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Irreversibility, sunk costs and investment under incomplete information
Author(s) -
Bellalah Mondher
Publication year - 2001
Publication title -
randd management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.253
H-Index - 102
eISSN - 1467-9310
pISSN - 0033-6807
DOI - 10.1111/1467-9310.00202
Subject(s) - sunk costs , complete information , valuation (finance) , investment (military) , economics , microeconomics , option value , context (archaeology) , cash flow , investment decisions , value of information , finance , mathematical economics , production (economics) , paleontology , politics , political science , law , biology
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.