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Real option analysis of a technology portfolio

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  • Petri Hilli
  • Maarit Kallio
  • Markku Kallio

Abstract

This article contributes to methodology of real options analysis of investments in capital intensive process industries, where relatively homogenous outputs are produced using commonly known production technologies. In addition to capacity expansion, the method can be used for analysis of mergers and acquisitions. Valuation of the real option is based on bid price; i.e., the maximum price the firm is willing to pay. To find such a price, stochastic optimization with an expected utility criterion is used to determine investments in product specific technologies as well as in publicly traded financial instruments (the competing investments). To operationalize the valuation principle, we develop a double binary tree employing Kalman filter for scenario generation. For exponential utility, valuation is carried out by dynamic programming. We extend known methods to allow interdependence of the mill cash flow and return on competing financial investments. For forest industries, we provide an illustration, where the underlying price process in our Kalman filter application is a vector error correction model.

Suggested Citation

  • Petri Hilli & Maarit Kallio & Markku Kallio, 2007. "Real option analysis of a technology portfolio," Review of Financial Economics, John Wiley & Sons, vol. 16(2), pages 127-147.
    • Handle: RePEc:wly:revfec:v:16:y:2007:i:2:p:127-147
    DOI: 10.1016/j.rfe.2005.07.002
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