Abstract

In this paper, we propose a model for determining the optimal time to renovate the assets or facilities. A key assumption is that the future cashflows, which are uncertain and decreasing in trend, are boosted by the renovations. With this research background, we employ a real options framework to derive the optimal timing of renovations based on a variety of assumed economic parameters, such as discount rate, income cash flow reduction rate and volatility, and renovation cost. We derive the optimal renovation timings, which take the form of thresholds, in a closed-form and investigate their properties analytically and numerically. It is found with numerical examples that the effects of several key parameters on the thresholds are non-monotonic, which shows a stark contrast to the traditional NPV method or standard real options models.