Optimal investment and option values under risk-aversion with empirical evidence from Swedish manufacturing

Abstract: An area of open research questions in economics involves the cost of capital and its relation to investment. One unresolved issue is in what way the desirability of investment projects depends on the risk with the project and how an increase in risk would affect the rate of investment. Much of the existing literature on investment under uncertainty supports the notion that greater uncertainty increases investment, in contrast with what one might suspect. The models in this dissertation stem from the conviction that in order to develop practically fruitful investment models it is necessary to combine honest data analysis with stochastic theory.Chapter I presents a survey of investment models under certainty.Chapter II considers three specific forms of risk-aversion. Optimal investment of a competitive firm facing uncertain real wages, productivity and investment costs is derived. It is shown that under risk-aversion an increase in risk can increase or decrease investment, depending on the correlation between the return on the firm and the return on all other projects in the economy. When bad times for the national economy mean bad times for a firm then optimal investment of a firm with owners that dislike risk (are risk-averse) is smaller than optimal investment when owners are risk-neutral.In Chapter III some evidence of risk-averse investment behavior is presented. The investment model assuming risk-aversion outperforms the model assuming risk-neutrality in explaining variations in investment. The reason is that when the rate of return on the firm is assumed to be correlated with the return on all other firms in the economy then the explanatory power of cost of capital for variations in investment is improved. Further, it is shown that an increase in the variance of real wages is related to decreasing investment, which favors the idea that variables measuring uncertainty can raise the explanatory power of investment models.In Chapter IV a model of irreversible investment is calibrated. It is shown that a cut in corporate income taxes or an increase in investment allowances has to be quite large to increase investment. Thus credibility may be more important than tax incentives to stimulate investment. In Chapter V assumptions, extensions and policy conclusions of the models are discussed.