Managing uncertainty: A case for using real options with option pricing model (OPM) to evaluate capital investment

TAPPI Journal ◽  
2013 ◽  
Vol 12 (7) ◽  
pp. 69-77
Author(s):  
V.R. PERRY PARTHASARATHY
Keyword(s):  
Option Pricing ◽  
Real Options ◽  
Cash Flow ◽  
Capital Investment ◽  
Paper Industry ◽  
Investment Decisions ◽  
Pulp And Paper Industry ◽  
Pulp And Paper ◽  
Pricing Model ◽  
Option Pricing Model

The pulp and paper industry relies heavily on the traditional discounted cash flow-based net present value (DCF-NPV) for making capital investment decisions. The deficiency of the DCF-NPV model is that it is static; once a pattern of cash flow is established, management does not have the option to change the direction when new information is available. However, flexibility to alter the investment decision is a powerful strategic and capital investment tool. Abundant research has established strong precedence for applications of “real options” in operational and strategic settings to provide useful insights in the evaluation of irreversible investments under uncertainty. The binomial or Black-Scholes option pricing model (OPM) for strategic planning and capital investment has been used in many other industries but not in the pulp and paper industry. The pulp and paper industry, though very capital intensive, has provided poor to moderate return on investment or return on capital and has never used the OPM and the flexibility it offers for capital investment decisions. This paper makes a case for using OPM for capital investment decisions by using the example of a hypothetical North American mill considering investments to modernize its papermaking operation.

Productivity performance of the Canadian pulp and paper industry

1990 ◽  
Vol 20 (6) ◽  
pp. 825-836 ◽  
Author(s):  
David L. Frank ◽  
Asghedom Ghebremichael ◽  
Tae H. Oum ◽  
Michael W. Tretheway
Keyword(s):  
Total Factor Productivity ◽  
Pollution Control ◽  
Capital Investment ◽  
Paper Industry ◽  
Labour Productivity ◽  
Pulp And Paper Industry ◽  
Pulp And Paper ◽  
Point Estimate ◽  
Factor Productivity ◽  
The Impact

This paper analyzes the productivity performance of the Canadian pulp and paper industry for the 1963–1984 period. The industry's productivity is first measured, then its sources are analyzed. Total factor productivity is used to measure industry productivity, and statistical estimation of neoclassical cost functions are used to determine sources of the productivity changes. In addition to decomposing the productivity changes into technical changes and changing the scale of the industry's output and capacity utilization, an attempt is also made to assess the impact of pollution control expenditures. The paper finds that although labour productivity grew at 2.5% per year (modest in comparison to other industries), the gross total factor productivity grew only by 1.2% per year. This is largely due to the fact that capital investment raises labour productivity but retards overall productivity. Of the 1.2% growth in total factor productivity, 0.88% was due to the increased scale of the industry output and 0.32% to technical change. Although there is no statistically conclusive evidence, the point estimate indicates that pollution control expenditures may have retarded productivity growth. However, this subject requires further investigation.

scholarly journals The Sunk Cost and the Real Option Pricing Model

Complexity ◽  
2021 ◽  
Vol 2021 ◽  
pp. 1-12 ◽  
Author(s):  
Songsong Li ◽  
Yinglong Zhang ◽  
Xuefeng Wang
Keyword(s):  
Option Pricing ◽  
Real Options ◽  
Real Option ◽  
Value Function ◽  
Intrinsic Value ◽  
Pricing Model ◽  
Sunk Cost ◽  
Financial Options ◽  
Real Option Pricing ◽  
Option Pricing Model

Although the academic literature on real options has grown enormously over the past three decades, hitherto an accurate real option pricing model has not been developed for investment decision analyses. In this paper, we propose a real option pricing model based on sunk cost characteristics, which can estimate the value of real options more accurately. First, we explore the distinctive features that distinguish real options from financial options. The study shows that the distinguishing feature of the real options is the sunk cost, which does not exist in the financial options. Based on the sunk cost characteristic of real options, we find that the exercise conditions of real and financial options are different. Second, we introduce the sunk cost into the intrinsic value function of real options and establish a new real option pricing model. Finally, this paper also discusses the properties of the intrinsic value function and pricing model of real options. We find that the application of the Black–Scholes option pricing model will overestimate the value of real options.

An R&D Project Dealing with Mechanical Bits and Pieces in Real Option Analysis

2012 ◽  
Vol 472-475 ◽  
pp. 583-586
Author(s):  
Hua Luo ◽  
Ming Zi Zhu
Keyword(s):  
Decision Tree ◽  
Option Pricing ◽  
Real Options ◽  
Real Option ◽  
Practical Case ◽  
Pricing Model ◽  
Market Uncertainty ◽  
Real Option Analysis ◽  
Real Options Valuation ◽  
Option Pricing Model

The goal of this paper is to study the R&D project under incomplete information. We extend the multi-step quadrinomial option pricing model through a practical case, which is the R&D project of the machinery to deal with mechanical bits and pieces. We pricing the real options valuation (ROV) of the project and show a decision tree, which can provide managers flexible decisions to analyze technology and market uncertainty.

scholarly journals Study on the Valuation Method for Overseas Oil and Gas Extraction Based on the Modified Trinomial Tree Option Pricing Model

2020 ◽  
Vol 2020 ◽  
pp. 1-15
Author(s):  
Jianye Liu ◽  
Zuxin Li ◽  
Dongkun Luo ◽  
Ruolei Liu
Keyword(s):  
Probability Distribution ◽  
Option Pricing ◽  
Cash Flow ◽  
Oil And Gas ◽  
Gas Extraction ◽  
Pricing Model ◽  
Valuation Method ◽  
Decision Points ◽  
Option Pricing Model ◽  
Trinomial Tree

Wandering of oil prices at lower values and the bitter reality have forced people to look for a more accurate valuation method for overseas oil and gas extraction of China. However, the currently available resource classification method, discount cash flow (DCF) method, and real option method all suffer from their own disadvantages. This paper identifies multiple uncertainty factors such as oil prices and reserves. It then investigates the transmission mechanism of how each uncertainty factor impacts the oil and gas extraction value and quantifies the transmission efficiency. The probability distribution patterns of each uncertainty factor have been determined; the trinomial tree option pricing model is modified, with consideration upon the nonstandardness of the probability distribution. Decision points and strategies space are designed in accordance with the practical oil and gas production; and the Bermuda option is adopted to replace the conventional decision-based tree model with the probability-based tree. Finally, a backward algorithm is developed to calculate the probability at each decision point, which avoids difficulties in determining the asset volatility ratio; and a case study is presented to demonstrate application of the proposed method. Results show that decision rights for overseas investment are valuable. The value of extraction does not yet necessarily grow with higher uncertainty, and instead, it is under joint effects of the cash flow and strategy space. So, valuation should incorporate the composite value of future cash flow and decision rights. Volatility of the value of extraction is not solely dependent on the oil price, but affected by multiple factors. Similar to the Bermuda option, the decision-making behavior for oil and gas extraction occurs only at finite decision points, to which the trinomial tree option pricing model is applicable. The adoption of probability distribution can to a great extent exploit the uncertain information. Replacement of the decision-based tree with the probability-based tree provides more accurate probability distribution of the calculated value of extraction, and moreover the disperse degree of the probability can reflect how high risks are, which is conducive to decision-making for investment.

scholarly journals Real options methodology in public-private partnership projects valuation

2014 ◽  
Vol 59 (200) ◽  
pp. 91-113 ◽  
Author(s):  
Biljana Rakic ◽  
Tamara Radjenovic
Keyword(s):  
Option Pricing ◽  
Real Options ◽  
Risk Sharing ◽  
Real Option ◽  
American Options ◽  
Pricing Model ◽  
Public And Private ◽  
Private Partnership ◽  
Toll Road ◽  
Option Pricing Model

PPP offers numerous benefits to both public and private partners in delivery of infrastructure projects. However this partnership also involves great risks which have to be adequately managed and mitigated. Private partners are especially sensitive to revenue risk, since they are mostly interested in the financial viability of the project. Thus they often expect public partners to provide some kind of risk-sharing mechanism in the form of Minimum Revenue Guarantees or abandonment options. The objective of this paper is to investigate whether the real option of abandoning the project increases its value. Therefore the binominal option pricing model and risk-neutral probability approach have been implemented to price the European and American abandonment options for the Build-Operate-Transfer (BOT) toll road investment. The obtained results suggest that the project value with the American abandonment option is greater than with the European abandonment option, hence implying that American options offer greater flexibility and are more valuable for private partners.

Sign in / Sign up

Export Citation Format

Share Document