Options , the Value of Capital , and Investment by Andrew

Capital investment decisions must recognize the limitations on the firm's ability to later sell off or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how this valuation relates to the q-theory of investment, and how these options affect the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options interact to determine the effect of uncertainty on investment, how these option values change in response to shifts of the distribution of future profitability, and how the q-theory and option pricing approaches to investment are related. * Abel and Eberly are associated with the Wharton School, University of Pennsylvania, and the N.B.E.R., Dixit is associated with Princeton University, and Pindyck with the Sloan School of Management, MIT, and the N.B.E.R. We thank the inventors of electronic mail, fax machines, and conference calls for facilitating this collaboration, and the participants in the 1995 CEPR Summer Symposium in Macroeconomics for helpful comments. All four authors thank the National Science Foundation for financial support, and Eberly also thanks a Sloan Foundation Fellowship for support.