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Strategic capital budgeting: Asset replacement under uncertainty

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  • Kort, P.M.

    (Tilburg University)

  • Pawlina, G.

    (Tilburg University)

Abstract

We 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 Info

Paper provided by Tilburg University in its series Open Access publications from Tilburg University with number urn:nbn:nl:ui:12-123062.

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Date of creation: 2003
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Publication status: Published in OR Spectrum (2003) v.25, p.443-479
Handle: RePEc:ner:tilbur:urn:nbn:nl:ui:12-123062

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Web page: http://www.tilburguniversity.edu/

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  1. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  2. Nalin Kulatilaka & Enrico C. Perotti, 1998. "Strategic Growth Options," Management Science, INFORMS, vol. 44(8), pages 1021-1031, August.
  3. Robin Mason & Helen Weeds, 2000. "Networks, Options and Preemption," Econometric Society World Congress 2000 Contributed Papers 1721, Econometric Society.
  4. Huisman, K.J.M. & Kort, P.M., 1999. "Effects of Strategic Interactions on the Option Value of Waiting," Discussion Paper 1999-92, Tilburg University, Center for Economic Research.
  5. Decamps, J.-P. & Mariotti, T., 2000. "Irreversible Investment and Learning Expternalities," Papers 00-534, Toulouse - GREMAQ.
  6. Han T. J. Smit & L. A. Ankum, 1993. "A Real Options and Game-Theoretic Approach to," Financial Management, Financial Management Association, vol. 22(3), Fall.
  7. Lambrecht, Bart & Perraudin, William, 2003. "Real options and preemption under incomplete information," Journal of Economic Dynamics and Control, Elsevier, vol. 27(4), pages 619-643, February.
  8. Enrico Perotti & Silvia Rossetto, 2000. "Internet Portals as Portfolios of Entry Options," Tinbergen Institute Discussion Papers 00-105/2, Tinbergen Institute.
  9. Grenadier, Steven R, 1996. " The Strategic Exercise of Options: Development Cascades and Overbuilding in Real Estate Markets," Journal of Finance, American Finance Association, vol. 51(5), pages 1653-79, December.
  10. Anonymous, 1998. "For the record: September - December 1998," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 61, December.
  11. Fudenberg, Drew & Tirole, Jean, 1985. "Preemption and Rent Equilization in the Adoption of New Technology," Review of Economic Studies, Wiley Blackwell, vol. 52(3), pages 383-401, July.
  12. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262200716, December.
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