The Decision To Build A Fence: A Real-Option Problem

Abstract

Real-option methods of Net Present Value (NPV) analysis are applied to
understand a capital budgeting decision concerning flexibility. The capital budgeting
problem under study here is the decision of whether Spade Ranch (Spade) should build
a fence. If this fence is built, then a hay-meadow could be converted into pasture land,
which would in turn permit the herd-size of the Spade Ranch to increase. However,
this fence building does not require the Spade to take the newly-fenced land out of hay
production and put it into cattle production. Instead, once the fence is built, the Spade
has the ability to switch land use from hay production to cattle production and vice
versa. The decision of whether or not to create this flexibility by fence-building is the
crux of this paper. What is the value of flexibility? If the fence costs less than the value
of this flexibility then we build the fence, otherwise no.
For two different scenarios, a linear programming model is employed to
define the relationship of Economic Value Added (EVA) to the question of whether
or not one should produce hay or cattle given that the existence of a fence permits a
decision maker to switch back and forth between hay and cattle production. These
two scenarios, each of which work under different pricing assumptions, produce
different EVA results and different production choices.
From this scenario work, the paper moves to the question of NPV. Is the
decision to build a fence a positive NPV investment decision or not? An option
pricing model is used to approach this question. Given a fence that provides for the
ability to switch back and forth between cattle and hay production, what is the value
of choosing additional cattle production by giving up the additional production of
hay for sale? As it turns out, the question of NPV for an investment that provides a
firm more flexibility by switching from the production of one product to another can
be answered. But the answer depends on the volatility of possible rates of return on
investment for both hay and cattle production, and their correlation with one another.