The use of Real Options and Decision Tree Method for Evaluation of Investment in Livestock

Abstract

As a result of global changes in trade and marketing of agricultural products, farmers are having to operate in a competitive environment. Uncertainties and risks resulting from factors such as price, yield, technology and weather conditions, manage and determine their actions. Hereof the evaluation acceptance of an investment project in agriculture must be accompanied by a study of the effects of uncertainty and risk. Conventional methods for the evaluation of investment as the net present value turns to limited as the environment and the dynamics in the environment presumes the use of advanced methods to evaluate the effectiveness of investment decisions. The analysis of the decision tree relies on subjective evaluation of probabilities and their distribution in time. The tree structure used in this analysis was developed to reflect the cooperation between random events and management decisions. The aim of this paper is to execute evaluation for the investment in cattle farms linked with the achievement of quality standards for the milk by the method of decision tree. The farm intends to introduce new technology and purchase equipment with which to improve the quality of the farm products. Investment is divided into three stages – in the first stage farm invest funds for market research, in the second-for pre-project studies for the hygienic and sanitary requirements and in the third stage will invest to purchase tangible fixed assets. Following the investment in terms of the analysis of the net present value calculations show that it is positive, i.e. project is eligible. Based on the results from the applying of the traditional methods of valuation of investments combined with the analysis of real options can benefit better evaluation results. They change the investment expenses and project risk. Based on modern financial valuation techniques for evaluation, real options approach overcomes the disadvantages of the present value.