Using real option analysis to quantify ethanol policy impact on the firm's entry into and optimal operation of corn ethanol facilities

- We use real option analysis to value a facility which produces ethanol from corn.
- Perhaps due to ethanol subsidy, correlation between corn and ethanol has increased.
- We show that increasing correlation will decrease project value.
- We investigate the impact of changed ethanol policy on business entry decisions.
- Increasing subsidy reduces project risk and induces more ethanol investment.

Ethanol crush spreads are used to model the value of a facility which produces ethanol from corn. A real option analysis is used to investigate the effects of model parameters on the related managerial decisions of (i) how to operate the facility through optimal switching from idled to operational status and (ii) the decision to enter into the project given its expected real option net present value. We present evidence of increased correlation between corn and ethanol prices, perhaps as a result of government policy which has induced more players to enter into the market. This paper investigates the subsequent negative effects on firms. Further, this paper illustrates the impact of an abrupt change in government policy, as what happened in January 2012, on a firm's decision to enter the business.