Managing uncertainty: A case for using real options with option pricing model (OPM) to evaluate capital investment

The pulp and paper industry relies heavily on the traditional discounted cash flow-based net present value (DCF-NPV) for making capital investment decisions. The deficiency of the DCF-NPV model is that it is static; once a pattern of cash flow is established, management does not have the option to change the direction when new information is available. However, flexibility to alter the investment decision is a powerful strategic and capital investment tool. Abundant research has established strong precedence for applications of “real options” in operational and strategic settings to provide useful insights in the evaluation of irreversible investments under uncertainty. The binomial or Black-Scholes option pricing model (OPM) for strategic planning and capital investment has been used in many other industries but not in the pulp and paper industry. The pulp and paper industry, though very capital intensive, has provided poor to moderate return on investment or return on capital and has never used the OPM and the flexibility it offers for capital investment decisions. This paper makes a case for using OPM for capital investment decisions by using the example of a hypothetical North American mill considering investments to modernize its papermaking operation.