Investment under Uncertainty: The Case of Replacement Investment Decisions

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.

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