Application of real options theory to forestry investment analysis [An article from: Forest Policy and Economics]

This digital document is a journal article from Forest Policy and Economics, published by Elsevier in 2004. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.

Description:
This paper demonstrates the utility of the real options approach to forestry investment analysis. The main objectives are to discuss the real option theory and show how it can be adopted to model uncertainty and managerial flexibility in forest management and investment. Secondly, we show how to calculate the option values of selected options that may be available to managers of forest industry firms. The paper provides an empirical application, which compares a forestry investment using the static Faustmann model and the real options approach. Four management options are used for the real options approach: an option to delay reforestation, an option to expand the size of the wood processing plant, an option to abandon the processing plant if timber prices fall below a certain level or due to corporate take-over, and multiple options that evaluated all three options together. All options were evaluated using the binomial option-pricing model, where timber values are assumed to follow a multiplicative binomial process. The results show that the Faustmann analysis rejected the investments as unprofitable, while the option analysis showed that all three options were highly valuable if exercised. When real options are considered, the traditional Faustmann model for assessing the profitability of a forestry investment may fail to provide an adequate decision-making framework because it does not properly value management's ability to adjust to shocks in the economy, as well as risks and uncertainty.