Paul D. Childs, Steven H. Ott, Alexander J. Triantis, Capital Budgeting for Interrelated Projects: A Real Options Approach, The Journal of Financial and Quantitative Analysis, Vol. 33, No. 3 (Sep., 1998), pp. 305-334

Paul D. Childs, Steven H. Ott, Timothy J. Riddiough, The Pricing of Multiclass Commercial Mortgage-Backed Securities, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 4 (Dec., 1996), pp. 581-603

We analyze the determinants of replacement investment decisions in a contingent claims model with maintenance and operation cost uncertainty. We find that the optimal time between replacements is increasing in the volatility of cost, the purchase price of a new asset, and the corporate tax rate; and is decreasing in the systematic risk of cost, the salvage value of the asset, and the investment tax credit. The optimal time between replacements can either increase or decrease with an increase in the depreciation rate. Extensions of the model to examine the effects of technological and tax policy uncertainty on replacement investment decisions give intuitive, but striking results. Uncertainty about the arrival of a technological innovation that would decrease maintenance and operation cost results in a significant decrease in replacement investment. Uncertainty in a tax law change that would encourage investment decreases current investment; and uncertainty in a tax law change that would discourage investment increases current investment.

We examine interactions between flexible financing and investment decisions in a model with stockholder–bondholder conflicts over investment policy. We find that financial flexibility encourages the choice of short-term debt thereby dramatically reducing the agency costs of under- and overinvestment. However, the reduction in agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set. The model has a number of testable predictions for the joint choice of leverage and maturity, and how these choices interact with a firm's growth opportunities.