Flexibility in sequential investment and catastrophic risk

We consider an investment problem such as the construction of power plants. The uncertainties considered in this investment problem are the evolution of cash flows obtained from plant operation and a catastrophic event, such as an earthquake, which drives the value of the project to zero due to external factors. We present the model of a sequential investment as well as the model of a single investment and demonstrate the effect of the catastrophic event on the flexibility of the sequential decision by comparing the option values of the single investment and the sequential one. In addition, for the case in which the costs associated with the construction and the catastrophic event are both dependent on the location, we determine the optimal investment timing and location of the plant simultaneously.