Capital investment under alternative marketing scenarios in the hog industry: A real option approach

This paper uses a real option approach to analyze the impact of alternative marketing contracts on the decision to invest in a cooperatively owned hog facility. For the numerical analysis of the impact, this paper uses a simulation method that incorporates early exercise, multiple-state variables, multi-choice decisions and temporal optimality. The results show that the option values that stem from the value of waiting to invest and choosing between alternative marketing methods amounts to 20-36% of the initial investment. Further, having an option to choose an alternative marketing method with different risk structure does add to the value of waiting to invest. Having an option-to enter a 15-year marketing contract increases the value of Waiting by as much as $117,097 for the pork production example in this paper. Finally, the value of the option to wait is unilaterally lower under a risk-reducing contract scenario than,under a spot market alternative. This could explain the explosion in hog production facility investment during the 1990s when prevalence of contract production increased.