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Irreversibility, sunk costs and investment under incomplete information

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Abstract:

Despite its importance to economic growth, the investment behavior of firms remains poorly understood. Existing models ignore irreversibility and the opportunity to wait for new information. Even if some recent literature accounts for these two characteristics, these models ignore information costs. This paper presents a framework for the valuation of investment opportunities accounting for information costs regarding the project cash‐flows.

We develop some basic models of irreversible investment to illustrate the option‐like characteristics of investment opportunities under incomplete information. We show how optimal investment rules can be obtained using option pricing theory under incomplete information. It is possible to value real options and investment decisions using our approach in a context of incomplete information. Simulations are provided to illustrate our main results.

Document Type: Original Article

DOI: https://doi.org/10.1111/1467-9310.00202

Affiliations: THEMA, Universit√© de Cergy, Cergy, and CEREG, Universit√© de Paris‐Dauphine, France

Publication date: 2001-04-01

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