A capital investment decision in the hog industry: A real option approach

Adam Christopher Maung, Purdue University

Abstract

This dissertation proposes an optimal investment decision model that accounts for project irreversibility and price uncertainty. By specifying the cash flow as a dual profit function, the methodology admits hog and feed prices, rather than a composite cash flow, as the underlying stochastic variables. The elegance of this specification is that it allows the investment option to be valued in the equivalent risk-neutral measure, because the futures contracts of the underlying commodities are traded in a financial market. The advantage of the market valuation via an equivalent risk-neutral measure is a risk-free discount rate. A Monte Carlo method for the American option is extended to estimate the option value. In addition to the multiple state variables, the Monte Carlo method incorporates a non-linear payoff, which is the present value of a non-linear profit function. ^ The methodology is applied to analyze the investment option associated with both horizontal and vertical expansion in the hog industry. A cooperative enterprise is defined as the decision maker in this investment opportunity given the emerging interest in producer cooperatives in the industry. In making a decision to invest in a new facility, the cooperative may choose between different marketing methods. If the future outlook of hog prices is not favorable, the producer may decide to enter a cost-plus contract with a packer. This type of contract curtails output price risk. Alternatively, the producer may choose to sell hogs in the cash market. Hence, the value of the investment option depends not only on the investment timing, but also on the type of marketing method used. The Monte Carlo simulation yields the estimated option value that ranges from 25 percent to 41 percent of the initial investment. In the vertical expansion, the farmer cooperative contemplates investing in a slaughter plant to have more control over marketing and production decisions by retaining ownership farther down the marketing chain. The results show that the value of the option to invest in a modest-size hog slaughter plant amounts to approximately two to three times that of the initial investment. ^

Degree

Ph.D.

Advisors

Major Professor: Ken Foster, Purdue University.

Subject Area

Economics, Agricultural

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