Policy Seminars -- Fall 2007
| Speaker: H. Dharma Kwon -- UCLA Anderson School of Management |
| Topic: Invest or Exit? Optimal Decisions in the Face of a Declining Profit Stream |
| Date/Place/Time: November 16, 2007 / UCLA Anderson School -- Entrepreneurs Hall C303 / 2:00 P.M. to 3:00 P.M. |
| 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 calculus, we show that the optimal policy 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 counter-intuitive result: an increase in volatility induces the firm to invest earlier. |
| Links to papers: Click here for paper |