Chapter 2 - On irreversibility, sunk costs and investment under incomplete information

Abstract

This chapter describes some simple models for the analysis of the investment decision under uncertainty, irreversibility, and sunk costs like shadow costs of incomplete information. In Merton's model, the expected returns increase with systematic risk, firm-specific risk, and relative market value. The expected returns decrease with relative size of the firm's investor base, referred to in Merton's model as the degree of investor recognition. The chapter also illustrates how optimal investment rules can be obtained using real option theory under shadow costs of incomplete information. The chapter also presents a justification for the foundations of information costs in investment decisions. These costs are based on the shadow costs of incomplete information in the spirit of Merton's model. In addition, the chapter also provides a basic continuous-time model of irreversible investment in the presence of information costs. This model shows when the firm should invest in a project in the presence of incomplete information. Following this, the basic model is extended so that the price of the firm's output is random and the firm can stop production whenever the price falls below variable cost. The value of the project and the value of the firm's option are derived to invest in the project as well as the optimal investment rule in the presence of information costs. Simulations are provided to illustrate the main results. Finally, the chapter compares some of the results with respect to some standard models.