Value Of Managerial Flexibility Research Articles

Risk premia in commodity price forecasts and their impact on valuation

Commodity price driven valuation models require a stochastic price input if the value of managerial flexibility, such as the option to defer investment until the optimal time and the option to abandon a project, is to be estimated. The risk-neutral version of the stochastic price model is typically used in academic work; however, risk-adjusted models of the expected spot price are often used in practice. These two approaches are connected by a risk premium which is unfortunately often difficult to estimate. In this work, we use natural gas futures prices in a Kalman filter approach with maximum likelihood estimation to parameterize the Schwartz and Smith (2000) stochastic price model, and then apply an asset pricing model to address the large uncertainty of the risk premia parameter estimates. To evaluate the impact of the risk premia and other parameters in the two-factor price model on project valuation, we apply the price model to a prototypical shale gas investment, both for a base reference case as well as for cases where there are real options to optimally time decisions to invest or to abandon the project. Using this approach, we are able to determine the implied risk-adjusted discount rate that would be used with the spot price forecast, given the two-factor model risk premia, and we also discuss the impact of the risk premia on project value relative to other model parameters.

Managerial flexibility in levelized cost measures: A framework for incorporating uncertainty in energy investment decisions

Many irreversible long-run capital investments entail opportunities for managers to respond flexibly to changes in the economic environment. However, common levelized cost measures used to guide decision-making, such as the levelized cost of electricity, implicitly assume that the values of random economic variables are known with certainty when investment decisions are made. This assumption implies, often incorrectly, that managerial flexibility carries zero value. This paper improves levelized cost measures by deriving an expansion that accounts for both uncertainties in relevant variables and the value of managerial flexibility in responding to them. This method is applied to quantify the value of flexibility in two example decision problems. In one, an operator of a natural gas electricity generation facility evaluates whether to invest in carbon capture capabilities. Another considers retirement decisions for U.S. nuclear plants. These examples illustrate that simplified cost metrics can inaccurately guide decision-making by inflating cost estimates relative to the proposed levelized cost measure that accounts for uncertainty and flexibility.

Optimal Expansion of a Hydrogen Storage System for Wind Power: A Real Options Analysis

This paper presents a real options-based techno-economic analysis of a hydrogen-based wind energy storage system (H2-WESS) deployed adjacent to a nearshore wind farm in northern Germany. The H2-WESS can be used to produce and store hydrogen when feed-in management takes place, in order to avoid the shutdown of wind turbines during times of excess electricity supply, or when the spot market electricity price falls below the estimated (efficiency-adjusted) market price of hydrogen. Moreover, an H2-WESS can provide negative minute reserve capacity. The modular design of the H2-WESS gives an investor the option to expand the capacity and gradually adapt to changing market conditions. The comprehensive and novel simulation model considers all relevant volatile inputs, such as stochastic wind conditions, feed-in management events, prices, and minute reserve calls. By means of a Monte Carlo simulation, annual revenues and their volatility are computed with a view on projected technology improvements until 2030. Based on the simulation results, a binomial real options pricing model is used to design four interdependent binominal trees and to evaluate a Bermuda-type compound expansion option. The decision trees, in which the investor can choose the maximum of the option to either upgrade the H2-WESS to the next expansion stage or to keep the real option alive, feature 390 time steps and 76,050 decision nodes each. Each compound decision takes the option of a smaller expansion stage explicitly into account. The compound expansion option to invest in a 5, 10, 15, or 20 MW H2-WESS has a 15-year expiration time and is found to have a value of about €2 million, compared to the net present value of a 5 MW H-WESS of about €-2.45 million. We conclude from the real options analysis that for a realistic valuation of modular energy projects subject to various uncertainties it is crucial to incorporate the value of managerial flexibility that is influenced. Due to the modular design, and in contrast to conventional power plants, the flexibility of the H2-WESS comprises many specific options.

Possibilistic risk aversion in group decisions: theory with application in the insurance of giga-investments valued through the fuzzy pay-off method

Giga-investments are large industrial investments that have long construction times, long economic lives, and that are to a large degree irreversible. These characteristics make ex-ante analysis of giga-investment difficult and require methods that can consider estimation of imprecision and the value of managerial flexibility. Fuzzy pay-off method is a recently introduced profitability analysis tool, based on using managerial cash-flow scenarios estimated by a group of experts, to form a fuzzy (possibilistic) pay-off distribution for an investment that is compatible with the requirements set by the circumstances surrounding giga-investments. Due to their large size, most giga-investments require external financing and most often lead investors must acquire insurance coverage to bring down the idiosyncratic risk of these projects to attract funding. Defining an insurance strategy requires an estimation of the risk as perceived by the group of experts (managers), who are supposed to be risk-averse. In this vein, this paper analyzes the effect of the risk aversion in the possibilistic setting, relevant to giga-investments, and in a multi-expert decision-making context. Insurance pricing for a giga-investment risk is reached through finding an optimal coinsurance rate in the group possibilistic framework. The presented models are new and contribute to the project insurance pricing literature.

Valuing managerial flexibility: an application of real option valuation in time of economic transition

The purpose of the paper is to present a real option valuation (ROV) model that will help to measure the value of managerial flexibility. The value of managerial flexibility appears to play a pivotal role nowadays, given the transition nature of Latvian economy. There are few academic works on the topic, yet none of the major companies in the Latvia have publicised ROV application. We have carried out ROV based on Scenario Planning and Strategic Alternatives. Having combined Scenario planning with Monte Carlo simulation and Risk–Neutral Probability–based ROV with alternative strategies of Company, authors provided a solution to the company's problem at hand. Thereby we have identified value maximising decisions regarding the Business Unit of the Latvian Company. The flow chart of ROV application has been created which would be a useful 'road map' for Latvian practitioners in time of economic transition.

Facilitating risky project negotiation: An integrated approach using fuzzy real options, multicriteria analysis, and conflict analysis

This paper proposes a risky project negotiation framework, comprising fuzzy real options, ordered weighted averaging (OWA), and the graph model of conflict resolution (GMCR). Fuzzy real options analysis is employed to evaluate risky projects where the value of managerial flexibility cannot be overlooked. For civil engineering project evaluation, OWA is used to estimate the parameters of the fuzzy real options model, such as initial values and volatilities, to reflect the risk preference of decision makers (DMs). Because it can take into account DMs’ values and preferences for a risky project, GMCR is utilized to identify equilibria, or potential resolutions of the conflict, among all possible states, or combinations of DMs’ choices. While an option pricing model is employed to estimate the values of decision makers (DMs) toward a risky project, all parts are integrated via fuzzy functions in this framework. A brownfield redevelopment case, the Ralgreen Community in Kitchener, Ontario, Canada, is used as a typical risky project to demonstrate how to apply this integrated approach. The main contribution of this paper is to demonstrate the comprehensive use of fuzzy methods to assess brownfield projects. For this purpose, stochastic methods face difficulties because risks cannot be fully reflected in market prices. Expert knowledge that is descriptive, multi-attribute, or subjective in nature can be effectively quantified using fuzzy representations.

Transformation of Scenario Planning into a Real Options Valuation in Time of Economic Transition: Latvian Case

The value of managerial flexibility appears to play a pivotal role nowadays, given the transition nature of Latvian economy. Overall aim of the research is to carry out Real Options Valuation (ROV) based on Scenario Planning, thereby identifying value maximizing decisions regarding the Business Unit of the Latvian Company. Having combined Scenario planning with Monte Carlo simulation and Risk-Neutral Probability-based ROV with alternative strategies of Company, authors provided a solution to the company's problem at hand. The flow chart of ROV application has been created which would be a useful “road map” for Latvian practitioners in time of economic uncertainties.

Hybrid model of evaluation of underground lead—zinc mine capacity expansion project using Monte Carlo simulation and fuzzy numbers

Large capital intensive projects, such as those in the mineral resource industry, are often associated with diverse sources of both endogenous and exogenous risks and uncertainties. These risks can greatly influence the project profitability. Having the ability to plan for these uncertainties is increasingly recognized as critical to long-term mining project success. In the mining industry in particular, the relationships between input variables that are controllable, and those that are not, and the physical and economic outcomes are complex and often nonlinear. The value of managerial flexibility is assessed using data on prices, costs, discount rates, grades, ore extraction, and metal output. Monte Carlo simulation of the mean reversion process is used to forecast revenue data based on an initial metal price, by using annualized volatility. Monte Carlo simulation of the Geometric Brownian Motion is used to forecast operating costs. To quantify the uncertainty in the parameters within a project such as capital investment, ore grade, and mill recovery, we used triangular, uniform, and normal statistical distribution, respectively. To decrease uncertainty related to selection of the appropriate discount rate, we have applied the concept of fuzzy sets theory. The result is a Net Present Value (NPV) based on the cash flows generated by the simulation over the timeframe of the project. When using fuzzy numbers, the fuzzy NPV itself is the payoff distribution from the project. The model explains investment behavior satisfactorily, both from a statistical and from an economic point of view.

Making Strategic Investment Decisions - Real Options Theory and Strategic Cost Management: Two Bottles for the Same Wine?

Since the end of the ’70s, many researchers have been pointing out some criticisms to the application of advanced financial techniques (e.g. Internal Rate of Return and Net Present Value) for valuing strategic investment decisions: a) their inability to take into account the value of managerial flexibility; b) their poor relationship with strategy. Real Options Theory (ROT) and Strategic Cost Management (SCM) have been proposed as the solutions for the two criticisms. The purpose of this paper is twofold. Firstly, it offers a fully-comparison between ROT and SCM articulating around a series of differentiating elements: 1) the relationship with the firm strategy; 2) the epistemological models surrounding SCM and ROT; 3) the way they focus on the risk and the uncertainty inherent in the decision; 4) their incentive towards an active management of the strategic investment; 5) the degree of formalisation of the structure of the two approaches; 6) the scope of their applicability; and 7) the most prominent difficulties linked to their implementation. Secondly, the paper examines whether ROT and SCM can be seen merely as two competing methods for firm decision-making, or if some integration between them is also possible. The underlying idea which is here purported is that ROT and SCM can be combined into a unitary and hybrid model for valuing strategic decisions, where the major advantages of the two techniques can be strengthened through their integration.

Genetically modified crops as real options: Identifying regional and country-specific differences

This paper employs real options methodology for evaluating profitability of genetically modified (GM) crops in volatile market and regulatory environments. Observed instances of market entry, or product introduction, are viewed as outcomes of profit maximizing decisions based on comparison of market entry costs, expected future returns, and the value of managerial flexibility. The process is estimated using simulated maximum likelihood. The estimates suggest that, in the developing countries, the downward volatility of the returns is higher resulting in lower adoption rates, whereas the environment in the top four industrialized GMO adopting countries appears to be costlier but much more optimistic. Commercial success of GM soybean and maize in Argentina, Brazil, and the U.S. is explained mostly by a combination of high upward return volatility and moderate entry costs. The findings may contribute to the general understanding, measurement, and possibilities of controlling the rate of technical advance in biotechnology.

Using Monte Carlo Simulation to Improve Ceramic R&D Investment Decisions

The success of ceramic companies is highly dependent on research and development (R&D). Thus, a pivotal aim of management is to allocate resources to the best scientific and financial R&D projects. But the valuation of ceramic R&D is a difficult task for managers. The conventional discounted cash flow (DCF) methods fail to consider the value of managerial flexibility provided by R&D projects. Real options Analysis (ROA) offers a superior way of capturing the value of flexibility. It enables decision-maker to value projects more accurately by incorporating managerial flexibilities into the valuation model. However, ROA can’t effectively deal with the volatility of parameters in itself under high uncertain circumstance. In view of the limitation of ROA, this paper uses Monte Carlo simulation to solve the parameters volatility problems. In the end, the case study proves that Monte Carlo simulation can improve R&D investment decisions, especially for highly unpredictable ceramic R&D projects.

Impact of the Behavior of the Underlying Assets on the Value of a Petroleum Project Under the Theory of Real Options: Case of GBM and MR Process

During this article we will discuss the problem behaviour of the value of the underlying asset, highlighting a central issue, what is the impact of different models that describe the behaviour of the value of underlying assets on the value of the oil project? The literature on real options is based on an assumption that the value of the underlying variable, cost of production of hydrocarbons or other relevant variables stochastic, following a process of geometric Brownian motion, GBM (Paddock, Siegel and Smith, 1988). In fact, most empirical research: Consider the initial investment decision but neglect the flexibility of operating the project; Suppose that the price of oil is stochastic, but unaware of the uncertainty about the costs of production and reserves of hydrocarbons; Suppose that oil prices follows a process of Brownian motion. The evolution of three variables, prices, production costs and quantities of reserves of hydrocarbons are presented in this article. The value of managerial flexibility is appreciated in this article using data on planned exploration and production of hydrocarbons by a TUNISIAN oil firm.

Risk, Trade, Recovery, and the Consideration of Real Options: The Imperative Coordination of Policy, Marketing, and Finance in the Wake of Catastrophe

Recovery from societal and market catastrophe is a daunting process that requires multifunctional, systemic, and long-term efforts. Humanitarian aid and donor assistance are rarely sufficient. Trade and other forms of direct investment in devastated markets offer another kind of recovery assistance. However, risks encountered in recovering economies can deter firms from investing. The authors apply a real-options framework to examine the financial feasibility of trading with recovering economies; they apply the framework to the countries of the war-disintegrated former Yugoslavia. The real-options framework considers the value of managerial flexibility in the presence of risks. The authors discuss implications for policy, marketing management, export development, and economic and societal recovery in several contexts.

Incorporating Strategic Consumer Behavior into Customer Valuation

The calculation of customer value without regard to marketing policy is problematic because the value of managerial flexibility and the impact of consumer learning are neglected. This article develops a structural dynamic programming model of consumer demand that includes marketing variables and consumer expectations of promotions. The author uses the estimated parameters to conduct policy experiments that yield more accurate forecasts of customer value and to study the impact of alternative marketing policies.

Competitive Options, Supply Contracting, and Electronic Markets

This paper develops a framework for analyzing business-to-business (B2B) transactions and supply chain management based on integrating contract procurement markets with spot markets using capacity options and forwards. The framework is motivated by the emergence of B2B exchanges in several industrial sectors to facilitate such integrated contract and spot procurement. In the framework developed, a buyer and multiple sellers may either contract for delivery in advance (the “contracting” option) or they may buy and sell some or all of their input/output in a spot market. Contract pricing involves both a reservation fee per unit of capacity and an execution fee per unit of output if capacity is called. The key question addressed is the structure of the optimal portfolios of contracting and spot market transactions for the buyer and these sellers, and the pricing thereof in market equilibrium. Existence and structure of market equilibria are characterized for the associated competitive game between sellers with heterogeneous technologies, under the assumption that they know the buyer's demand function. This allows an explicit characterization of the price of capacity options and the value of managerial flexibility, as well as providing conditions under which B2B exchanges are efficient and sustainable.

Real options: valuing flexibility in strategic mergers and acquisitions as an exchange ratio swap

In recent years, practitioners and academics have argued that traditional discounted cash flow (DCF) valuation models do not adequately capture the value of managerial flexibility to delay, grow, scale down or abandon projects. The insight is that a business investment opportunity can be conceptually compared to a financial option. The purpose of this paper is to develop a theoretical model based on option pricing theory to value managerial flexibility arising in stock for stock exchanges. The paper shows how a mergers and acquisition (M&A) deal may be optimally structured as a real options swap by including managerial flexibility of both the acquiring and target firms when stock prices are volatile. Using a recent acquisition case example from US banking industry the paper illustrates how the proposed exchange ratio swap optimize deal value and avoids earnings per share (EPS) dilution to both parties. Appropriate valuation of managerial flexibility is important given the historical premiums paid in takeovers. While the fact that such premiums exist lends some credibility to the idea that at least implicitly managerial flexibility is valued, the real options approach allows for more explicit valuation of such flexibility.

An option model for R&D valuation

The valuation of research and development is a difficult task for managers. The traditional net present value methods fail to consider the value of managerial flexibility provided by R&D projects the option to implement the results of the project if the research phase is successful, or terminate it if the results are not promising. The ability to abandon the effort allows management to limit losses and is similar to a stock option, which can be valued using well-established option pricing theory (Black-Scholes model). Unfortunately, many of the assumptions made for stock prices are not applicable to R&D projects, making it difficult to apply the Black-Scholes model to real options. In particular, changes in the value of the underlying asset resulting from R&D efforts are not entirely random and cannot be modelled as a random walk. The model presented in this paper addresses this problem by making no assumptions about how the underlying asset value changes over time. Instead, the R&D value is derived from the production and marketing costs and anticipated revenues of the project. This approach provides a simple tool that will appeal to practitioners familiar with cost and revenue projections.

Valuing Managerial Flexibility: An Application of Real-Option Theory to Mining Investments

The value of managerial flexibility is assessed using data on prices, costs, grades, reserves, ore extraction, and metal output for a panel of Canadian copper mines. A real-option model is estimated and solved for project and option values. Most empirical researchers (i) consider the initial-investment decision but neglect flexible operation thereafter, (ii) assume that price is stochastic but ignore cost and reserve uncertainty, and (iii) model price as a nonstationary stochastic process. The evolution of three state variables, price, cost, and reserves, is assessed here. Differences in assumptions compared to others are found to lead to large differences in estimated project and option values.

Real options in practice: an exploratory survey of how finance officers deal with flexibility in capital appraisal

Dissatisfaction with discounted cash flow techniques has lead to a growing literature focusing on the value of managerial flexibility in handling real asset investments, a subject area known as real options. This paper describes an exploratory survey of senior finance officers in industrial firms, examining the significance that real options assumed in their investment decisions, whether their firms had established pro- cedures for assessing real options, and whether their intuitions were consistent with what theory prescribes.We found that, while real options commonly occurred and were generally significant in determining how decision-makers regard an investment, there was wide variation between individual decision-makers in their perception of real options. Most respondents could recall an example of a real option with which they had dealt, and in about half the cases the option had been necessary for the associated investment to be sanctioned. Few firms have procedures to assess options in advance. Real options may not always be desirable since, in the eyes of at least some respondents, they can reduce organizational commitment to a project. Very few decision-makers seemed to be aware of real option research but, mostly, their intuitions agreed with the qualitative prescriptions of such work.