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Irreversible investment, asset returns, and time-inconsistent preferences

ABSTRACT This paper introduces time-inconsistent preferences into the standard model of capacity choice and investigates its influences on entrepreneurial firms' investment decisions and asset returns. With time-inconsistent preferences, the entrepreneurial firm's expansion decision becomes more conservative. In addition, we find the value reduction caused by time-inconsistent preferences is more substantial in growth opportunities than assets in place. For asset returns, we show that time inconsistency lowers the beta of the firm through the channel of growth opportunities since the beta of assets in place is not affected by time-inconsistent preferences. Finally, the impacts on the capacity choice, firm value and asset returns also depend on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding future time-inconsistent behavior.