Stochastic Equipment Capital Budgeting with Technological Progress

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.

Real options approach for technology renewal in an Electronic Manufacturing Service (EMS) company

“…This paper presents a real options approach to get the optimal renewal time for technology replacement through a study case for an EMS company. We selected four models for implementation: the deterministic model (Linnard & Gane, 1968); the one-factor model (Dobbs, 2004); the two-factor model (Adkins & Paxson, 2011); and the two-factor model with technological progress (Adkins & Paxson, 2014).…”

“…2.4 Technological improvement (Adkins & Paxson, 2014) extended the two-factor model by adding the technological improvement factor, we specifically present the anticipated technological progress model. Technological advancement is inevitable in businesses and industries.…”

“…The prior machine is replaced with an improved one. (Adkins & Paxson, 2013) (Adkins & Paxson, 2014) extended the two-factor model to consider technological progress. Four models are selected for implementation.…”

“…Four models are selected for implementation. In the first section, we describe the deterministic model (Linnard & Gane, 1968); the one-factor model (Dobbs, 2004); the two-factor model (Adkins & Paxson, 2011); and the two-factor model with technological progress (Adkins & Paxson, 2014). We examine the models and guide the implementation.…”