Investing in Perennial Pasture Improvement: A Real Options Analysis

In investment analysis, uncertainty and irreversibility can undermine net present value (NPV) as a decision rule since the option to delay investment may have value. We apply the real option theory of investment to the pasture investment decision facing livestock producers in southwest Western Australia. In 2006, livestock producers thinned their herds as pasture availability dwindled due to extreme drought conditions. This left producers with a unique opportunity to either establish new perennial pastures for their cattle or utilize volunteer annual pasture and invest in more sheep breeders. In either case, large and irreversible investments fraught with multiple sources of uncertainty implies that one can gain useful insights by casting the investment problem in a real option context. The results suggest that required rates of return for each investment alternative are about 1% to 1.5% higher than standard NPV would suggest with sheep production having the lower required rate of return.