'Obsolescence Risk and Project Appraisal: Application to Stranded Assets in the Oil and Gas Industries'

Abstract

The purpose of this paper is to develop a valuation model for projects, explicitly taking into account the combined effects of taxation and the risk of obsolescence. In the modelling process it is assumed that a project's pre-tax net operating cash flows follow a geometric Brownian motion with a declining trend parameter. Obsolescence risk is introduced by means of a Poisson jump. The risk effects on the tax on flows and tax savings through tax depreciation are then evaluated separately. Through sensitivity analysis it is demonstrated that the expected time to obsolescence can have a more dramatic effect upon valuation than moderate changes in tax depreciation rates and corporate tax rates.

Keywords: capital budgeting; dynamic programming; product life cycle; tax; stranded assets; uncertainty

JEL Classification: Q35