Volume Flexibility and Capacity Investment: A Real Options Approach

Abstract

This paper considers the investment decision of a firm where it has to decide about the timing and capacity. We obtain that in a fast growing market, right after investment the firm produces below capacity, where the utilization rate (the proportion of capacity that is used for production right after the investment) increases with market uncertainty for a very big market trend, and shows no monotonicity for a moderately large market trend. On the other hand we get that, for a slowly growing or shrinking market, the firm produces up to capacity right after investment. In the intermediate case, the firm produces up to capacity right after investment when uncertainty is low and below capacity when uncertainty is high, whereas the utilization rate decreases with the market uncertainty.