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An Option Valuation Analysis of Investment Choices by a Regulated Firm

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Author Info

  • Elizabeth Olmsted Teisberg

    (Harvard University, Graduate School of Business Administration, Soldiers Field Road, Boston, Massachusetts 02163)

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    Abstract

    This paper analyzes a utility power plant construction project using an option pricing model of the value of the capital investment. It includes descriptive factors frequently ignored in the valuation of capital investments by regulated firms, including lead time, lumpy and sequential cost outlays, irreversibility of expenditures, and uncertainty about regulatory outcomes for completed projects. The analysis shows the value of shorter lead time technologies, the value of flexibility to delay or abandon construction, the incentive to delay construction under uncertain regulation, and how cost recovery policies, such as possible disallowance of Allow for Funds Used During Construction (AFUDC), create incentives to invest less, but to complete construction quickly. The analysis may also apply in unregulated contexts, where the value of a completed project is affected by taxation, the possibility of nationalization, or possible competitors' actions that create uncertain restrictions on potential profits.

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    File URL: http://dx.doi.org/10.1287/mnsc.40.4.535
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 40 (1994)
    Issue (Month): 4 (April)
    Pages: 535-548

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    Handle: RePEc:inm:ormnsc:v:40:y:1994:i:4:p:535-548

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    Related research

    Keywords: uncertain regulation; electric utilities; real option valuation; capital investment; regulatory incentives;

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    Cited by:
    1. Fernando Camacho & Flavio Menezes, 2009. "Access pricing and investment: a real options approach," Journal of Regulatory Economics, Springer, vol. 36(2), pages 107-126, October.
    2. Pasquale Lucio Scandizzo & Odin K Knudsen, 2010. "Risk Management and Regulation Compliance with Tradable Permits under Dynamic Uncertainty," CEIS Research Paper 163, Tor Vergata University, CEIS, revised 28 May 2010.
    3. Davis, Graham A., 1998. "Estimating Volatility and Dividend Yield When Valuing Real Options to Invest or Abandon," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 725-754.
    4. Lander, Diane M. & Pinches, George E., 1998. "Challenges to the Practical Implementation of Modeling and Valuing Real Options," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 537-567.
    5. Graeme Guthrie, 2006. "Regulating Infrastructure: The Impact on Risk and Investment," Journal of Economic Literature, American Economic Association, vol. 44(4), pages 925-972, December.
    6. Fernando T. Camacho & Flavio M. Menezes, 2008. "Price Regulation and Investment: A Real Options Approach," Discussion Papers Series 373, School of Economics, University of Queensland, Australia.
    7. Murillas Maza, Arantza, 2000. "Uncertainty and Real Options. Investment and Development of Fishing Resources (II)," BILTOKI 2000-02, Universidad del País Vasco - Departamento de Economía Aplicada III (Econometría y Estadística).
    8. Choi, Hyun-Woo & Kim, In Joon & Kim, Tong Suk, 2002. "Contingent claims valuation of optional calling plan contracts in telephone industry," International Review of Financial Analysis, Elsevier, vol. 11(4), pages 433-448.
    9. Martzoukos, Spiros H. & Trigeorgis, Lenos, 2002. "Real (investment) options with multiple sources of rare events," European Journal of Operational Research, Elsevier, vol. 136(3), pages 696-706, February.

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