TY - JOUR AU - Simmons, Garland PY - 2019/03/15 Y2 - 2024/03/29 TI - The Decision To Build A Fence: A Real-Option Problem JF - Journal of Business Strategies JA - J Bus Strategies VL - 36 IS - 1 SE - Research Articles DO - 10.54155/jbs.36.1.45-58 UR - https://jbs-ojs-shsu.tdl.org/jbs/article/view/35 SP - 45-58 AB - <p>Real-option methods of Net Present Value (NPV) analysis are applied to<br>understand a capital budgeting decision concerning flexibility. The capital budgeting<br>problem under study here is the decision of whether Spade Ranch (Spade) should build<br>a fence. If this fence is built, then a hay-meadow could be converted into pasture land,<br>which would in turn permit the herd-size of the Spade Ranch to increase. However,<br>this fence building does not require the Spade to take the newly-fenced land out of hay<br>production and put it into cattle production. Instead, once the fence is built, the Spade<br>has the ability to switch land use from hay production to cattle production and vice<br>versa. The decision of whether or not to create this flexibility by fence-building is the<br>crux of this paper. What is the value of flexibility? If the fence costs less than the value<br>of this flexibility then we build the fence, otherwise no.<br>For two different scenarios, a linear programming model is employed to<br>define the relationship of Economic Value Added (EVA) to the question of whether<br>or not one should produce hay or cattle given that the existence of a fence permits a<br>decision maker to switch back and forth between hay and cattle production. These<br>two scenarios, each of which work under different pricing assumptions, produce<br>different EVA results and different production choices.<br>From this scenario work, the paper moves to the question of NPV. Is the<br>decision to build a fence a positive NPV investment decision or not? An option<br>pricing model is used to approach this question. Given a fence that provides for the<br>ability to switch back and forth between cattle and hay production, what is the value<br>of choosing additional cattle production by giving up the additional production of<br>hay for sale? As it turns out, the question of NPV for an investment that provides a<br>firm more flexibility by switching from the production of one product to another can<br>be answered. But the answer depends on the volatility of possible rates of return on<br>investment for both hay and cattle production, and their correlation with one another.</p> ER -