16. Doing the Managerial Flexibility Maths

This chapter maps the linkages between NPVs and binomial tree calculations, where volatilities are explicitly evaluated. A step-by-step illustration is presented, showing how binomial tree analysis is performed using economic costs of supplies. This involves estimating the node values for fuel and the associated transport and conversion costs to estimate fuel costs. The capital recovery factor and variable costs, which are fairly stable, are added to fuel costs to derive power prices. The cash margins are simply the difference between the power prices and the economic cash costs of supplies, which is equivalent to the fuel and variable costs. The risked payoffs are derived from the binomial tree, referred to as the strategic economic payoffs, weighted by their risk-adjusted probabilities for up or down moves. When the commitment costs are deducted from this sum, we now have the strategic option value (or expanded NPV). The value of managerial flexibility is simply the difference between a rigid and a flexible supply in terms of pricing or volume.