Using real options to evaluate ethanol plant expansion decisions
Abstract
Purpose
The purpose of this paper is to investigate how to incorporate market price risk into investment decisions. The investigation focuses on investments to expand ethanol production facilities. The model is used to determine if such a real option approach can explain recent changes in the level of plant investment activity.
Design/methodology/approach
The paper demonstrates how real option analysis and Monte Carlo simulation can be used to evaluate ethanol plant investments by using available historical industry and market price data. We focus on existing small‐to‐medium, dry milling plants and the real option to expand the scale of operations. The binomial option pricing model is used to identify optimal strategies.
Findings
Increasing profitability and volatility appear to favor the strategy of investing during 2005‐2007. However, when the prices of corn and natural gas rise and plant profitability declines during 2007‐2008, the best strategy is increasingly to either postpone the investment or reject the decision to expand.
Originality/value
This paper is a first application of real option analysis to ethanol plant expansion decisions. The methodology used in the paper can be adapted by analysts, investors, and lenders in the ethanol industry to improve their investment analyses.
Keywords
Citation
Pederson, G. and Zou, T. (2009), "Using real options to evaluate ethanol plant expansion decisions", Agricultural Finance Review, Vol. 69 No. 1, pp. 23-35. https://doi.org/10.1108/00021460910960444
Publisher
:Emerald Group Publishing Limited
Copyright © 2009, Emerald Group Publishing Limited