AN EMPIRICAL EXAMINATION OF THE HANGOVER EFFECT OF IRREVERSIBILITY ON INVESTMENT
| Date | 01 July 2006 |
| Published date | 01 July 2006 |
| DOI | http://doi.org/10.1111/j.1467-9485.2006.00384.x |
| Author | Hong Bo |
AN EMPIRICAL EXAMINATION OF THE
HANGOVER EFFECT OF
IRREVERSIBILITY ON INVESTMENT
Hong Bo
n
Abstract
Irreversibility does not only raise the user cost of capital and discourage new
investment but also hinders disinvestment because of the hangover effect. This paper
derives a theoretical model that separates the impact of conventional convex
adjustment costs from the impact of irreversibility, based on which we test the
hangover effect of irreversibility by using a panel of Dutch listed firms during
1985–2000. We find that the sample firms cut both the capital stock and the inventory
stock facing shocks to sales and cash flow, but they cut the inventory stock by a larger
magnitude than they cut the capital stock. Given that fixed investment is more
irreversible than inventory investment, the result suggests that the diminished impact of
irreversibility provides the firm with more flexibility in responding to uncertainty,
which lends support for the hangover effect of irreversibility on investment.
I Intro ductio n
Capital investment is at least partially irreversible, i.e., once invested, the
investor looses some value of the investment project because of sunk costs and
inefficient capital markets (Pindyck, 1991). A narrow definition of irreversibility
is that the reselling prices of capital goods are lower than their purchasing prices.
A broader view of irreversibility means that revising investment decisions is
always costly. The investigation of the impact of irreversibility on investment is
intertwined with the literature on the adjustment costs of capital (see Caballero,
1999). Because of the existence of the irreversibility constraint, the traditional
(convex) adjustment cost of capital is not sufficient to model the relationship
between investment and fundamentals, therefore the augmented adjustment
costs function of capital, which includes fixed costs and costs related to
irreversibility, should be applied (e.g., Abel and Eberly, 1994, 1999). Abel and
Eberly (1999) distinguish between the short-run and the long-run effect of
irreversibility on investment. The short-run effect is referred to the user cost
effect and the long-run effect is referred to the hangover effect. On the one hand,
in the short run because of the existence of the wedge between purchasing and
reselling prices of capital goods, the marginal cost that guides investment
decisions and the required marginal revenue of capital also increase, which
n
University of London
Scottish Journal of Political Economy, Vol. 53, No. 3, July 2006
rScottish Economic Society 2006, Published by Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA
358
discourages investment. Therefore, irreversibility has an adverse impact on
investment because of higher user cost of capital. On the other hand, when
facing unfavourable states of nature, for instance, a lower demand, the firm is
less able to disinvest because of the irreversibility constraint, which implies a
higher level of capital stock in the long-run. This is called the hangover effect.
The more severe the irreversibility constraint, the higher the cost of cutting back
investment and the more difficulties the firm has in divesting. According to Abel
and Eberly (1999), irreversibility may have a positive impact on the expected
capital stock under uncertainty because of the hangover effect.
Empirically, some studies explain lumpy investment by referring to non-
convex adjustment cost of capital that is related to irreversibility (Doms and
Dunne, 1998; Cooper et al., 1999). Guiso and Parigi (1999) using the surveyed
planned investment data test how the investment–uncertainty relationship is
changed by the irreversibility constraint. Chirinko and Schaller (2002) find the
evidence of the irreversibility premium, which is the difference between the
discounted rate guiding the investment decision with irreversibility constraints
and the standard Jorgensonian user cost of capital. Abel and Eberly (2002)
provide evidence that the relationship between investment and Tobin’s Qis not
linear in the presence of fixed costs and irreversibility constraints.
Does irreversibility hinder disinvestment behaviour of the firm? The empirical
examination on the hangover effect of irreversibility is very much lagged behind
the theory. The current paper aims to empirically examine the hangover effect of
irreversibility on investment by using firm-level panel data. The contribution of
the paper is to provide evidence that the hangover effect of irreversibility does
exist at the firm level.
Although the theory predicts that the user cost effect and the hangover effect
of irreversibility exist simultaneously, the impact of irreversibility on investment
under uncertainty should differ between adjusting capital goods that are already
assets-in-place and executing investment plans. By intuition, if the firm has not
invested yet, the decision on ‘investing or waiting’ will be affected negatively by
the user cost effect and its combination with the hangover effect. The firm knows
that the investment project that is more irreversible, e.g., the asset is more firm
specific and lacks secondary capital markets, will have a higher cost of capital
because the difference between the purchasing and reselling prices will be larger.
In addition, the firm also anticipates that once this project is executed it will pay
higher costs to divest. This implies that the data on the planned investment
should be able to reflect the overall effect of irreversibility (both the user cost
effect and the hangover effect) on investment. However, for the fixed capital
goods that are already assets-in-place, the hangover effect of irreversibility is
more relevant because only for the assets-in-place, it is obvious that the
restriction of irreversibility makes the firm less able to cut investment facing
uncertainty even the firm wishes to do so. Therefore, one examining the impact
of irreversibility on investment by inspecting the data on the existing capital
stock (assets-in-place) should only be able to test the hangover effect.
The hangover effect predicts that the expected capital stock is higher under
the irreversibility constraint than the case of reversibility. Because the firm is not
EMPIRICAL EXAMINATION OF THE HANGOVER EFFECT 359
rScottish Economic Society 2006
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