Strategic capital budgeting: asset replacement under market uncertainty

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. We take into account strategic interactions among the firms competing in the product market 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. Furthermore it is shown that result ii) carries over to the case where firms have to decide about starting production rather than about replacing existing facilities. Correspondence to: Grzegorz PawlinaThis research was undertaken with support from the European Union's Phare ACE Programme 1997. The content of the publication is the sole responsibility of the authors and in no way represents the views of the Commission or its services. The authors would like to thank Kuno Huisman, Enrico Pennings, two anonymous referees, and participants of the Advances in Game Theory Conference in Hilvarenbeek, EFMA 2002 in London, and the Workshop on Recent Topics in Real Options Valuation in Krems for helpful comments.G. Pawlina