Figure 72 Value Under No Flexibility Always Operate The Plant

Retail P=$500 (known) Flexibility: Plant (or not)

Retail P=$600, Cost C=$100 Decision: None (Plant Runs)

Revenues: $75,000,000 Fixed Costs: $50,000,000 Rent: $10,000,000 Net: $15,000,000

Retail P=$400, Cost C=$100 Decision: None (Plant Runs)

Revenues: $45,000,000 Fixed Costs: $50,000,000 <1 Rent: $10,000,000 Net: -$15,000, 000

Retail P=$800, Cost C=$100 Decision: None (Plant Runs)

Revenues: $105,000,000 Fixed Costs: $50,000,000 Rent: $10,000,000 Net: $45,000,000

Retail P=$400, Cost C=$100 Decision: None (Plant Runs)

Revenues: $45,000,000 Fixed Costs: $50,000,000 Rent: $10,000,000 Net: -$15, 000, 000

Retail P=$600, Cost C=$100 Decision: None (Plant Runs)

Revenues: $75,000,000 Fixed Costs: $50,000,000 Rent: $10,000,000 Net: $15,000,000

Retail P=$200, Cost C=$100 Decision: None (Plant Runs)

Revenues: $15,000,000 Fixed Costs: $50,000,000 Rent: $10,000,000 Net: -$45, 000, 000

If you have perfect flexibility, you get "the max."

Figure 7.3 shows your valuation and optimal decision tree now. Again, the figure highlights important flexibility-related choices in blue. The fat boxes indicate that you operate the plant; the thin boxes that you do not. You earn +$15M or -$10M in the first year. The expected value is $2.5M, which discounts to $2.3M (indicated at the bottom of the figure). The final year, you earn +$45M, -$10M, +$15M, or -$10M, which is an expected value of $10M and a discounted value of $8.3M. Therefore, this firm is worth +$10.5M. The value to having knowledge and the flexibility to act on it—knowledge without flexibility is useless!—has transformed this firm from a nothing into a gem. It is this value-through-flexibility that your "strategic options to respond" has created. Put differently, the value of your real option is +$10.5M.

The Option to Delay Choice: Often, you do not have full flexibility. Instead, you have some strategic options, but not perfect flexibility. For example, what would happen if you had the option to delay your decision by one year, more specifically, to run the plant only if the price appreciates to $600/u, but not if it depreciates to $400/u? If you run the plant next year, you have to run it the following year. If you do not run the plant next year, you cannot run it the following year, either. Figure 7.4 shows your revised decision tree. The value of this strategic option is still a respectable $4.4M. The reason why it does not reach +$10.5M is that you would still operate the plant in the final period if the price is $400/u (which you would rather not do), and you would fail to run the plant in the final period if the price is $600/u (which you would rather do).

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