# Real Options in Capital Investment: Models, Strategies, and Applications

By Lenos Trigeorgis | Go to book overview

that the project's value is concave in β1. Note that with β1 = 1.0 (practically no yield uncertainty, since β2 = .95), the project's value stabilizes at \$561.40, a 31 percent increase in value over the case when β1 = .50.

Another interesting feature is that of a corresponding change in the optimal production and inventory policy as a result of change in the yield variability. For example, corresponding to points A, B, C, and D of Figure 16.4, there are different optimal policies. While enumeration of each optimal policy is omitted, Table 16.1 provides further interesting results. For instance, if yield was a controllable factor, then management should be willing to spend up to \$58.80 (i.e., \$559.30 - \$500.50) to improve yield variability from β1 = .60 to β1 = .80.

Table 16.1
Impact of Yield Variability on the Optimal Value of a Production System
Yield Variability
Parameter
1)
Expected value of System (\$)Flexibility
Value
(\$)
Flexible
(Both products)
Dedicated
(Product 1)
Dedicated
(Product 2)
.50428.30290.70201.50137.60
.60500.50321.70235.80178.80
.80559.30322.70237.90236.60
1.0561.40322.70238.50238.70

The valuation model illustrated here can also be used as an aid in establishing renegotiation prices in the event of unexpected input price increases. This can be done by following the lattice price nodes for which the project's value is negative. Alternatively, the same approach can be used in identifying "penalty" costs if contract abandonment were considered as an option. The model can also be employed to obtain the value both of production and inventory capacities. Specifically, the additional project value obtained by increasing capacity (in accordance with increased demand) should reflect the maximum cost of increased capacity (i.e., the capacity shadow price).

16.5 CONCLUSION

This chapter has examined an important decision problem concerning manufacturing firms, namely that of valuing production projects and agreements where input prices and output yields fluctuate randomly over time. The chapter has addressed the various problems involved in valuing produc-

-298-

If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items
Notes

#### Cited page

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

#### Cited page

Real Options in Capital Investment: Models, Strategies, and Applications

• Title Page iii
• Contents v
• Tables and Figures ix
• Preface xiii
• Chapter 1 Real Options: An Overview 1
• Introduction 1
• Acknowledgments 28
• Notes 28
• Part I Real Options and Alternative Valuation Paradigms 29
• Chapter 2 Methods for Evaluating Capital Investment Decisions Under Uncertainty 31
• Introduction 31
• Conclusion 44
• Notes 45
• Chapter 3 Merging Finance Theory and Decision Analysis 47
• Introduction 47
• Summary and Conclusion 65
• Acknowledgments 66
• Notes 66
• Chapter 4 The Strategic Capital Budgeting Process: A Review of Theories and Practice 69
• Introduction 69
• Conclusions 84
• Acknowledgments 86
• Notes 86
• Part II General Exchange or Switching Options and Options Interdependencies 87
• Chapter 5 The Value of Flexibility: A General Model of Real Options 89
• Introduction 89
• Concluding Remarks 105
• Acknowledgments 105
• Notes 106
• Chapter 6 The Valuation of American Exchange Options with Application to Real Options 109
• Introduction 109
• Conclusion 119
• Acknowledgments 120
• Notes 120
• Chapter 7 Operating Flexibilities in Capital Budgeting: Substitutability and Complementarity in Real Options 121
• Introduction 121
• Conclusion 130
• Acknowledgments 131
• Notes 131
• Part III Strategy, Infrastructure, and Foreign Investment Options 133
• Chapter 8 The Value of Options in Strategic Acquisitions 135
• Introduction 135
• Implications and Conclusions 147
• Acknowledgments 148
• Notes 148
• Chapter 9 Corporate Governance, Long-term Investment Orientation, and Real Options in Japan 151
• Introduction 151
• Implications and Conclusions 158
• Notes 160
• Chapter 10 Volatile Exchange Rates and the Multinational Firm: Entry, Exit, and Capacity Options 163
• Introduction 163
• Conclusions 178
• Acknowledgments 180
• Notes 180
• Part IV Mean Reversion/ Alternative Formulations in Natural Resources, Shipping, and Start - Up Ventures 183
• Chapter 11 The Effects of Reversion on Commodity Projects of Different Length 185
• Introduction 185
• Conclusions and Extensions 199
• Appendix 201
• Acknowledgments 204
• Notes 204
• Chapter 12 Contingent Claims Evaluation of Mean-Reverting Cash Flows in Shipping 207
• Introduction 207
• Conclusions 216
• Appendix 217
• Acknowledgments 218
• Notes 218
• Chapter 13 Valuing Start-Up Venture Growth Options 221
• Introduction 221
• Conclusion 236
• Appendix 237
• Acknowledgments 238
• Notes 238
• Part V Other Applications: Pollution Compliance, Land Development, Flexible Manufacturing, and Financial Default 241
• Chapter 14 Investment in Pollution Compliance Options: The Case of Georgia Power 243
• Introduction 243
• Notes 262
• Chapter 15 Optimal Land Development 265
• Introduction 265
• Conclusions and Extensions 277
• Appendix 278
• Acknowledgments 279
• Notes 279
• Chapter 16 Multiproduct Manufacturing with Stochastic Input Prices and Output Yield Uncertainty 281
• Introduction 281
• Conclusion 298
• Appendix 300
• Notes 301
• Chapter 17 Default Risk in the Contingent Claims Model of Debt 303
• Introduction 303
• Conclusions and Extensions 317
• Acknowledgments 318
• Notes 319
• Bibliography 323
• Author Index 347
• Subject Index 351
• About the Editor and Contributors 357
Settings

#### Settings

Typeface
Text size Reset View mode
Search within

Look up

#### Look up a word

• Dictionary
• Thesaurus
Please submit a word or phrase above.

Why can't I print more than one page at a time?

Help
Full screen
Items saved from this book
• Bookmarks
• Highlights & Notes
• Citations
/ 364

### How to highlight and cite specific passages

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

## Cited passage

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

## Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.