Scandinavian Working Papers in Business Administration

SSE/EFI Working Paper Series in Business Administration,
Stockholm School of Economics

No 1999:4: Capital budgeting in a situation with variable utilisation of capacity - an example from the pulp industry

Henrik Andersson ()
Additional contact information
Henrik Andersson: Dept. of Business Administration, Stockholm School of Economics, Postal: P.O. Box 6501, S-113 83 Stockholm, Sweden

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 way.

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 insignificant.

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

JEL-codes: C60; G31; M21

53 pages, September 30, 1999

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