Capital renewal as a real option |
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Authors: | Matthew J Reindorp Michael C Fu |
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Institution: | a Department of Industrial Engineering and Innovation Sciences, Technische Universiteit Eindhoven, 5600 MB Eindhoven, The Netherlands b Robert H. Smith School of Business and Institute for Systems Research, University of Maryland, College Park, Maryland 20742, USA |
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Abstract: | We consider the timing of replacement of obsolete subsystems within an extensive, complex infrastructure. Such replacement action, known as capital renewal, must balance uncertainty about future profitability against uncertainty about future renewal costs. Treating renewal investments as real options, we derive an optimal solution to the infinite horizon version of this problem and determine the total present value of an institution’s capital renewal options. We investigate the sensitivity of the infinite horizon solution to variations in key problem parameters and highlight the system scenarios in which timely renewal activity is most profitable. For finite horizon renewal planning, we show that our solution performs better than a policy of constant periodic renewals if more than two renewal cycles are completed. |
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Keywords: | Investment analysis Maintenance Replacement Facilities planning and design Simulation |
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