The Option to Downscale Production in Recessionary Times

This paper values the option of a firm to downscale production in recessionary times. The regulator allows downscaling as long as the recession lasts. The end of the recession is modelled via a Poisson process. We show that the disinvestment timing is affected by two contrary effects. First, when the probability increases that the recession will be over soon, the firm will disinvest sooner, because after the recession is over the downscale option no longer exists. Second, the firm will downscale later because the expected future revenue stream increases when the recession will be over sooner. As a result the disinvestment trigger is non-monotonic in the intensity of the Poisson process. The second effect dominates when the recession is expected to last long. We also study the disinvestment problem in case there is a risk of bankruptcy due to lack of available funds in the credit market. It is shown that the optimal disinvestment threshold is the same as when there is no bankruptcy risk. This threshold, however, may not be appropriate due to the bankruptcy threshold.