Operational asset replacement strategy: A real options approach

This paper analyses the problem of replacement by investigating the optimal moment of investment replacement in a given tax environment with a given depreciation policy. An operation and maintenance cost minimization model, based on the definition of equivalent annual cost, is applied to a real options paradigm. The developed methodology allows for an innovative evaluation of the flexibility of replacement process analysis. A new two-factor evaluation function is introduced to quantify decisions on asset replacement under a unique cycle environment. This study improves upon previous findings in the literature as it accounts for autonomous salvage value processes. Based on partial differential equations, this model achieves a general analytical solution and particular numerical solution. The results differ significantly from those observed in one-factor models by showing evidence of over-evaluation in optimal levels of replacement, and by confirming suspicions that different types of uncertainties produce non-monotonous effects on the optimal replacement level. The scientific contribution of this study lies in new and stronger approaches to equivalent annual cost literature, supplying an algorithm for operation and maintenance cost minimization that is conditioned by autonomous salvage value. This study also contributes to the real options literature by developing a two-factor model with Brownian processes applied to asset replacement.