A Multi-Cycle Two-Factor Model of Asset Replacement

Abstract

The aim of this article is to analyse the asset replacement problem in the perspective of optimal replacement time given a certain tax environment and depreciation policy. Using a real options approach, our model minimises current operation and maintenance costs and permits a new valuation of the replacement flexibility under a multi-cycle environment. The innovation on the valuation process comes from adding an autonomous salvage value factor. Results from partial differential equations reveal relevant differences from those observed in one-factor models, specifically in optimal replacement levels and in the non-monotonous effects of salvage value variation.This paper provides enhancements to existing literature on equivalent annual cost by formulating a cost-minimisation problem conditioned by autonomous salvage value dynamics, and it contributes to Real Options literature by introducing a salvage value factor in the valuation model.