Impact of Plant Utilization on Irreversible Investment Under Uncertainty with Application to Refinery Investment

Why are some regions preferred when investors consider irreversible investment? This study offers an explanation to this question and suggests improvements that will assist disadvantaged regions improve on their bid for funds. The paper considers irreversible investment under uncertainty when installed capacity utilization is incorporated. We develop a normative model for irreversible investment problem under uncertainty using real options approach. Capacity utilization was not a major consideration by previous authors who assumed that installed capacity would be fully utilized. Variations in capacity utilization may be attributed to disruption in input supply or infrastructural bottlenecks that limit firms to get their products to customers. This study modifies the geometric Brownian motion for the value of a project to account for capacity utilization in the derivation of irreversible investment decision rule. The proposed model provides a theoretical explanation of how utilization affects irreversible investment decisions. Data on petroleum refinery margins is used to illustrate application of the proposed model to refinery investment. The study reveals that capacity utilization has an inverse effect on the investment trigger, and so, links irreversible investment decisions to plant utilization. We recommend optimal utilization of installed plant capacity for regions seeking funds for irreversible investment

Real Options in Irreversible Investment under Uncertainty: a Review

The use of real options approach to determine the optimal time to execute irreversible investment under uncertainty has been studied extensively. Several relationships between uncertainty and irreversible investment has been proposed. We review the literature with the aim of answering the following questions: (i) What is the inadequacy in the methods used to solve the optimal timing problem in real options analysis for irreversible investment? (ii) What is the relationship between uncertainty and irreversible investment? (iii) How do you choose the stochastic process to incorporate in a real options analysis of an irreversible investment? Based on our study we clarify the apparent ambiguity in the relationship between uncertainty and irreversible investment and present four fundamental relationships between uncertainty and irreversible investment. Guidelines for selecting appropriate stochastic processes to include in an empirical study of an irreversible investment are suggested and some possible future directions of research are charted