Privatization of Businesses and Flexible Investment: A Real Option Approach
19 Pages Posted: 19 Jul 2010
Date Written: July 18, 2010
In this article, we study the situation, where by partial privatization a private company is given the opportunity to invest into a government owned business. After payment of an initial instalment cost, the private company's investments are flexible within a range $[0,k]$ until the business is completed. We model the problem in a real option framework, using geometric mean reversion to describe the dynamics of the business. We determine the optimal time for the private company to enter and pay the initial instalment cost as well as the optimal dynamic investment strategy that it follows afterward. For the latter, analytic solution cannot be obtained. We use quadratic splines in order to solve the corresponding dynamic programming problem. Finally we determine the optimal degree of privatization in our model from the government's perspective.
Keywords: investment decisions, privatization, real options, industrial organization, stochastic optimal control, dynamic programming
JEL Classification: C63, L14, L20
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