Hostname: page-component-78c5997874-m6dg7 Total loading time: 0 Render date: 2024-11-03T01:45:31.112Z Has data issue: false hasContentIssue false
  • English
  • Français

Investment under Uncertainty: The Case of Replacement Investment Decisions

Published online by Cambridge University Press:  06 April 2009

David C. Mauer  and
Steven H. Ott
David C. Mauer
Affiliation:
School of Business, University of Wisconsin-Madison, Madison, WI 53706
Steven H. Ott
Affiliation:
College of Business and Economics, University of Kentucky, 40506
Get access Rights & Permissions [Opens in a new window]

Abstract

We analyze the determinants of replacement investment decisions in a contingent claims model with maintenance and operation cost uncertainty. We find that the optimal time between replacements is increasing in the volatility of cost, the purchase price of a new asset, and the corporate tax rate; and is decreasing in the systematic risk of cost, the salvage value of the asset, and the investment tax credit. The optimal time between replacements can either increase or decrease with an increase in the depreciation rate. Extensions of the model to examine the effects of technological and tax policy uncertainty on replacement investment decisions give intuitive, but striking results. Uncertainty about the arrival of a technological innovation that would decrease maintenance and operation cost results in a significant decrease in replacement investment. Uncertainty in a tax law change that would encourage investment decreases current investment; and uncertainty in a tax law change that would discourage investment increases current investment.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 30 , Issue 4 , December 1995 , pp. 581 - 605
Copyright
Copyright © School of Business Administration, University of Washington 1995

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Auerbach, A. J., and Hines, J. R.. “Investment Tax Incentives and Frequent Tax Reforms.” American Economic Review Proceedings, 78 (05 1988), 211–216.Google Scholar
Breeden, D. T. “An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities.” Journal of Financial Economics, 7 (09 1979), 265–296.CrossRefGoogle Scholar
Constantinides, G. M. “Market Risk Adjustment in Project Valuation.” Journal of Finance, 33 (05 1978), 603–616.CrossRefGoogle Scholar
Cox, D. R., and Miller, H. D.. The Theory of Stochastic Processes. London, England: Methuen and Co. Ltd. (1970).Google Scholar
Dixit, A. K. “The Art of Smooth Pasting.” Vol. 55 in Fundamentals of Pure and Applied Economics, Lesourne, Jacques and Sonnenschein, Hugo, eds. Chur, Switzerland: Harwood Academic Publishers (1993).Google Scholar
Dixit, A. K., and Pindyck, R. S.. Investment under Uncertainty. Princeton, NJ: Princeton Univ. Press (1994).CrossRefGoogle Scholar
Dumas, B. “Super Contact and Related Optimality Conditions.” Journal of Economics Dynamics and Control, 15 (1991), 675–695.CrossRefGoogle Scholar
Emery, D. R., and Finnerty, J. D.. Principles of Finance with Corporate Applications. St. Paul, MN: West Publishing Company (1991).Google Scholar
Feldstein, M. S., and Rothschild, M.. “Towards an Economic Theory of Replacement Investment.” Econometrica, 42 (05 1974), 393–423.CrossRefGoogle Scholar
Hull, J., and White, A.. “Valuing Derivative Securities Using the Explicit Finite Difference Method.” Journal of Financial and Quantitative Analysis, 25 (03 1990), 87–100.CrossRefGoogle Scholar
Ibbotson Associates. Stocks, Bonds, Bills, and Inflation 1991 Yearbook. Chicago, IL: Ibbotson Associates (1991).Google Scholar
Ingersoll, J. E. Jr. Theory of Financial Decision Making. Totowa, NJ: Rowman and Littlefield (1987).Google Scholar
Ingersoll, J. E. Jr., and Ross, S. A.. “Waiting to Invest: Investment and Uncertainty.” Journal of Business, 65 (01 1992), 1–29.CrossRefGoogle Scholar
Jorgenson, D. W.; McCall, J. J.; and Radner, R.. Optimal Replacement Policy. Chicago, IL: Rand McNally & Company (1967).Google Scholar
Kamien, M. I., and Schwartz, N. L.. “Optimal Maintenance and Sale Age for a Machine Subject to Failure.” Management Science, 17 (04 1971), 495–504.CrossRefGoogle Scholar
Karatzas, I., and Shreve, S. E.. Brownian Motion and Stochastic Calculus. Berlin, Germany: Springer-Verlag (1988).Google Scholar
Kau, J. B.; Keenan, D. C.; and Kim, T.. “Default Probabilities for Mortgages.” Journal of Urban Economics, 35 (05 1994), 278–296.CrossRefGoogle Scholar
Kulatilaka, N., and Perotti, E.. “What is Lost by Waiting to Invest?” Working Paper, Boston Univ. (1994).Google Scholar
Lewellen, W. G., and Mauer, D. C.. “Public Utility Valuation and Risk under Incentive Regulation.” Journal of Regulatory Economics, 5 (09 1993), 263–287.CrossRefGoogle Scholar
Malliaris, A. G., and Brock, W. A.. Stochastic Methods in Economics and Finance. Amsterdam, Netherlands: North-Holland (1982).Google Scholar
Massé, P.Optimal Investment Decisions: Rules for Action and Criteria for Choice. Englewood Cliffs, NJ: Prentice-Hall Inc. (1962).Google Scholar
Mauer, D. C., and Triantis, A. J.. “Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework.” Journal of Finance, 49 (09 1994), 1253–1277.CrossRefGoogle Scholar
McDonald, R., and Siegel, D. R.. “The Value of Waiting to Invest.” Quarterly Journal of Economics, 101 (11 1986), 707–728.CrossRefGoogle Scholar
McLaughlin, R., and Taggart, R. A. Jr. “The Opportunity Cost of Using Excess Capacity.” Financial Management, 21 (Summer 1992), 12–23.CrossRefGoogle Scholar
Merton, R. C. “An Intertemporal Capital Asset Pricing Model.” Econometrica, 41 (09 1973a), 867–880.CrossRefGoogle Scholar
Merton, R. C. “The Theory of Rational Option Pricing.” Bell Journal of Economics and Management Science, 4 (Spring 1973b), 141–183.Google Scholar
Ott, S. H., and Thompson, H. E.. “Uncertain Outlays in Time-to-Build Problems.” Managerial and Decision Economics (forthcoming, 1995).3.0.CO;2-N>CrossRefGoogle Scholar
Pindyck, R. S. “Investments of Uncertain Cost.” Journal of Financial Economics, 34 (08 1993), 53–76.CrossRefGoogle Scholar
Rust, J. “Optimal Replacement of GMC Bus Engines: An Empirical Model of Harold Zurcher.” Econometrica, 55 (1987), 999–1034.Google Scholar
Sick, G.Capital Budgeting with Real Options. Monograph 1989–3, Salomon Brothers Center for the Study of Financial Institutions Monograph Series in Finance and Economics, New York Univ. (1989).Google Scholar
Sick, G.Real Options. Jarrow, R. A., Maksimovic, V., and Ziemba, W. T., eds. Amsterdam, Netherlands: North-Holland (forthcoming, 1995).Google Scholar
Trigeorgis, L.Real Options and Interactions with Financial Flexibility.” Financial Management, 22 (Autumn 1993), 202–224.CrossRefGoogle Scholar
Ye, M.-H. “Optimal Replacement Policy with Stochastic Maintenance and Operation Costs.” European Journal of Operational Research, 44 (1990), 84–94.CrossRefGoogle Scholar