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Abstract
This paper uses real option analysis to evaluate investment decisions in ethanol
facilities. First, we consider the option to expand the scale of a conventional ethanol
plant. Second, we evaluate the option to choose a production technology given three drymilling
choices – a conventional natural gas-fueled plant, a stover-fueled plant, and a
stover-plus-syrup-fueled plant. We develop input-output coefficients and annual cash
flow projections for a hypothetical small ethanol plant (50 million gallon capacity) using
available industry and market price data.
Scenario analysis is done to evaluate the effect of profitability and volatility on the
option to expand. We find that the best decision during 2001-07 is often to expand, since
the net present values of the investment project are positive. However, there are states in
the binomial tree where it is best to wait. In relatively few such states the expansion
project is simply rejected. During the early part of the period low profitability and high
volatility more frequently favor strategies of waiting to invest until prices and
profitability improve. During the latter part of the period (2005-07), profitability is
sharply higher and most often the best strategy is to invest in the expansion. This result is
consistent with the observed rapid increase in industry production capacity during 2005-
07. However, more recent market developments, sharply higher corn and natural gas
prices and slightly higher ethanol prices during late 2007-early 2008, have combined to
sharply reduce expected plant cash flow and profitability and cash flow volatility. The
implication is that plant investment plans in 2008 would be increasingly placed on hold,
which the real option model correctly predicts.
The real option analysis of technology choice indicates that the stover-fueled
technologies are most often chosen when compared to a natural gas-fueled conventional
technology based on the prices that existed during 2001-2007.