Investment analysis for capacity management based on real options

Investment portfolio management in the capital-intensive industry is a challenging task. It is essentially decision-making under uncertainty: on one hand the market outlook is uncertain due to e.g. possible price fluctuations of raw material, technological break-through, and competitive position, on the other hand the production system is aging increasing the uncertainty regarding the future productivity of the plant. One way to deal with uncertainty is the active planning of real options related to managing production assets. A method for assessing real options in the context of capacity management is presented in the paper. The method divides the investment planning horizon into two market outlook periods. The first period represents the current, emergent market situation for which real options, planned in the previous time period, may be optimally exercised, thus optimising production capacity according to demand. The second market outlook period represents an uncertain production environment for which real options can be planned, based on demand forecasts. The rotation of the periods is continuous, each entailing planning and execution of real options according to demand forecasts and the gradually resolving uncertainty as future becomes present. The method is applicable in spreadsheet programs which support Monte Carlo simulation. A worked example is presented with simulated distributions of revenues related to investment portfolios including real options. The main objective of the paper is, however, to promote real options thinking related to dynamic capacity management.