Strategic Capital Budgeting: Asset Replacement Under Market Uncertainty

30 Pages Posted: 20 Jun 2002

See all articles by Grzegorz Pawlina

Grzegorz Pawlina

Lancaster University - Department of Accounting and Finance

Peter M. Kort

Tilburg University - Department of Econometrics & Operations Research; Tilburg University - Center for Economic Research (CentER)

Date Written: March 6, 2002

Abstract

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

Pawlina, Grzegorz and Kort, Peter, Strategic Capital Budgeting: Asset Replacement Under Market Uncertainty (March 6, 2002). EFMA 2002 London Meetings. Available at SSRN: https://ssrn.com/abstract=314827 or http://dx.doi.org/10.2139/ssrn.314827

Grzegorz Pawlina (Contact Author)

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+ 44 1524 592834 (Phone)
+ 44 1524 847321 (Fax)

Peter Kort

Tilburg University - Department of Econometrics & Operations Research ( email )

Tilburg, 5000 LE
Netherlands
+31 13 466 2062 (Phone)
+31 13 466 3072 (Fax)

HOME PAGE: http://center.uvt.nl/staff/kort/

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2062 (Phone)
+31 13 466 3072 (Fax)

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