Strategic capital budgeting: Asset replacement under uncertainty
AbstractWe consider a firm's decision to replace an existing production technology with a new, more cost-efficient one.Kulatilaka and Perotti [1998, Management Science] nd that, in a two-period model, increased product market uncertainty could encourage the firm to invest strategically in the new technology.This paper extends their framework to a continuous-time model which adds flexibility in timing of the investment decision.This flexibility introduces an option value of waiting which increases with uncertainty.In contrast with the two-period model, despite the existence of the strategic option of becoming a market leader due to a lower marginal cost, more uncertainty always increases the expected time to invest.Furthermore, it is shown that under increased uncertainty the probability that the firm finds it optimal to invest within a given time period always decreases for time periods longer than the optimal time to invest in a deterministic case.For smaller time periods there are contrary effects so that the overall impact of increased uncertainty on the probability of investing is in this case ambiguous.
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Bibliographic InfoPaper provided by Tilburg University in its series Open Access publications from Tilburg University with number urn:nbn:nl:ui:12-123062.
Date of creation: 2003
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Publication status: Published in OR Spectrum (2003) v.25, p.443-479
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Other versions of this item:
- Pawlina, G. & Kort, P.M., 2001. "Strategic Capital Budgeting: Asset Replacement Under Uncertainty," Discussion Paper 2001-4, Tilburg University, Center for Economic Research.
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
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