Production Processes with Different Levels of Risk

Addressing the Replacement Option

Abstract

It is often found that a company has the opportunity to change its original production process to a different one. Here we consider two different situations: in the first one, the new production process may lead to larger losses (in case the demand decreases), but may also lead to larger profits (in case the demand increases); so we increase the risk. In the second one, the opposite holds (and we decrease the risk). We derive the optimal replacement strategy, and we study the impact of the drift and the volatility in the decision. Afterward, we include the option to exit the market and we compare both situations (with and without the exit option), concluding that in case the investment is in a less risky process, the impact of the exit option is different, depending on a relation involving the costs and the drift parameters.