SSE/EFI Working Paper Series in Business Administration
Capital budgeting in a situation with variable utilisation of capacity - an example from the pulp industry
Abstract: It is well known that the profitability within the process
industry is heavily dependent upon the degree of utilisation of the plants.
Utilisation, in turn, is dependent upon the often very volatile market
conditions for the commodity produced.
This paper examines the
implications for capital budgeting, dealing with a situation of changing
levels of utilisation. A paper-pulp mill is chosen for the purpose of
investigating whether, in this specific case, the variation of utilisation
in response to changing market conditions affects plant value in any major
Comparing a fixed and a variable production rate (using the net
present value rule and option pricing by means of the Feynman-Kac formula),
it is found that the difference in value is considerable. However, an
inappropriately specified price process may explain the difference. The
geometric Brownian motion assumed allows the price to decline to almost
zero. In order to overcome this problem, an alternative price process
allowing for mean reversion in the nominal price of pulp is developed and
tested. The value of the ability to cut production is then found to be
Based on the findings of this study, it is not
worthwhile to model a variable utilisation of capacity. It is, however, of
utmost importance to evaluate different assumptions about pulp price
behaviour, as this will affect results substantially.
Keywords: Capital budgeting; real options; mean reversion; Feynman-Kac; (follow links to similar papers)
JEL-Codes: C60; G31; M21; (follow links to similar papers)
53 pages, September 30, 1999
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