Incentivizing Irreversible Investment

Existing dynamic investment models that show that a manager can be incentivized to implement the optimal investment policy rely on the assumption that the firm is operating in an ever-expanding product market. This paper presents an analytically tractable, discrete-time, neoclassical model with irreversible investment and the possibility of unfavorable demand events. We show that even when the principal is uninformed about changes in demand for the firm's output, there exists a performance measurement system that leads to goal congruent investment incentives for the manager. If the principal can observe the unfavorable demand events, then goal congruence can be achieved using very simple accrual accounting rules, such as straight-line depreciation.

Impact of Plant Utilization on Irreversible Investment Under Uncertainty with Application to Refinery Investment

Why are some regions preferred when investors consider irreversible investment? This study offers an explanation to this question and suggests improvements that will assist disadvantaged regions improve on their bid for funds. The paper considers irreversible investment under uncertainty when installed capacity utilization is incorporated. We develop a normative model for irreversible investment problem under uncertainty using real options approach. Capacity utilization was not a major consideration by previous authors who assumed that installed capacity would be fully utilized. Variations in capacity utilization may be attributed to disruption in input supply or infrastructural bottlenecks that limit firms to get their products to customers. This study modifies the geometric Brownian motion for the value of a project to account for capacity utilization in the derivation of irreversible investment decision rule. The proposed model provides a theoretical explanation of how utilization affects irreversible investment decisions. Data on petroleum refinery margins is used to illustrate application of the proposed model to refinery investment. The study reveals that capacity utilization has an inverse effect on the investment trigger, and so, links irreversible investment decisions to plant utilization. We recommend optimal utilization of installed plant capacity for regions seeking funds for irreversible investment.

An Integral Equation Approach to the Irreversible Investment Problem with a Finite Horizon

This paper studies an irreversible investment problem under a finite horizon. The firm expands its production capacity in irreversible investments by purchasing capital to increase productivity. This problem is a singular stochastic control problem and its associated Hamilton–Jacobi–Bellman equation is derived. By using a Mellin transform, we obtain the integral equation satisfied by the free boundary of this investment problem. Furthermore, we solve the integral equation numerically using the recursive integration method and present the graph for the free boundary.

Labor Absorption, Inflation Volatility, and Inflation Targeting Framework (ITF): The Case of Three Economic Sectors in Indonesia

Labor is one of the important inputs which affecting shocks in economy. Various economic problems increase when unemployment is high. High volatility (uncertainty) at prices (this study used inflation), is a risk for the company. When facingthe uncertainty, the company can choose to delay investing and change the decisions in recruitment plan; it is used to collect the information about prices before investing (this conceptcalled Irreversible Investment), subsequently cause a reduction in labor absorption. Moreover, this uncertainty is a cost for the company. This condition makes it difficult for companies to determine the optimal number and combination of inputs (including labor), as consequences the company has to decide reducing the inputs. Inflation Targeting Framework (ITF) is one of the frameworks used by Bank Indonesia and the government to reduce and stabilize inflation. There are pros and cons of the irreversible investment concept and the success of the ITF. This study aims to determine whether uncertainty in inflation (illustrated by inflation volatility) affects investment and labor absorption. In addition, it is to find out whether the ITF has succeeded in making inflation stable and affecting other macroeconomic variables. The data used are annual data from volatility of inflation, employment, investment, GDP and ITF dummy. This study used three sectors in Indonesia, for instance, the industrial; trade, restaurants, accommodation services and transportation sector; and transportation, warehousing and communication, because of limited data. The result of this study was that volatility affect the labor absorption, both directly and indirectly (through investment). Furthermore, the ITF has affected the volatility of inflation.

Product market competition, oil uncertainty and corporate investment

PurposeThe purpose of this study is to examine the effect of product market competition on the oil uncertainty–investment relation.Design/methodology/approachThe authors use firm-level financial data from the COMPUSTAT database, competition proxies from Hoberg and Phillips (2016) and macroeconomic data on crude oil price uncertainty. Corporate investment is measured as capital expenditure scaled by total assets or as the annual change in (net) total fixed assets plus depreciation. Since our panel data covers a short period (22 years) and the regressions include a combination of a lagged dependent variable and firm fixed effects, the authors apply Blundell and Bond’s (1998) GMM system when regressing corporate investment on the interaction between oil uncertainty and competition.FindingsConsistent with the theories in the irreversible investment literature, the authors first show that investments are negatively related to oil uncertainty. Second, they show that firms in competitive industries decrease their investments in response to heightened uncertainty by a higher degree than firms in concentrated industries, suggesting that competition can exacerbate negative investment outcomes when success is uncertain. The authors also examine how competition relates to investment asymmetric reactions to positive and negative oil price return volatilities and find a stronger negative relationships between competition and investment-positive oil price volatility, indicating that increasing the probability of a negative outcome due to uncertainty leads firms to reduce investment to a larger extent.Practical implicationsThe findings provide useful insights to guide corporate investment decisions under oil price change uncertainty. In particular, if firms can wait for the resolution of uncertainty before deciding to pursue irreversible investment in a competitive market, they can avoid potentially large losses by foregoing investment when the outcomes are unfavorable. This is because competition brings a greater uncertainty to firm performance if the investment outcome is poor, as firms in competitive industries share a large proportion of industry-wide profits with rivals and, thus, competition could erode profit margins and increases the likelihood of being driven out of the market. Hence, firms in competitive markets should balance between strategic preemptive motives and waiting for the resolution of uncertainty before deciding to pursue investment.Originality/valueThis study is the first to examine the effect of competition on the relationship between investment and oil price uncertainty. Moreover, it is the first to examine the effect of competition on the asymmetric response of investment to oil price uncertainty emanating from positive and negative changes in oil price.