The value of capacity sizing under risk aversion and operational flexibility

• Main Authors: CHRONOPOULOS, Michail, DE REYCK, Bert, SIDDIQUI, Afzal
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2013
• Subjects: Capacity sizing; energy sector; real options; risk aversion; Operations and Supply Chain Management; Risk Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/6757; https://doi.org/10.1109/TEM.2012.2211363
• Institution: Singapore Management University

Risk aversion typically erodes the value of an investment opportunity, often increasing the incentive to delay investment. Although this may be true when the decision maker has discretion only over the timing of investment, any additional discretion over the capacity of a project may lead to different results. In this paper, we extend the traditional real options approach by allowing for discretion over capacity while incorporating risk aversion and operational flexibility in the form of suspension and resumption options. In contrast to a project without scalable capacity, we find that increased risk aversion may actually facilitate investment because it decreases the optimal capacity of the project. Finally, we illustrate how the relative loss in the value of the investment opportunity due to an incorrect capacity choice may become less pronounced with increasing risk aversion and uncertainty.