On the Optimal Lifetime of Real Assets

We show that the “abandonment” model emphasized by researchers in capital budgeting and the “steady state” replacement model emphasized by economic theorists constitute sub-cases of a more general class of transitory replacement models in which the horizon of reinvestments is determined endogenously along with the other decision variables. Moreover, comparisons between our model and that of steady state replacement revealed that there are considerable differences. In particular, we found that: i) the two models lead to different estimates concerning the profit horizon, the duration of replacements, the timing of abandonment or scrapping, and the impact of productive capacity and market structure on service lives, as these are determined by various parameters, ii) even though the steady state replacement policy may result in higher total profit, it does so at great expense in flexibility for the planner, because the replacements are built into the model from the beginning, and iii) the transitory replacement policy seems more realistic in that the replacements are undertaken only if forced on the planner by decreasing profits.