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Options, the Value of Capital, and Investment

Andrew B. Abel, Avinash K. Dixit, Janice C. Eberly and Robert S. Pindyck
The Quarterly Journal of Economics
Vol. 111, No. 3 (Aug., 1996), pp. 753-777
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/2946671
Page Count: 25
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Options, the Value of Capital, and Investment
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Abstract

Capital investment decisions must recognize the limitations on the firm's ability to later sell or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how their valuation relates to the q theory of investment, and their effect on the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options determine the effect of uncertainty on investment, how they are changed by shifts of the distribution of future profitability, and how the q-theory and option pricing approaches are related.

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