Investments of uncertain cost

Abstract

I study irreversible investment decisions when projects take time to complete, and are subject to two types of uncertainty over the cost of completion. The first is technical uncertainty, i.e., uncertainty over the amount of time, effort, and materials that will ultimately be required to complete the project, and that is only resolved as the investment takes place. The second is input cost uncertainty, i.e., uncertainty over the prices and quantities of labor and materials that are expected to be required, and which is external to the firm's investment activity. This paper derives simple decision rules that maximize the firm's value, and that are easy to implement. I show how these two types of uncertainty have very different effects on the decision to invest, and how they affect the value of the opportunity to invest.