Irreversible Investment, Capacity Choice and the Value of the Firm

A model of capacity choice and utilization is developed consistent with value maximization when investment is irreversible and future demand is uncertain. Investment requires the full value of a marginal unit of capacity to be at least as large as its full cost. The former includes the value of the firm's option not to utilize the unit, and the latter includes the opportunity cost of exercising the investment option. We show that for moderate amounts of uncertainty, the firm's optimal capacity is much smaller than it would be if investment were reversible, and a large fraction of the firm's value is due to its options for future growth. We also characterize the behavior of capacity and capacity utilization, and discuss implications for the measurement of marginal cost and Tobin's q