An Optimal Multiple Stopping Approach to Infrastructure Investment Decisions

27 Pages Posted: 13 Feb 2013 Last revised: 28 Oct 2015

See all articles by Eric Dahlgren

Eric Dahlgren

Columbia University

Tim Leung

University of Washington - Department of Applied Math

Date Written: February 3, 2015

Abstract

The energy and material processing industries are traditionally characterized by very large-scale physical capital that is custom-built with long lead times and long lifetimes. However, recent technological advancement in low-cost automation has made possible the parallel operation of large numbers of small-scale and modular production units. Amenable to mass-production, these units can be more rapidly deployed but they are also likely to have a much quicker turnover. Such a paradigm shift motivates the analysis of the combined effect of lead time and lifetime on infrastructure investment decisions. In order to value the underlying real option, we introduce an optimal multiple stopping approach that accounts for operational flexibility, delay induced by lead time, and multiple (finite/infinite) future investment opportunities. We provide an analytical characterization of the firm's value function and optimal stopping rule. This leads us to develop an iterative numerical scheme, and examine how the investment decisions depend on lead time and lifetime, as well as other parameters. Furthermore, our model can be used to analyze the critical investment cost that makes small-scale (short lead time, short lifetime) alternatives competitive with traditional large-scale infrastructure.

Keywords: optimal multiple stopping, real option, infrastructure investments, lead time, operational flexibility

JEL Classification: C41, G13, H54

Suggested Citation

Dahlgren, Eric and Leung, Tim, An Optimal Multiple Stopping Approach to Infrastructure Investment Decisions (February 3, 2015). Journal of Economic Dynamics and Control, Vol. 53, 2015, Available at SSRN: https://ssrn.com/abstract=2216025 or http://dx.doi.org/10.2139/ssrn.2216025

Eric Dahlgren

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

Tim Leung (Contact Author)

University of Washington - Department of Applied Math ( email )

Lewis Hall 217
Department of Applied Math
Seattle, WA 98195
United States

HOME PAGE: http://faculty.washington.edu/timleung/

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