Invest or exit? Optimal decisions in the face of a declining profit stream

DOI10.1287/OPRE.1090.0740zbMATH Open1232.91628arXiv1901.01486OpenAlexW2012486259MaRDI QIDQ3098261FDOQ3098261

Authors: H. Dharma Kwon 

Publication date: 17 November 2011

Published in: Operations Research (Search for Journal in Brave)

Abstract: Even in the face of deteriorating and highly volatile demand, firms often invest in, rather than discard, aging technologies. In order to study this phenomenon, we model the firm's profit stream as a Brownian motion with negative drift. At each point in time, the firm can continue operations, or it can stop and exit the project. In addition, there is a one-time option to make an investment which boosts the project's profit rate. Using stochastic analysis, we show that the optimal policy always exists and that it is characterized by three thresholds. There are investment and exit thresholds before investment, and there is a threshold for exit after investment. We also effect a comparative statics analysis of the thresholds with respect to the drift and the volatility of the Brownian motion. When the profit boost upon investment is sufficiently large, we find a novel result: the investment threshold decreases in volatility.

Full work available at URL: https://arxiv.org/abs/1901.01486

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zbMATH Keywords

diffusionsequential decision analysisinvestment criteria

Mathematics Subject Classification ID

Management decision making, including multiple objectives (90B50) Portfolio theory (91G10)

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