We study optimal replacement and abandonment decisions for real assets, when both revenues and costs are uncertain and deteriorate with age. We develop an implicit representation of the renewal boundary as the solution to a set of simultaneous equations. This quasi-analytical method has the merit of computational ease and transparency. We show that the correlation between revenues and operating costs has a significant influence on the renewal boundary, and that the increase in revenue immediately following a renewal has a greater relative influence on the boundary than either operating cost or renewal cost. The quasi-analytical method is sufficiently flexible to deal with other real option models involving 2 variables
We derive the optimal investment timing and real option value for a facility with price and quantity uncertainty, where there might be a government subsidy proportional to production quantity. Where the subsidy is proportional to the multiplication of the price and quantity, dimensionality can be reduced. Alternatively, we provide quasianalytical solutions for different quantity subsidy arrangements: permanent (policy is certain); retractable; suddenly permanent; and suddenly retractable. Whether policy uncertainty acts as a disincentive for early investment depends on the type of subsidy arrangement. The greatest incentive for early investment is an actual retractable subsidy, a 'flighty bird in hand'.
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