In this section we will alter the parameters of our base case estimation from chapter 6 and analyze the subsequent changes of the investment value as well as the investment trigger price. All changes made to the parameters are done in a ceteris paribus (i.e all else equal) manner. This assumption is in line with Pindyck & Dixit (1994), which show that the change of a variable, such as the interest rate, might have an implicit impact upon the convenience yield through the expected change of the underlying asset. A consequence for such a careless interpretation is that the results provided will lack realism. One must therefore be careful when intuitively explaining the sensitivity of the input variables, since they often times are interconnected.
We will now discuss each parameter and the effect a change in the input variable will have on both the trigger price and project value, everything else kept constant, starting with volatility.
7.1 Impact of changes in Volatility
As one can see from the real options theory covered in chapter 3, uncertainty is crucial for the real options value. If one already had certain information of the future state, the option to initiate an investment at a future state will not be worth anything. This means that, for a volatility of 0, the results in the table below would have been in line with the DCF approach.
But as we have seen from chapter 2, the market for power in Norway has many sources of uncertainty attached to it; both from demand, supply and transmission, and the real option will thus have a value and marginally increase the total value of the investment.
However, we see that the trigger price will increase significantly with more uncertainty, which is also intuitive since investors will demand a higher price to initiate an irreversible investment in a more uncertain environment due to the high level of alternative costs.
These results are in line with other results from literature, such as Dixit and Pinduck 1994 and Kjærland 2007.
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Effects of changes in volatility
7.2 Impact of changes in Risk-Free Rate
Interest rate is according to theory ambiguous in its effect on the value of the real option. On the one hand, an increased interest rate will increase the time value of deferral of the investment, and thus increase the real options value directly. But on the other hand, an increased interest rate will also reduce the value of the future cash flows, and thus reduce the value of the real option indirectly. This ambiguity makes the total effect on the value of the real option hard to predict.
As the next table illustrates, an increased interest rate will increase the value of our project.
The changes in the table below are in line with both Pindyck & Dixit (1994), as well as Kjærland (2007).
The trigger price will also increase with an increase in the interest rate, since a higher interest rate will increase the opportunity cost of investing now. This result is also in line with Pindyck & Dixit (1994) and Kjærland (2007).
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Effects of changes in the risk free rate
7.3 Impact of changes in Convenience Yield
The value of the investment is highly sensitive to changes in the convenience yield. Increased convenience yield increases the value of currently owning the underlying asset rather than holding an option to invest. This can be perceived intuitively by contemplating on the interpretation of convenience yield being an intermediate income for the holder of the asset and not to the holder of the option. A change in convenience yield is by far the most sensitive parameter and as shown in the table an increase of 0.1% will decrease value by 20%. This result is in line with Kjærland (2007) and Dixit & Pindyck (1994), although the latter experience a slightly less decrease in project value with marginal increases in the convenience yield input parameter.
Furthermore, one sees from the table below that the trigger price will increase slightly with a marginal increase in the convenience yield.
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Effects of changes in the convenience yield
7.4 Impact of changes in Investment Costs
The project value is not affected by changes in the investment price, which is intuitive since the investment value will not change the expected future cash flow, but rather the investment today.
Following this reasoning we see that the timing option on when to invest is sensitive to changes in the investment parameter. An increased investment cost will increase the trigger price, since the investment becomes less lucrative and will demand higher future cash flows to compensate for this increased investment cost. These results are inline with Dixit & Pindyck 1994 and Kjærland 2007.
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Effects of changes in the investment cost
7.5 Impact of changes in Marginal Cost
An increase in the level of marginal cost should decrease the value of future cash flows and thus the project value, and at the same time increase the trigger price since the investor will be less likely to invest in a project with higher costs and decreased cash flows. The results beneath are inline with theory, and a marginal increase will lead to a lower expected value of the project, but this effect will be limited due to the low marginal cost level within the power generation industry.
Furthermore, this increase in marginal cost will decrease the willingness to pay for the investor, and thus increase the trigger price. These results are inline with Dixit & Pindyck 1994 and Kjærland 2007.
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Effects of changes in the marginal cost
7.6 Summary
Changes in the input parameter will change the project value and the optimal trigger price in various ways. Our analysis showed that the project value is most sensitive to changes in the convenience yield, whilst the optimal trigger price change with increases in volatility and investment cost. Furthermore, we saw that our results are in line with theoretical approaches and also with the existing key literature on the subject, such as Dixit & Pindyck 1994.
Our analysis shows that volatility or interest rate will increase the value of the project and also the trigger price, due to a higher alternative cost of irreversible projects. Furthermore, an increase in the convenience yield will significantly decrease the value of the investment, of the asset will increase his profits, and it will also. Finally, we explained how the investment cost only affects the trigger price and that the marginal cost will decrease the investment value and increase the trigger price, however less significant due to the low level of marginal cost in the industry.
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