Option Value Approach Research Articles

Combining Forest-Level Analysis with Options Valuation Approach—A New Framework for Assessing Forestry Investment

Abstract The conventional forest investment assessment at the stand level has difficulty dealing with multiple decisions and capturing the operational flexibility involved in timber production. By combining forest-level analysis with the options valuation approach, this article suggests a new framework for forestry investment assessment. We first articulate the new framework and discuss a few technical issues encountered in adopting it. Then, we present three empirical examples (entry decision, land acquisition, and harvest timing) to illustrate how forest-level analysis and/or real options valuation can be done and what we may learn from this type of exercise. We believe that while adopting this new framework entails challenges, it represents a great opportunity to expand the field of forest investment assessment. FOR. SCI. 47(4):475–483.

Investment in site-specific crop management under uncertainty: implications for nitrogen pollution control and environmental policy

This paper applies an option-pricing model to analyze the impact of uncertainty about output prices and expectations of declining fixed costs on the optimal timing of investment in site-specific crop management (SSCM). It also analyzes the extent to which the level of spatial variability in soil conditions can mitigate the value of waiting to invest in SSCM and influence the optimal timing of adoption and create a preference for custom hiring rather than owner purchase of equipment. Numerical simulations show that while the net present value (NPV) rule predicts that immediate adoption is profitable under most of the soil conditions considered here, recognition of the option value of investment indicates that it is preferable to delay investment in SSCM for at least 3 years unless average soil quality is high and the variability in soil quality and fertility is high. The use of the option value approach reveals that the value of waiting to invest in SSCM raises the cost-share subsidy rates required to induce immediate adoption above the levels indicated by the NPV rule.

Investment in site‐specific crop management under uncertainty: implications for nitrogen pollution control and environmental policy

AbstractThis paper applies an option‐pricing model to analyze the impact of uncertainty about output prices and expectations of declining fixed costs on the optimal timing of investment in site‐specific crop management (SSCM). It also analyzes the extent to which the level of spatial variability in soil conditions can mitigate the value of waiting to invest in SSCM and influence the optimal timing of adoption and create a preference for custom hiring rather than owner purchase of equipment. Numerical simulations show that while the net present value (NPV) rule predicts that immediate adoption is profitable under most of the soil conditions considered here, recognition of the option value of investment indicates that it is preferable to delay investment in SSCM for at least 3 years unless average soil quality is high and the variability in soil quality and fertility is high. The use of the option value approach reveals that the value of waiting to invest in SSCM raises the cost‐share subsidy rates required to induce immediate adoption above the levels indicated by the NPV rule.

The option value of non-contaminated forest watersheds

Non-contaminated drinking water may become a scarce resource in the future. In that case, forest watersheds will play a significant role in ensuring the supply of clean drinking water. However, forest management affects this supply considerably. Christmas tree production is an important income generator in Danish forestry but is also a significant contributor to non-point contamination of groundwater resources because of its application of fertiliser and pesticides. This paper analyses the decision to convert a natural or semi-natural forest into Christmas tree production, when groundwater contamination is irreversible and future returns on non-contaminated groundwater resources and Christmas tree production are uncertain. It is concluded that conventional expected net present value analysis which treats conversion as a ‘now or never’ decision, may not lead to an optimal decision rule. It is shown how the option to postpone conversion and acquire new information should be included. Application of an option value approach shows that the optimal decision strategy is more conservative when the option to postpone is recognised, i.e. option value analysis prescribes that the return on Christmas tree production should be higher to justify conversion. An empirical example shows that when using option value analysis the return on Christmas tree production should increase by more than 100% to justify conversion. Moreover, it is shown that the economic value of a natural forest may increase by more than 12% when the option value is included.

Optimal timing in the problem of family farm transfer from parent to child: an option value approach

The optimal time for transferring the family farm from parent to child is modeled in an option value framework. It is assumed that parents have the ability to wait and enrich their information set before making the decision when to transfer the farm to a succeeding child rather than making a prompt decision. The results indicate that the optimal timing depends on the wedge between the parents' critical level of utility and disutility from the farm transfer to a succeeding child. The arguments of parents' utility function are country/culture and family-specific.

Small Firm Investment and Financing Decisions: An Option Value Approach

This paper reviews and discusses recent developments undergone by investment theory, and tries to address both financial and real decisions within an uncertain environment, here, the Italian economy. According to the recent "option value" approach to investment, if differing degrees of reversibility characterize the accumulation process by groups of firms (small and larger firms), we should expect their investment decisions to differ under uncertainty. On the other hand, asset reversibility has an influence on firm financing policy, given the observed relationship between asset and liability composition. Assuming a different degree of investment reversibility for small and larger firms, we explore how they react to interest rate uncertainty using the Italian experience during the 1980s as a benchmark. The main result of this paper is that interest rate uncertainty exerts a negative influence on firms' investment demand. The relationship is stronger for large firms than for small firms. Another result is that firm leverage also shows a negative relationship with interest rate uncertainty.

Damned If You Do, Damned If You Don't: An Option Value Approach to Evaluating the Subsidy of the CPR Mainline

We revisit the 'excess subsidy' granted to the CPR for the first transcontinental railway in 1881. Previous studies have evaluated the subsidy from an ex post perspective, and concluded that it was 'too large.' We argue that the subsidy should be evaluated from an, ex ante perspective, which explicitly accounts for uncertainty. Using an option value approach, which takes account of the risk and irreversibility of the investment, we show that it is likely that the subsidy was not excessive at all, but rather was required to compensate the.CPR for forgoing the option to construct the line at the privately optimal time in the future.

Optimal timing of transmission line investments in the face of uncertain demand: An option valuation approach

Grid-based electrification programmes involve irreversible transmission line investments that can be delayed by temporarily resorting to decentralized powet supply technologies. In this context, decision-makers face the difficulty that the future evolution of demand and, thus, the returns from postponing the transmission line investment are uncertain. This imposes an opportunity cost resembling the value of a financial call option. Therefore, standard option valuation techniques can be applied to solve the problem of timing transmission line investments in the presence of stochastic demand. It is shown, analytically and in terms of numerical examples, that demand uncertainty may provide a strong incentive to defer the extension of the grid beyond the date that would be optimal under deterministic conditions.

The option valuation approach to mortgage pricing

The analysis of mortgage securities has made significant advances in the last few years. Prepayment forecasting is much improved and price-yield methodologies have been standardized. Development of techniques known as “option-based pricing models” has recently provided an important new tool for evaluating mortgage instruments.