|M.Sc Thesis||Department of Industrial Engineering and Management|
|Supervisor:||Prof. Avner Bar Ilan|
|Full Thesis text|
In our work we have analysed the firm's decision to build a production facility in different locations. One location is "domestic" and the other is "foreign". For this analysis we have extended the classic Dixit's model of the real-options by allowing for different stochastic processes for the output price and the input cost. The two processes are correlated. But, contrary to the Dixit’s model, the investment is fully irreversible. The decision whether to build a plant, and its location, depends on various parameters. In particular, we study the effect of both sources of uncertainty (in prices and costs), correlation coefficient, mean rates of change, and interest rate.
We have shown that in the presence of input costs uncertainty, higher uncertainty about the output price not always delays investment. This result holds true only if price and cost are positively correlated. The described effect has been mostly ignored by traditional real-options studies. Also, we have shown how the model can be applied to the problem of production facility location. We present here examples that demonstrate the potential explanatory ability of the model regarding location of production facilities. The positive correlation between output price and production costs makes location of the production facility at the output market's country more attractive. In this way the firm reaches less uncertain profit flow. Nevertheless, the compensation for the lower correlation (if production facility and the market are located in different states) in terms of production cost or investment expenditures can turn over this rule. We conclude that the correlation between the revenue and the production cost is a crucial determinant of the firm’s decision regarding the decision to invest, its location and timing, rather than just the price or cost uncertainty.