Academic journal article Financial Management

Investment Timing for Dynamic Business Expansion

Academic journal article Financial Management

Investment Timing for Dynamic Business Expansion

Article excerpt

We investigate the timing of business expansion. With an indefinite sequence of growth opportunities that have constant returns to scale, current investment neither displaces nor impairs future returns. In a dynamic setting with expansion restricted to a fraction of firm size, the endogenously determined cost of capital uniformly exceeds the value maximizing return threshold for expansion. Taking this into account, a manager accelerates investment to facilitate larger and more valuable future investments when earnings stochastically improve. This result is the opposite of deferral that the investment literature recommends due to irreversibility. This means that the managerial application of the cost of capital as an expansion hurdle rate is improperly conservative.

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We investigate the managerial trade-off between the investment delaying force of irreversibility and the accelerating force of follow-on options when managerial choice endogenously determines corporate growth. If the firm has an infinite sequence of growth opportunities with constant returns to scale, current investment neither displaces nor impairs future investment returns. These expansion features weaken the managerial incentive to defer irreversible investment.

Furthermore, when expansion is restricted to a fraction of firm size, we demonstrate that the endogenously determined cost of capital, expected return on business value, uniformly exceeds the value maximizing expansion return threshold. In other words, a manager accepts marginal investments that return less than the cost of capital to facilitate larger and more valuable future investments when earnings stochastically improve. In this instance, the force of increasing the follow-on options dominates the force of irreversibility for expansion timing. We confirm that the managerial application of the cost of capital as an expansion hurdle rate is improperly conservative. A value maximizing manager expands sooner than a manager who uses the cost of capital as an expansion hurdle rate.

There are four features of our business expansion model that, when combined, lead to new results. First, we relate the process for operating profit with the process for capital investment so that growth in both is endogenous. Rather than exogenous profit growth driving capital growth, value maximizing managerial decisions jointly determine profit and capital growth. Profit that grows only with capital growth removes a managerial attraction to waiting. Second, we presume indefinite expansion opportunities with constant returns to scale. Current investment neither displaces nor impairs future investment returns, which weakens the managerial incentive for investment delay. Third, the manager has a dynamic option to grow that includes the ability to suspend growth upon inadequate profitability. Current investment does not impair future investment returns because the manager can suspend growth upon inadequate profitability. This ability to suspend unprofitable growth reduces the incentive to delay current investment. Fourth, we apply an expansion proportionality constraint so that small firms make small investments and large firms make large investments. If a manager expands business prematurely when profit is possibly inferior, current investment increases the size and dollar value of future expansion upon stochastically improved profitability. Downside earnings risk is no greater as the manager can defer growth once started.

It is important to compare value maximizing models with the cost of capital analysis since the cost of capital is ingrained in the corporate practice of business expansion evaluation. As managers recognize that the cost of capital is not an appropriate benchmark for business investment decisions in dynamic settings in the presence of various real options, they will look to the financial literature for guidance. The most likely resource is Dixit and Pindyck (1994). …

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