Replacement decisions with multiple stochastic values and depreciation

YesWe develop an analytical real-option solution to the after-tax optimal timing boundary for a replaceable asset whose operating cost and salvage value deteriorate stochastically. We construct a general replacement model, from which seven other particular models can be derived, along with deterministic versions. We show that the presence of salvage value and tax depreciation significantly lowers the operating cost threshold that justifies (and thus hastens) replacement. Although operating cost volatility increases defer replacement, increases in the salvage value volatility hasten replacement, albeit modestly, while increases in the correlation between costs and salvage value defer replacement. Reducing the tax rate or depreciation lifetime, or allowing an investment tax credit, yield mixed results. These results are also compared with those of less complete models, and deterministic versions, showing that failure to consider several stochastic variables and taxation in the replacement process may lead to sub-optimal decisions

From Consumer Incomes to Car Ages: How the Distribution of Income Affects the Distribution of Vehicle Vintages

This paper studies the relationship between consumer incomes and ages of the durable goods consumed. At the household level, it presents evidence from the Consumer Expenditure Survey of a negative correlation between incomes and ages of the vehicles owned, controlling for the size of the vehicle stock. At the aggregate level, it constructs a dynamic, heterogeneous agents, discrete choice model with multiple vehicle ownership, to study the relationship between the distribution of consumer incomes and the distribution of vehicle vintages. Two versions of the model are solved, one with the restriction of at most one vehicle per agent and one with multiple vehicle ownership. For each version of the model, the parameters are calibrated to match vehicle ownership data for 2001. The moments of the income distribution are then varied to generate predictions for mean and median ages of vehicles and the results from the two versions of the model are compared. While these are mostly similar, some of the differences are quite illuminating.

Intertemporal Constraints, Shadow Prices, and Financial Asset Values

The conditions under which the unobserved shadow price of capital can be equated to the financial value of the firm have been developed in an important paper by Hayashi (1982). Employing a more powerful analytic method, this paper reexamines the shadow price- asset value relation in a model with a general set of intertemporal constraints. For a model with one capital good, a general relation between shadow prices and asset values is derived, and restrictive assumptions implicit in previous work are highlighted. Of particular importance is the relation between the marginal and average survival rates of capital, and the critical role of geometric depreciation. The impact of a discrete-time framework in specifying and interpreting econometric models is also explored.

The Theorem of Proportionality in Mainstream Capital Theory: An Assessment of its Conceptual Foundations

It is ascertained that the theorem of proportionality, which maintains that replacement investment is a constant proportion of the outstanding capital stock, has several fundamental shortcomings. It derives from a model founded on assumptions that are highly restrictive and unlikely to hold in reality. It is alien to the thinking of researchers in industrial organization and other neighboring fields to economics that treat the durability of capital goods as a choice variable. It ignores several thorny conceptual and methodological issues and, perhaps most important, it may have restrained seriously the progress towards developing models based on more realistic approaches of production. However, despite its shortcomings, the theorem continues to dominate mainstream capital theory, most probably because of: a) its simplicity, and b) the lack of a model that might yield a better theorem in terms of standard criteria, like explanatory and predictive power, simplicity, fruitfulness, etc. For this reason attention is drawn to recent research which shows that a model centered on the heterogeneous structure of capital and the useful lives of its components is both feasible and exceedingly rich in theoretical and empirical implications.Capital longevity, replacement, depreciation, scrappage, maintenance, utilization, obsolescence.

Quantifying the Distortionary Fiscal Cost of ‘The Bailout’

We utilize an overlapping generations model with endogenous production and incomplete markets to quantify the distortionary costs associated with financing the increase in government expenditures directed to investments in the private sector in 2008 and 2009 (also known as ‘the bailout’), and its differential impact on different groups of the population (in the USA). In our baseline calibration, this distortion corresponds to a loss of approximately $300 billion dollars in total household consumption. For plausible alternative assumptions regarding both the expected and actual duration of this increase in expenditures, or the willingness of foreign institutions and/or investors in absorbing additional government debt, this number can increase to$800 billion. We find that the cost falls more dramatically on those households which are either older and/or wealthier. Retirees face approximately 50% of the cost, as younger agents still expect to be alive when the economy has returned to its steady-state. Across wealth groups, the top 25% of the wealth distribution bears almost two thirds of the cost.Fiscal Policy, tax distortions, bailout, incomplete markets

Q Theory Without Adjustment Costs & Cash Flow Effects Without Financing Constraints

Tobin's Q exceeds one, even without any adjustment costs, for a firm that earns rents as a result of monopoly power or of decreasing returns to scale in production. Even when there are no adjustment costs and marginal Q is always equal to one, Tobin's Q is informative about the firm's growth prospects. We show that investment is positively related to Tobin's Q (which is observable average Q). This effect can be quantitatively small, which has been taken as evidence of very high adjustment costs in the empirical literature, but here is consistent with no adjustment costs at all. In addition, cash flow has a positive effect on investment, and this effect is larger for smaller, faster growing and more volatile firms, even though capital markets are perfect. These results provide a new theoretical foundation for Q theory and also cast doubt on evidence of financing constraints based on cash flow effects on investmentQ Theory, Cash Flow, Investment

Valuation of International Oil Companies –The RoACE Era

High oil prices are normally expected to stimulate exploration and the development of new oil and gas fields. But over the last few years, financial analysts have focused strongly on short-term accounting return (RoACE) for benchmarking and valuation, and this has led to high capital discipline among oil and gas companies. We analyse how high oil prices can be explained in terms of an implicit capacity game between the oil companies, and explore the stability of the current equilibrium. Our approach is an investigation of a key assumption among financial analysts, namely the presumed positive relation between RoACE and stock market valuation. Based on panel data for 11 international oil and gas companies, we seek to establish econometric relations between market valuation on one hand, and simple financial and operational indicators on the other. Our findings do not support the perceived positive relation between reported RoACE and market-based multiples. Recent evidence also suggests that the stock market is increasingly concerned about reserve replacement and sustained profitable growth. The current high-price equilibrium is therefore hardly stable.

Investment and Q in Spanish manufacturing firms

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IS THE "STANDARD REAL OPTIONS APPROACH" APPROPRIATE FOR INVESTMENT DECISIONS IN HOG PRODUCTION?

Applications of the real options approach hardly consider investment returns to be the result of competitive markets such as markets for agricultural products. The reason is probably that Dixit and Pindyck (1994, ch. 8) show in their very popular book "Investment under Uncertainty" that the investment triggers of firms in competitive markets are equal to those of firms with exclusive options. In this study, however, it is shown that this result is restricted to markets in which assets have infinite lifetime. If assets are subject to depreciation and subsequent reinvestment opportuni-ties, competition leads to significantly lower investment triggers. The reason is that depreciation of replaceable assets allows to compensate the potential decline in returns after negative demand shocks because of the non-replacement of depreciated assets. Accordingly, applications of the real options approach to investments in e.g. pig production should consider this effect. The results are obtained by an agent-based simulation approach in which a number of competing firms derive their investment triggers by a genetic algorithm. Since this method allows to understand the re-sulting price dynamics, an alternative method is presented that allows to simulate the identified price dynamics directly and which also can be used to determine investment triggers for specific conditions.Livestock Production/Industries,