How economic depreciation shapes the relationship of uncertainty with investments’ size & timing

Abstract

This paper identifies and analyzes the effects of the rate of economic depreciation of capital stock on a monopolist’s investment option and capacity decision in a dynamic and uncertain market environment, where continuous economic depreciation cannot be fully offset. We find that the firm’s capital stock is increasing in the rate of depreciation for low rates and decreasing for higher rates. Further, when considering the timing of investment, we show that the effect of uncertainty on investment is level-dependent on the rate of depreciation: only for sufficiently high rates of depreciation there is a positive relationship between capital investment and uncertainty, and the impact of uncertainty on the present value of the firm is mitigated. The fact that the impact of economic depreciation on the firm’s investment problem is level dependent demonstrates that its consideration by investors and managers is not trivial.