Irreversible Investment with Regime Shifts

Under the real options approach to investment under uncertainty, agents formulate optimal policies under the assumption that firms’ growth prospects do not vary over time. This paper proposes and solves a model of investment decisions in which the growth rate and volatility of the decision variable shift between different states at random times. A value-maximizing investment policy is derived such that in each regime the firm’s investment policy is optimal and recognizes the possiblity of a regime shift. Under this policy, investment is intermittent and increases with marginal q. Moreover, the rate of investment typically is very small but exhibits some spurts of growth. Implications for marginal q and the user cost of capital are also examined.