Replacement Investment: Optimal Economic Life Under Uncertainty

Abstract

Replacement investment is essentially a regenerative optimal stopping problem; that is, the key decision concerns when to terminate the life of existing plant - and hence when to start over again. This paper examines this optimisation problem within a continuous time framework and studies the qualitative and quantitative impact of uncertainty on the timing of new investment (and the criteria that should be used for terminating the life of existing plant). Copyright Blackwell Publishers Ltd, 2004.

Sequential investments with stage-specific risks and drifts

“…Alvarez (1999) establishes that irreversible exit is viable only when the productive project value falls below the abandonment option value. Mauer and Ott (1995) include salvage value in a productive asset replacement model, while Dobbs (2004) deduces its value from the operating cost threshold. By considering alternative ordered forms of flexibility including abandonment, Keswani and Shackleton (2006) show the significance of the abandonment option in reducing the investment timing trigger thereby prompting earlier exercise, a finding endorsed by Wong (2012).…”

Replacement decisions with multiple stochastic values and depreciation

“…We observe that most real-option models which allow for stochastic variables, treat abandonment only implicitly. Salvage value and depreciation are interpreted by Mauer and Ott (1995) as functions of a stochastic operating cost as a way of reducing dimensionality to one, while Dobbs (2004) embeds the salvage value into a one-factor model. Ye (1990) allows combined maintenance and operating cost to follow an arithmetic Brownian motion, with a fixed investment cost, no salvage value or depreciation.…”

Free cash flow models, terminal values and the timing of asset replacements∗

“…This process is subject to at least two major concerns. The first is the failure to recognise that the timing of asset replacements is stochastic, and this has been addressed (Mauer and Ott, 1995;Dobbs, 2004). The second issue is the failure to explicitly consider the age profile of a firm's assets at the valuation horizon; this age profile affects the timing of future replacements and therefore affects the present value of these expenditures.…”