Academic journal article Review of Business & Finance Studies

Using Options Pricing Theory to Value Safety & Ergonomics Projects: A Case Study

Academic journal article Review of Business & Finance Studies

Using Options Pricing Theory to Value Safety & Ergonomics Projects: A Case Study

Article excerpt

ABSTRACT

This paper applies option pricing theory to value an investment in safety & ergonomics. Utilizing both traditional and perpetual call option frameworks, we quantify project value overlooked by traditional discounted cash flow techniques. In a case study format, it is shown that delaying investment allows the firm to reduce uncertainty associated with safety & ergonomic interventions; with increased costs of delaying encouraging speedier implementation.

JEL: G30, G31, G32, G39

KEYWORDS: Capital Budgeting, Options Pricing, Case Study

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The application of options pricing theory to investments in tangible assets is commonly known as real options analysis and provides a method for quantifying the value of flexibility in investment timing, while considering the impact of uncertainty. Real options analysis allows investment managers to value project abandonment, delay, expansion, and development.

Real options analysis is most appropriately applied to business decisions dependent on the value of additional information, investment timing, and cash flow uncertainty. Uncertainty is inherent in the evaluation of all safety and ergonomics (S&E) interventions; consequently, making accurate economic evaluations of such decisions can be rather difficult. Numerous sources of uncertainty exist. In particular, experts are unable to predict the precise number of workers who will develop work-related musculoskeletal disorders (WMSD) or suffer work-related injuries. In addition to the frequency of occurrences, accident severity is an important driver of costs which cannot be readily predicted. Further, no intervention is completely effective in preventing injuries. As such, the extent to which a given intervention is effective within a target population is unknown. At best, the intervention will reduce the probability an accident or WMSD will occur. This scenario of partial effectiveness introduces additional uncertainty regarding the number and severity of accidents or WMSDs that may be prevented due to an intervention.

Both accidents and WMSDs have direct and indirect costs associated with them. The most significant direct costs are medical expenses for the treatment of injuries, monies paid to employees such as disability and replacement wages, and expenses associated with rehabilitation. Generally, these expenses are translated to the company through worker's compensation insurance. The company pays an insurance premium, which is based to a varying extent on the actual injury rate experienced by the company internally. Indirect costs include expenses such as the worker's pay for the remainder of the day, lost productivity, mechanical repairs, supervisor/administration time, etc. Additional expenses include costs related to relief staffing, absenteeism, and employee turnover. Understanding these costs and their sources will allow companies to more accurately evaluate potential opportunities for avoiding or reducing costs by taking steps to prevent the accidents or WMSDs.

The purpose of this paper is to provide a detailed economic analysis of safety and ergonomics interventions similar to Lanoie and Troth er (1998). However, instead of using traditional discounted cash flow techniques, we utilize an options pricing approach to evaluate investment in S&E.

This paper is organized as follows. Section 2 reviews the literature. Section 3 lays out the principles of option pricing theory and real options. Section 4 uses a practical case study to illustrate the applicability of real options analysis techniques to investment decision making in the area of S&E. Section 5 provides concluding remarks.

LITERATURE REVIEW

The idea that discounted cash flow analysis may be insufficient to capture the true value of investment opportunities has been around for several decades. Myers (1977) was one of the first to examine this and suggest the application of option pricing theory to real investments. …

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