The Decision To Build A Fence: A Real-Option Problem

Abstract

Real-option methods of Net Present Value (NPV) analysis are applied tounderstand a capital budgeting decision concerning flexibility. The capital budgetingproblem under study here is the decision of whether Spade Ranch (Spade) should builda fence. If this fence is built, then a hay-meadow could be converted into pasture land,which would in turn permit the herd-size of the Spade Ranch to increase. However,this fence building does not require the Spade to take the newly-fenced land out of hayproduction and put it into cattle production. Instead, once the fence is built, the Spadehas the ability to switch land use from hay production to cattle production and viceversa. The decision of whether or not to create this flexibility by fence-building is thecrux of this paper. What is the value of flexibility? If the fence costs less than the valueof this flexibility then we build the fence, otherwise no.For two different scenarios, a linear programming model is employed todefine the relationship of Economic Value Added (EVA) to the question of whetheror not one should produce hay or cattle given that the existence of a fence permits adecision maker to switch back and forth between hay and cattle production. Thesetwo scenarios, each of which work under different pricing assumptions, producedifferent EVA results and different production choices.From this scenario work, the paper moves to the question of NPV. Is thedecision to build a fence a positive NPV investment decision or not? An optionpricing model is used to approach this question. Given a fence that provides for theability to switch back and forth between cattle and hay production, what is the valueof choosing additional cattle production by giving up the additional production ofhay for sale? As it turns out, the question of NPV for an investment that provides afirm more flexibility by switching from the production of one product to another canbe answered. But the answer depends on the volatility of possible rates of return oninvestment for both hay and cattle production, and their correlation with one another.