Investment decisions in hog finishing: an application of the real options approach

In this paper, option-pricing theory is applied to an investment problem in hog production. A stochastic simulation model capable of pricing American-type options is developed. This is achieved by recursive calculation of the exercise frontier. The model is used to determine the investment trigger and the disinvestment trigger for a pig-fattening barn under German market conditions. It turns out that the investment trigger, taking into account the value of waiting in an uncertain environment, can be considerably higher compared to classical investment criteria such as the net present value. This offers an explanation as to why farmers are indeed reluctant to invest in hog production. Another finding is the sensitivity of the option prices with respect to the stochastic process that is assumed for revenues and variable costs of the production activity.