The Real Options Approach to Evaluating a Risky Investment by a New Generation Cooperative: Further Processing

Farmers continue to be interested in opportunities for value added production through further processing. New Generation Cooperatives (NGCs) offer member commitment through up-front capital contributions on the part of members. For a potential start-up NGC, one of new and novel issues that face the management of an NGC is making project commitments against the total capital available, both equity and debt capital. Because of the up-front capital commitment by members, NGCs invite managers to make commitments in phases, rather than one initial go or no-go decision. Thus, the capital decision is complex and requires managerial vision in terms of an uncertain world beset by constant shifts in prices, interest rates, consumer tastes, and technology. This paper considers a novel means of evaluating this investment decision, one that encompasses risk components mentioned above. When the outcome of an investment is least certain, real options analysis has the greatest potential analytic value. As time goes by and prospects for an underlying investment become clearer, the value of an option diminishes. The methodology of real options is novel because it encourages managers, at time t, to weigh equally all imaginable alternatives, good and bad. A project's net present value (NPV) is simply the difference between the project's value and its cost. By definition of the NPV rule, managers should accept all projects with a net present value greater than zero. The distinction between real options and conventional decision-making arises in that the standard net present value rule does not take into account managerial flexibility over time. Flexibility is especially important when the project involves sunk cost investments that can never be retrieved. Typically, investment in a new processing facility is a sunk cost, once the decision is made to build the facility. The analysis herein examines a NGC for corn tortilla chip processing, comparing both conventional NPV and real options analyses. PowerSim, a dynamic simulation model, is used is the analysis. This modeled investment is sunk, and the investment in a certain technology is sunk at the time the decision is made to construct the facility. The results indicate that the flexibility of managers is an important criterion for making decisions regarding sunk cost investments.

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