Interdependencies between operating options

Abstract

This paper presents a computationally feasible technique to value operating flexibilities in making capital budgeting decisions. We investigate how the value of a project is affected by the simultaneous introduction of several operating options. Previous studies have focused on operating options one at a time. A numerical example demonstrates the options to wait to invest, to abandon, and to temporarily shut down -- first, one at a time and then more than one at a time. -- As expected, the project value increases with the introduction of additional options. Adding new options, however, reduces the value of the previously available options. We also study the impact of adding new options on the critical boundaries at which existing options are exercised. These results help sharpen our intuition about the effects of and interactions between operating options. Easiliy implemented on a Personal Computer, the model is sufficiently general to handle various types of production flexibilities and assumptions regarding the economic environment. Hence, for the first time, we have available a quantitative technique that accounts for operating flexibilities that can be incorporated practically in the capital budgeting process.