Optimal investment facing possible accidents

Abstract

This paper studies the optimal behavior of a firm over time that faces the probability ofcausing an environmental disaster by its activities. Here, we can think of explosions in thechemical industry, oil tankers that lose oil, etc. In the static literature, a distinction is madebetween small firms and large firms. Small firms are called undercapitalized in the sensethat the firm cannot pay for the accident because the accidental damage exceeds the value ofthe firm. As soon as this happens, the firm is declared bankrupt. This gives an incentive tospend part of the safety budget on distributing dividends to the shareholders under the motto:pay dividends as long as it is still possible.

In this paper, we extend the static framework to a dynamic one. The major reason is tofind out under what circumstances it can be optimal for a small firm to expand in order tobecome a large firm that has the means to fully pay for the damage caused by an environmentalaccident. Admittedly, this paper is only a first step in reaching this goal. Here, wedetermine the optimal safety expenditures and the convergence behavior of long‐run investmentpolicies.