Evaluating Complex Flexible Processes as Multiple Switching Options

Option models have provided insight into the value of flexibility to switch from one state to another (such as switching a mine or refinery from operating to closed status). More complex flexible processes offer multiple possibilities for switching states. A fabrication facility, for example, may offer options to shift from the current status to any of several alternatives (reflecting reconfiguration of basic facilities to accommodate different operating processes with different outputs). New algorithms enable practical application of complex option pricing models to flexible facilities, improving analysts’ ability to draw sound conclusions about the effects of flexibility and innovativeness on share value. Careful attention to estimating the matrix of correlations among the values of potential alternative states allows explicit integration of financial analysis and strategic analysis—especially the influence of substitutes and the anticipated reactions of competitors, suppliers, and potential new entrants. [JEL: G31, G13]