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Stochastic Equipment Capital Budgeting with Technological Progress

Authors


  • We thank Nelson Areal, Alcino Azevedo, Michael Brennan, Chen Chao-Chun, Geoffrey Evatt, Michael Flanagan, Nicos Koussis, Spiros Martzoukos, Ser-Huang Poon, Artur Rodrigues, Mark Shackleton, Azfal Siddique, Richard Stapleton, an anonymous referee, and participants at the EFMA 2011 Conference at the University of Minho, Braga, for their valuable comments on earlier versions.

Abstract

We provide multi-factor real option models (and quasi-analytical solutions) for equipment capital budgeting under uncertainty, when there is either unexpected, or anticipated, or uncertain (volatile) technological progress. We calculate the threshold level of revenues and operating costs using the incumbent equipment that would justify replacement. Replacement is deferred for lower revenue thresholds. If progress is anticipated or highly uncertain, alert financial managers should wait longer before replacing equipment. Replacement deferral increases with decreases in the expected correlation between revenue and operating costs, and with increases in the revenue and/or operating cost volatility. Uncertain technological progress increases the real option value of waiting. The best approach for equipment suppliers is to reduce the expected revenue and/or cost volatility, and/or reduce the expected uncertainty of technological innovations, since then an incentive exists for the early replacement of old equipment when a technologically advanced version is launched.

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