Investment under Uncertainty: The Role of Inventory Dynamics

Abstract

Finished-good inventory is very common under market uncertainty. We build a continuous-time model to study how the inventory will impact firm value and investment decisions. Our model shows that the value of a company following the optimal inventory policy can be significantly higher than the traditional non-inventory company, particularly if the inventory-holding cost is not large. This premium becomes small as holding cost is increased, and large when demand is volatile, and when price elasticity is large. We also show that the optimal investment size can be significantly larger than the traditional no-inventory firm, particularly when the inventory-holding cost is low, demand volatility is high, and price elasticity is low. This paper develops a simulation algorithm to solve iterative optimization problem in a path-dependent economy.