Decisions in Economics and Finance

, Volume 35, Issue 1, pp 75–89

Privatization of businesses and flexible investment: a real option approach

Article

Abstract

In this article, we study the situation, where the opportunity is given to invest into a government-owned business by partial privatization to a private company. After payment of an initial installment cost, the private company’s investments are flexible within a range [0, k] until the business is completed. We model the problem in a real option framework, using geometric mean reversion to describe the dynamics of the business. We determine the optimal time for the private company to enter and pay the initial installment cost as well as the optimal dynamic investment strategy that it follows afterward. For the latter, analytic solution cannot be obtained. We use quadratic splines in order to solve the corresponding dynamic programming problem. Finally, we determine the optimal degree of privatization in our model from the government’s perspective.

Keywords

Investment decisions Privatization Real options Industrial organization Stochastic optimal control Dynamic programming 

JEL Classification

C63 L14 L20 

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Copyright information

© Springer-Verlag 2011

Authors and Affiliations

  • Walailuck Chavanasporn
    • 1
  • Christian-Oliver Ewald
    • 2
    • 3
  1. 1.School of Economics and FinanceUniversity of St. AndrewsSt. Andrews, FifeUK
  2. 2.School of Mathematics and StatisticsUniversity of SydneySydneyAustralia
  3. 3.Center for Dynamic Macro Economic AnalysisUniversity of St. AndrewsSt. Andrews, FifeUK

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