Irreversible investment in alternative projects (Q2494023)

The authors revisit the problem of the choice between mutually exclusive investment projects under uncertainty. The starting point of the analysis is the model in which a decision-maker has to choose among alternative projects of different scales. The instantaneous cash-flow generated by any of these projects is a linear function of a single geometric Brownian motion that represents the dynamics of the output price, and of the constant output flow of the project. Parameter restrictions are provided under which the optimal invstment strategy is not a trigger strategy and the optimal investment region is dichotomous. A sufficient condition for the dichotomy of the optimal investment region is that project 1 generates only a marginally lower output flow than the project 2, but entails a significantly lower sunk capital cost. It is proved that if the volatility of the output price process is high enough, the optimal investment region is never dichotomous and, no matter the current output price, it is never optimal to invest in project 1. In contrast, whenever the decision-maker has the option to switch from project 1 to project 2 by incurring the corresponding capital cost, there are output and cost parameters such that the dichotomy of the optimal investment region is preserved .