Using Real Options Theory to Irrigation Dam Investment Analysis: An Application of Binomial Option Pricing Model

Abstract

This paper demonstrates the utility of the real options approach to irrigation dam investment analysis. The main objective is to show how to calculate the option values of selected options that may be available to managers of irrigation dam investments. The paper provides an empirical application, which compares an irrigation dam investment using the static Net Present Value (NPV) model and the real options approach and shows how it can be adopted to model uncertainty and managerial flexibility in dam management. Four management options are used for the real options approach: an option to delay the investment, an option to enlarge the dam, an option to abandon the dam, and multiple options that evaluated all three options together. All options were evaluated using the binomial option pricing model, where water values are assumed to follow a multiplicative binomial process. The analysis show that although the traditional NPV approach accepted the investment as profitable the option approach provided better results showing that all three options were highly valuable if exercised. When real options are considered, the traditional NPV model for assessing the profitability of a dam investment may fail to provide an adequate decision-making framework because it does not properly value management’s ability to adjust to shocks in the economy, as well as risks and uncertainty.