The value of flexibility

Abstract

This paper develops a framework to evaluate the economic value derived from a firm's ability to switch between different modes of production in the face of uncertain prices. The model, cast as a set of simulataneous stochastic dynamic programs, is solved for the ex-ante value of flexibility, the optimal technology choice, and critical prices at which switching is optimal. This general model of flexibility is used to synthesize several recent studies of real options encountered in capital budgeting. For example, the model yields as special cases (a) the value of waiting to invest, (b) the option to abandon, (c) the value of having an option to shut down, (d) the replacement timing and technology choice, and (e) the "time to build" option for irreversible projects that require sequential outlays. We use an illustrative example with two modes to show that the value of flexibility is monotonically increasing with price variability and switching frequency. The value of flexibility can contribute about a 15 percent improvement over the better fixed technology. Early in the life of the project it is optimal to switch modes when the difference between values under one mode (for the current period and optimal switching thereafter) and the other mode exceeds the switching cost. Towards the end of the economic life, the above difference must be significantly larger for swithcing to occur.