THE EFFECTS OF ABANDONMENT OPTIONS ON INVESTMENT TIMING AND INTENSITY

This paper examines how the presence of an abandonment option affects the timing and intensity of a firm’s investment. We develop a continuous‐time model wherein a firm is endowed with a perpetual option to invest in a project at any time by incurring an investment cost at that instant. The amount of the investment cost is directly related to the intensity of investment that is endogenously chosen by the firm at the investment instant. The project generates a stream of stochastic revenue flows with a concomitant stream of constant cost flows, both of which increase with the investment intensity. We show that allowing the firm to make an irreversible decision to abandon the project does not affect the firm’s optimal investment intensity if the investment cost is totally reversible. Otherwise, the option to abandon the project induces the firm to choose a lower level of investment intensity. Furthermore, we show that the presence of the abandonment option pushes down the firm’s optimal investment trigger, thereby hastening the undertaking of the project.