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Irreversible capital accumulation under interest rate uncertainty

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  • Luis Alvarez

Abstract

We consider the optimal sequential irreversible investment policy of a value maximizing firm facing decreasing returns to scale and interest rate uncertainty. We characterize the optimal accumulation policy and its value for a broad class of diffusion models of the short interest rate by focusing on the marginal investment decision and deriving the marginal value of capital explicitly. We also state a set of conditions under which there is a maximal capital stock above which the option to expand productive capacity further in the future becomes valueless. Hence, our results indicate that interest rate uncertainty may limit the size of an optimally investing firm. Copyright Springer-Verlag 2010

Suggested Citation

  • Luis Alvarez, 2010. "Irreversible capital accumulation under interest rate uncertainty," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 72(2), pages 249-271, October.
    • Handle: RePEc:spr:mathme:v:72:y:2010:i:2:p:249-271
    DOI: 10.1007/s00186-010-0319-0
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    More about this item

    Keywords

    Interest rate uncertainty; Irreversible investment; Incremental capital accumulation; G31; G11; E22;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity

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