Estimating the Optimal Farm Size under Uncertainty: an Application of Real Options Methodology

Konstadinos A Mattas,Anastasios Ch Michailidi

doi:10.3844/ajabssp.2006.10.16

Abstract

Farm structure and optimal farm size have always attracted the interest of research as they constitute some of the intense problems of farm efficiency and farm income. Although several approached have been employed to handle with this problem a real options approach can significantly contribute on this matter. This article provides an empirical example of applying real options approach in investigating a typical Greek farm in the town of Velvendo. Several scenarios are used to estimate the optimal farm size employing both discounted cash flow (DCF) methods and real options. Although DCF methods cannot be directly compared with real options theory, we use a direct comparison in order to highlight the constraints and the limitations of these methods since they are still widely used in the investment analysis. Despite the disadvantages of the DCF methods they are still useful in calculating the starting values used in the real options approach. Results clearly demonstrate the contribution of the real options approach as decision making is drastically alters when real options outcome is considered. Moreover results facilitate a better understanding in terms of public policy and agricultural policy dynamics.

Highlights

The number of farms in Greece has drastically dropped over the past two decades, whereas the average farm size has shown an upward trend
In this work, the farm profitability is assessed by applying discounted cash flow (DCF) methods and a real options approach
This paper offers an example of a contractual agreement within a farm enlargement project that can be assessed using the real options technique

Summary

Introduction

The number of farms in Greece has drastically dropped over the past two decades, whereas the average farm size has shown an upward trend. The issue of the appropriate farm size and farm structure has been attracted the interest of agricultural policy both in Europe[1] and the US[2]. This particular interest by policy makers is attributed to a large extends to various income supporting schemes in rural and mountainous areas. Concerns over expected changes in the farm structure were expressed and rise by the public advocating several policies targeted to small farms. From a methodological point of view, applying traditional DCF methods in farm evaluation is not sufficient enough, as they do not reflect the dynamic and constantly changing business environment. The real options approach in farm evaluation appreciates the value of managerial flexibility and the potential to improve expected returns on the undertaken investment

Objectives

Results

Conclusion