A model for irreversible investment with construction and revenue uncertainty

This paper presents a model of investment in projects that are characterized by uncertainty over both the construction costs and revenues. Both processes are modeled as spectrally negative Lévy jump-diffusions. The optimal stopping problem that determines the value of the project is solved under fairly general assumptions. It is found that the current value of the benefit-to-cost ratio (BCR) decreases in the frequency of negative shocks to the construction process. This implies that the cost overruns that can be expected if one ignores such shocks are increasing in their frequency. Based on calibrated data, the model is applied to the proposed construction of high-speed rail in the UK and it is found that its economic case cannot currently be made and is unlikely to be met at any time in the next decade. In addition it is found that ignoring construction uncertainty leads to a substantial probability of an erroneous decision being taken.