors and Affiliations

  1. Departamento de Ingeniería Industrial y de Sistemas, Pontificia Universidad Católica de Chile, Chile

    Gonzalo Cortazar & Andrés Löwener

  2. Anderson Graduate School of Management, University of California at Los Angeles, USA

    Eduardo S. Schwartz

Authors
  1. Gonzalo Cortazar
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  2. Eduardo S. Schwartz
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  3. Andrés Löwener
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Additional information

We thank Scott Wo, the referee and the editor for their comments and suggestions. Cortázar and Lowener acknowledge the financial support from FONDECYT and FONDER.

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Cortazar, G., Schwartz, E.S. & Löwener, A. Optimal investment and production decisions and the value of the firm. Rev Deriv Res 2, 39–57 (1998). https://doi.org/10.1007/BF01487306

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  • DOI: https://doi.org/10.1007/BF01487306

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