QUANTIFYING THE ROLE PLAYED BY SUNK CAPITAL COSTS IN REAL-OPTIONS MODELS Vivek Ghosal n Abstract Sunk capital costs are essential in generating hysteresis in real-options models that examine firms’ decisions under uncertainty. The standard results show that greater uncertainty, in the presence of sunk capital costs, dampens firms’ economic activity across a wide range of decision variables. In empirical examination of these models, there is a considerable lack of evidence on the conditioning effects of sunk capital costs. In this paper, I first detail alternative ways to use publicly available data to construct measures of sunk capital costs. The data reveal substantial differences across industries in their magnitudes of sunk capital costs. Second, I provide some evidence that the presence of higher sunk capital costs significantly exacerbates the effects of uncertainty. I Introduction The theoretical considerations of the real-options models are spelled out in the contributions by Dixit (1989), Dixit and Pindyck (1994) and numerous contributions since then. Theory shows that the presence of uncertainty and sunk capital costs imply an option value of waiting, and are likely to be important determinants of firms’ entry, exit and investment decisions. In terms of empirical testing, there is a sizeable literature that has examined the effects of uncertainty on investment. 1 The focus of this study is on assessing the conditioning effects of sunk capital costs on the impact of uncertainty on firms’ entry and exit decisions. The theory points to greater sunk capital costs dampening investment under uncertainty. Similarly, theory points to uncertainty having a restraining effect on firms’ entry and exit decisions and that this effect will be greater when sunk capital costs are higher. My review of the literature revealed relatively little empirical evidence on the role played by sunk capital costs in determining the effects of uncertainty. n School of Economics, Georgia Institute of Technology 1 See the surveys in Carruth et al. (2000) and Lensink et al. (2001), and the papers by Leahy and Whited (1996) and Ghosal and Loungani (1996, 2000). Scottish Journal of Political Economy, Vol. 57, No. 3, July 2010 r 2010 The Author Journal compilation r 2010 Scottish Economic Society. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA 343