Capacity flexibility premium under different demand uncertainties

In this paper, we study the effect of different demand shocks on flexibility premium in capacity investment. We find that capacity flexibility premium is significantly higher under additive demand uncertainty than that under multiplicative demand shock. The result suggests that real options approach is more appropriate for investment decision in additive model, and when under multiplicative demand shock the simple net present value (NPV) rule is efficient enough for firm to make accurate decision. That may provide additional theoretical support to explain why many firms still prefer NPV approach in reality. Before using real options approach indiscriminately, first to analyze and identify the nature of demand should be necessary. We examine this problem by dynamic programming and extend the application of bi-variable tree approach for jump diffusion stochastic processes.