Economic Evaluation of the Mediterranean Dead Sea Project: An Application of Real Options Theory
27 Pages Posted: 24 Jul 2002
Date Written: July 8, 2002
This paper uses real options theory to value an investment opportunity known as the Mediterranean-Dead Sea hydroelectric project. We employ a discrete time model to:
-quantify simultaneous variation of three decision variables over the useful life of the project;
-value options to: postpone the start of the project, expand it during its economic life, or abandon it when its net present value becomes negative;
-conduct sensitivity analysis of project payoffs under different environmental conditions.
We use a dynamic programming model to value the three types of options. The computations are organized using a decision tree to define a strategy for obtaining the maximal net present value of benefits from project exploitation. The calculations evaluate all possible construction and installation decisions corresponding to each combination of the states of the world and states of the system. The real options analysis proves to be particularly useful since project construction costs are both high relative to its benefits and variable with respect to different possible states of the world.
The best decision is to wait one or two periods before starting the project, while a second best decision is to start the project right away. Both the option to halt construction temporarily and the option to abandon the project increase its net present value significantly. Waiting becomes more valuable as interest rates increase and as variation in fuel prices decreases. If interest rates are relatively low or if a higher variance in fuel prices occurs, capacity expansions can be done more frequently and in bigger increments.
JEL Classification: G13,G12,G31,G32,M21,H43,H49,R32,Q4,O22
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