Renewing Assets with Uncertain Revenues and Operating Costs

Roger Adkins and Dean Paxson

Journal of Financial and Quantitative Analysis, 2011, vol. 46, issue 3, 785-813

Abstract: 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.

Date: 2011
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