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Optimal Risk Adoption and Capacity Investment in Technological Innovations

Sendstad, L. H., Chronopoulos, M. and Hagspiel, V. (2021). Optimal Risk Adoption and Capacity Investment in Technological Innovations. IEEE Transactions on Engineering Management, doi: 10.1109/TEM.2021.3056142

Abstract

Technological innovations often formulate new market regimes and create incentives to abandon existing, less attractive ones. However, this decision depends not only on market forces, such as economic and technological uncertainty, but also on attitudes toward risk. Although greater risk aversion typically raises the incentive to postpone investment, the impact of risk aversion becomes more complex when a firm has discretion over both the timing and the size of a project. We develop a utility-based regime-switching framework in order to analyze how a firm with discretion over investment timing and project scale may choose to abandon an existing market regime to enter a new one. Results indicate that greater risk aversion hastens investment in an existing regime by decreasing the amount of installed capacity, but delays its abandonment, thereby hindering the transition to a new one. In contrast, greater demand uncertainty in the new market regime raises the value of the investment opportunity and, in turn, the incentive to abandon the existing regime. Furthermore, we find that uncertainty over the arrival of a technological innovation may accelerate investment in the existing regime and reduce the relative loss in project value in the absence of managerial discretion over project scale.

Publication Type: Article
Additional Information: This work is licensed under a Creative Commons Attribution 4.0 License. For more information, see https://creativecommons.org/licenses/by/4.0/
Publisher Keywords: Investment analysis, real options, regime switching, risk aversion, technological innovation
Subjects: H Social Sciences > HG Finance
T Technology > TA Engineering (General). Civil engineering (General)
Departments: Bayes Business School > Actuarial Science & Insurance
Date available in CRO: 04 Oct 2021 10:57
Date deposited: 4 October 2021
Date of acceptance: 27 January 2021
Date of first online publication: 26 February 2021
URI: https://openaccess.city.ac.uk/id/eprint/26861
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