Keywords: Irreversibility, real options, adjustment costs
Abstract: We investigate the empirical relationship between company investment and
measures of uncertainty, controlling for the effect of expected future profitability on
current investment decisions. We consider three measures of uncertainty derived from (1)
the volatility in the firm's stock returns; (2) disagreement among securities analysts in
their forecasts of the firm's future profits; and (3) the variance of forecast errors in
analysts' forecasts of the firm's future profits. We consider two controls for expected
profitability: (1) a standard measure of Brainard-Tobin's q constructed from the firm's
stock market valuation; and (2) an alternative measure of the q ratio constructed from
discounted forecasts of the firm's future profits.
Our sample consists of publicly-traded U.S. companies that were tracked by two
or more securities analysts for at least four consecutive years between 1982 and 1999.
The results show that all three measures of uncertainty are positively correlated and
appear to pick up underlying movements in uncertainty. When we consider these
measures individually, we find a significantly negative long-run effect of higher
uncertainty on capital accumulation, which is robust to the inclusion of either of our
controls for expected profitability. When we consider our uncertainty measures jointly,
we find that the level of disagreement among analysts provides the most informative
indicator for identifying this long-run effect of uncertainty on capital accumulation. In
addition, we find a significantly negative short-run interaction term between share price
volatility and current sales growth, consistent with the idea that investment will respond
less to a given demand shock at higher levels of uncertainty. These effects of uncertainty
on investment are shown to be quantitatively as well as statistically significant.
Full paper (536 KB PDF)
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Last update: April 22, 2004