Abstract
We consider an operator of machinery with deteriorating efficiency, facing the problem of optimally timing of either a minor (maintenance) investment or a major (replacement) investment under price uncertainty. If a maintenance investment is chosen, the efficiency of the machinery will deteriorate more slowly, and replacing later is still possible. The optimal decision rule is expressed in the form of thresholds for long-run prices, indicating that it may be rational to wait to see which of the large and small investment is the better choice. We relate the setting to repowering of green energy facilities, such as hydropower plants and wind farms. Our analysis provides several managerial insights. We characterize the conditions that govern whether the smaller investment should be considered at all, and we quantify the effect of having a replacement option embedded in a maintenance option. Our analysis demonstrates that the large investment may get postponed significantly in expectation, which recognizes maintenance as a temporary alternative to replacement.
Highlights
Similar to replacement, many maintenance tasks have discretion over timing, uncertain benefits, and irreversible costs. Both maintenance and replacement actions can be viewed as exercising real options [11], as opposed to the traditional view, which casts maintenance to be performed until marginal benefits equal marginal costs [5]
Unlike Ref. [24], we study the interaction between a maintenance option and a replacement option when the associated profits are uncertain, which is new to the real options literature on asset management
This paper examines the decisions of a firm concerning a potential maintenance or replacement of machinery within a real options framework
Summary
Owners of assets with deteriorating performance often have a range of possible actions to choose from in order to increase future expected profits. Similar to replacement, many maintenance tasks have discretion over timing, uncertain benefits, and irreversible costs. The problem of determining maintenance and replacement schedules under price uncertainty is of particular importance for operators of existing green energy facilities, such as wind farms and hydropower plants. Particular focus has been given to the replacement option, which is the process of replacing existing machinery or equipment with new ones that have higher capacity and/or efficiency. We refer to this process as repowering. We consider performance-enhancing activities, such as maintenance and replacement, as real options and analyze the range of flexibility that is offered by joint valuation of projects of different scales.
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