Strategic Capital Budgeting: Asset Replacement Under Uncertainty

G. Pawlina, P.M. Kort

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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.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages27
Volume2001-4
Publication statusPublished - 2001

Publication series

NameCentER Discussion Paper
Volume2001-4

Keywords

  • capital budgeting
  • uncertainty
  • investment
  • game theory

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