Strategic Capital Budgeting: Asset Replacement Under Market Uncertainty
30 Pages Posted: 20 Jun 2002
Date Written: March 6, 2002
In this paper, the impact of product market uncertainty on the optimal replacement timing of a production facility is studied. The existing production facility can be replaced by a technologically more advanced and thus more cost-effective one. Strategic interactions among the firms competing in the product market are taken into account by analyzing the problem in a duopolistic setting. We calculate the value of each firm and show that i) a preemptive (simultaneous) replacement occurs when the associated sunk cost is low (high), ii) despite the preemption effect uncertainty always raises the expected time to replace, and iii) the relationship between the probability of optimal replacement within a given time interval and uncertainty is decreasing for long time intervals and humped for short time intervals. Further more, it is shown that result ii) carries ver to the case here firms have to decide about starting production rather than about replacing existing facilities.
Keywords: capital budgeting, real options, first passage time, product market uncertainty, Cournot duopoly
JEL Classification: C61, D81, G31
Suggested Citation: Suggested Citation