Barking up the right tree: binomial option valuation of investments in steel making : a case study of Metals and Polymers (Ukraine)

Abstract: This paper investigates the impact of real options on the value of a particular business entity. Theoretically, the paper benefits from use of an option pricing model which is based on a two-state (binomial) framework. This model provides an intuitive appeal by visually showing the evolution of the value of a business in terms of discrete time intervals. In contrast to majority of similar studies, this paper utilizes an extended version of the binomial framework that combines both volatility and drift (in actual expression, it is substituted by risk-free rate). Empirically, the analysis is supported by financial data from Ukrainian steel-making company Metals and Polymers Ltd. Properties of production process, as well as institutional environment, enable to detect two business opportunities examined by means of the theoretical model selected. These opportunities are option to expand and option to abandon. The potential of the company in terms of profitability is estimated using conventional NPV analysis, with no options included. This estimation is then enhanced by implementing the options chosen. To account for different economic scenarios, some independent variables are taken fixed while others are loosen to float in the imposed intervals. Among the variables, changeable (floating) ones are rate of corporate tax, rate of volatility and discount rate. It is shown that in the presence of options the value of the company is significantly higher than without them. Moreover, its value is subject to noticeable fluctuations depending on alterations in the changeable variables.