Handout 1C - Investment and Hysteresis Observed Phenomena:...

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Investment and Hysteresis Observed Phenomena: Firms use high “hurdle rates” in investment (capital budgeting) decision Firms enter when ,exit when (inertia or hysteresis) Intuition: Investment is irreversible; investment opportunity does not disappear immediately; economic environment has ongoing uncertainty. Waiting has positive value.(Dixit(1992)) Corporate Finance © Professor Ho-Mou Wu 1C-1 Spring 2004 - < ATC P + ATC P
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Reconstruct the Theoretical Model 1C-2 Assumptions (1)A single investment project, with a given scale. Once launched, this project lasts forever, i.e., cannot (2) be abandoned or expanded. (3)Only one risk neutral company is considering this project. (4)The future revenue R follows a Geometric Brownian Motion.( lnRt at time t is approximately normal.) (5)The company is centralized. No informational asymmetry. Spring 2004 Corporate Finance © Professor Ho-Mou Wu
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Understanding the reasoning Waiting can avoid risk and realize upside gains, but waiting has its opportunity cost. There exists an optimal investment trigger H (invest if R>H) In figure 1 in Dixit(1992), comparing the value of waiting and the value of investing immediately(
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This note was uploaded on 01/23/2011 for the course FGB 780 taught by Professor Edwardchang during the Spring '09 term at Missouri State University-Springfield.

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Handout 1C - Investment and Hysteresis Observed Phenomena:...

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