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Valuing Regulatory Flexibility: A Real Options Approach to Cost-Benefit Analysis

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The field of real options has been slow to develop because of the complexity of the techniques and the difficulty of fitting them to the realities of corporate strategic decision-making. Such complexity, and the resulting challenge of getting senior management “buy-in,” has been a major barrier to wider corporate adoption of real option techniques. To overcome this barrier, The Boeing Company has invested heavily to develop state-of-the-art methods and tools. The goal is to create a real options approach that uses the language and frameworks of standard DCF analysis—a framework the company’s financial analysts and managers are already familiar with and feel comfortable using. The result has been a method of valuation (referred to at Boeing as the “DM” Method that, while algebraically equivalent to the Black-Scholes formula for valuing financial options, uses information that arises naturally in a standard DCF project financial valuation.
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The long history of the theory of option pricing began in 1900 when the French mathematician Louis Bachelier deduced an option pricing formula based on the assumption that stock prices follow a Brownian motion with zero drift. Since that time, numerous researchers have contributed to the theory. The present paper begins by deducing a set of restrictions on option pricing formulas from the assumption that investors prefer more to less. These restrictions are necessary conditions for a formula to be consistent with a rational pricing theory. Attention is given to the problems created when dividends are paid on the underlying common stock and when the terms of the option contract can be changed explicitly by a change in exercise price or implicitly by a shift in the investment or capital structure policy of the firm. Since the deduced restrictions are not sufficient to uniquely determine an option pricing formula, additional assumptions are introduced to examine and extend the seminal Black-Scholes theory of option pricing. Explicit formulas for pricing both call and put options as well as for warrants and the new "down-and-out" option are derived. The effects of dividends and call provisions on the warrant price are examined. The possibilities for further extension of the theory to the pricing of corporate liabilities are discussed.
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The loss of human life resulting from environmental contaminants generally does not occur contemporaneously with the exposure to those contaminants. Some environmental problems produce harms with a latency period whereas others affect future generations. One of the most vexing questions raised by the cost-benefit analysis of environmental regulation is whether discounting, to reflect the passage of time between the exposure and the harm, is appropriate in these two scenarios. The valuations of human life used in regulatory analyses are from threats of instantaneous death in workplace settings. Discounting, to reflect that in the case of latent harms the years lost occur later in a person's lifetime, is appropriate in these circumstances. Upward adjustments of the value of life need to be undertaken, however, to account for the dread and involuntary nature of environmental carcinogens as well as for higher income levels of the victims. By not performing these adjustments, the regulatory process may be undervaluing lives by as much as a factor of six. In contrast, in the case of harms to future generations, discounting is ethically unjustified. It is simply a means of privileging the interests of the current generation. Discounting raises analytically distinct issues in the cases of latent harms and harms to future generations. In the case of latent harms, one needs to make intra-personal, intertemporal comparisons of utility, whereas in the case of harms to future generations one needs to define a metric against which to compare the utilities of individuals living in different generations. Thus, the appropriateness of discounting should be resolved differently in the two contexts.
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How are firms’ investment decisions influenced by potential instability in the regulatory environment? Firms that anticipate regulatory change may alter their responses to current policies, potentially rendering those policies less effective. This article explores the pattern of investments in renewable generation assets in the US electricity industry following the implementation of Renewable Portfolio Standard (RPS) policies. Viewing these investments through the lens of transaction cost economics, the article investigates whether the likelihood of future regulatory change in a state dampened (or spurred) firm responses to RPS policies in that state. I find that firms invested less in new assets in states that had previously passed and repealed legislation to restructure the electricity industry, indicating that perceived regulatory instability reduces new investment and undermines policy goals. (JEL D02, D81, D23, D21, K2)
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[Introduction] Many analytical approaches to setting environmental standards require some consideration of costs and benefits. Even technology- based regulation, maligned by cost-benefit enthusiasts as the worst form of regulatory excess, typically entails consideration of economic costs. Cost-benefit analysis differs, however, from other analytical approaches in the following respect: it demands that the advantages and disadvantages of a regulatory policy be reduced, as far as possible, to numbers, and then further reduced to dollars and cents. In this feature of cost-benefit analysis lies its doom. Indeed, looking closely at the products of this pricing scheme makes it seem not only a little cold, but a little crazy as well. Consider the following examples, which we are not making up. They are not the work of a lunatic fringe, but, on the contrary, they reflect the work products of some of the most influential and reputable of today's cost-benefit practitioners. We are not sure whether to laugh or cry; we find it impossible to treat these studies as serious contributions to a rational discussion. Several years ago, states were in the middle of their litigation against tobacco companies, seeking to recoup the medical expenditures they had incurred as a result of smoking. At that time, W. Kip Viscusi - a professor of law and economics at Harvard and the primary source of the current $6.3 million estimate for the value of a statistical life' - undertook research concluding that states, in fact, saved money as the result of smoking by their citizens. Why? Because they died early! 3 They thus saved their states the trouble and expense of providing nursing home care and other services associated with an aging population. 4 Viscusi didn't stop there. So great, under Viscusi's assumptions, were the financial benefits to the states of their citizens' premature deaths that, he suggested, "cigarette smoking should be subsidized rather than taxed." ' Amazingly, this cynical conclusion has not been swept into the dustbin where it belongs, but instead recently has been revived: the tobacco company Philip Morris commissioned the well-known consulting group Arthur D. Little to examine the financial benefits to the Czech Republic of smoking among Czech citizens. Arthur D. Little International, Inc., found that smoking was a financial boon for the government-partly because, again, it caused citizens to die earlier and thus reduced government expenditure on pensions, housing, and health care.6 This conclusion relies, so far as we can determine, on perfectly conventional cost-benefit analysis. There is more. In recent years, much has been learned about the special risks children face due to pesticides in their food, contaminants in their drinking water, ozone in the air, and so on. Because cost-benefit analysis has become much more prominent at the same time, there is now a budding industry in valuing children's health. Its products are often bizarre. Take the problem of lead poisoning in children. One of the most serious and disturbing effects of lead contamination is the neurological damage it can cause in young children, including permanently diminished mental ability. Putting a dollar value on the (avoidable, environmentally caused) retardation of children is a daunting task, but economic analysts have not been deterred. Randall Lutter, a frequent regulatory critic and a scholar at the AEI-Brookings Joint Center for Regulatory Studies, argues that the way to value the damage lead causes in children is to look at the amount parents of affected children spend on chelation therapy, a chemical treatment that is supposed to cause excretion of lead from the body. 7 Parental spending on chelation supports an estimated valuation of as low as $1100 per IQ point lost due to lead poisoning. 8 Previous economic analyses by the EPA, based on the children's loss of expected future earnings, have estimated the value to be much higher-up to $9000 per IQ point. 9 Based on his lower figure, Lutter claims to have discovered that too much effort is going into controlling lead: "Hazard standards that protect children far more than their parents think is appropriate may make little sense"; thus, " [ t]he agencies should consider relaxing their lead standards." 1 0 In fact, Lutter presents no evidence about what parents think, only about what they spend on one rare variety of private medical treatment (which, as it turns out, has not been proven medically effective for chronic, low-level lead poisoning)." Why should environmental standards be based on what individuals are now spending on desperate personal efforts to overcome social problems? For sheer analytical audacity, Lutter's study faces some stiff competition from another study concerning kids-this one concerning the value, not of children's health, but of their lives. In this second study, researchers examined mothers' car-seat fastening practices. 2 They calculated the difference between the time required to fasten the seats correctly and the time mothers actually spent fastening their children into their seats.1 3 Then they assigned a monetary value to this difference of time based on the mothers' hourly wage rate (or, in the case of nonworking moms, based on a guess at the wages they might have earned).14 When mothers saved time-and, by hypothesis, money-by fastening their children's car seats incorrectly, they were, according to the researchers, implicitly placing a finite monetary value on the life-threatening risks to their children posed by car accidents. Building on this calculation, the researchers were able to answer the vexing question of how much a statistical child's life is worth to its mother. (As the mother of a statistical child, she is naturally adept at complex calculations comparing the value of saving a few seconds versus the slightly increased risk to her child!) The answer parallels Lutter's finding that we are valuing our children too highly: in car-seat-land, a child's life is worth only about $500,000.16 In this Article, we try to show that the absurdity of these particular analyses, though striking, is not unique to them. Indeed, we will argue, cost-benefit analysis is so inherently flawed that if one scratches the apparently benign surface of any of its products, one finds the same kind of absurdity. But before launching into this critique, it will be useful first to establish exactly what cost-benefit analysis is, and why one might think it is a good idea. [...] [Conclusion] Two features of cost-benefit analysis distinguish it from other approaches to evaluating the advantages and disadvantages of environmentally protective regulations: the translation of lives, health, and the natural environment into monetary terms, and the discounting of harms to human health and the environment that are expected to occur in the future. These features of cost-benefit analysis make it a terrible way to make decisions about environmental protection, for both intrinsic and practical reasons. Nor is it useful to keep cost-benefit analysis around as a kind of regulatory tag-along, providing information that regulators may find "interesting" even if not decisive. Cost-benefit analysis is exceedingly time - and resource - intensive, and its flaws are so deep and so large that this time and these resources are wasted on it. Once a cost-benefit analysis is performed, its bottom line number offers an irresistible sound bite that inevitably drowns out more reasoned deliberation. Moreover, given the intrinsic conflict between cost-benefit analysis and the principles of fairness that animate, or should animate, our national policy toward protecting people from being hurt by other people, the results of cost-benefit analysis cannot simply be "given some weight" along with other factors, without undermining the fundamental equality of all citizens-rich and poor, young and old, healthy and sick. Cost-benefit analysis cannot overcome its fatal flaw: it is completely reliant on the impossible attempt to price the priceless values of life, health, nature, and the future. Better public policy decisions can be made without cost-benefit analysis, by combining the successes of traditional regulation with the best of the innovative and flexible approaches that have gained ground in recent years.
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Critiques of risk regulation rely pervasively on estimates of the costs of various federal regulations per life saved. As Professor Heinzerling illustrates in this Article, most of these estimates derive from a single source, a table prepared in the 1980s by an economist at the Office of Management and Budget, John Morrall. That table reports costs per life saved reaching hundreds of millions, even billions, of dollars. These oftcited estimates are, however, vastly higher than the agencies' own estimates of costs and benefits. The divergence in estimates stems from the fact that Morrall adjusted the agencies' figures by discounting future lives saved and, in many cases, greatly decreasing estimates of risk. Without these adjustments, Professor Heinzerling demonstrates, the costs per life saved of the allegedly costliest regulations drop, in virtually every case examined, to less than $5 million. This number compares favorably to currently cited estimates of the monetary value of a human life. Moreover, Morrall's calculations exclude many unquantified benefits of the regulations in question. An assessment of the cost-effectiveness of current risk regulation thus turns on one's opinions regarding discounting, risk assessment, and regulatory purposes. These in turn depend on one's views of the relative worth of lives saved today and lives saved in the future, the appropriate response to scientific uncertainty, and the relevance of unquantified benefits. As Professor Heinzerling argues, these matters involve choices among values about which reasonable people may disagree. Thus, instead of providing an objective basis for setting regulatory priorities and judging the wisdom of regulation, figures on costs per life saved embody the very normative judgments they have been thought to support.
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ABSTRACT The U.S. Office of Management and Budget introduced in 2003 a significant, new requirement for the treatment of uncertainty,in Regulatory Impact Analyses (RIAs) of proposed regulations, requiring agencies to perform a formal quantitative uncertainty assessment regarding aregulation’s benefits and costs if either is expected to reach $1 billion annually. Despite previous use in other contexts, such formal assessments ofuncertainty have rarely been employed in RIAs or other regulatory analyses. We describe how formal quantitative assessments of uncertainty — inparticular, Monte Carlo analyses — can be conducted, we examine the additional effort that would be required of public agencies in developing RIAs, and we assess how the resulting information can affect the evaluation of regulations. For illustrative purposes, we compare Monte Carlo analysis with methods ,typically used in RIAs to evaluate ,uncertainty in the ,context of economic,analyses carried out for the U.S. Environmental Protection Agency’s Nonroad Diesel Rule, which became effective in 2004. Keywords: regulation, benefit-cost analysis, uncertainty, Monte Carlo analysis JEL Classification: L510, K230, Q580 Words: 8,000 Jaffe is a Manager at Analysis Group, Inc.. Stavins is the Albert Pratt Professor of Business and Government, John
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This paper analyzes cost-benefit analysis from legal, economic, and philosophical perspectives. The traditional defense of cost-benefit analysis is that it maximizes a social welfare function that aggregates unweighted and unrestricted preferences. We follow many economists and philosophers who conclude that this defense is not persuasive. Cost-benefit analysis unavoidably depends on controversial distributive judgments; and the view that the government should maximize the satisfaction of unrestricted preferences is not plausible. However, we disagree with critics who argue that cost-benefit analysis produces morally irrelevant evaluations of projects and should be abandoned. On the contrary, cost-benefit analysis, suitably constrained, is consistent with a broad array of appealing normative commitments, and it is superior to alterative methods of project evaluation. It is a reasonable means to the end of maximizing overall welfare when preferences are undistorted or can be reconstructed. And it both exploits the benefits of agency specialization and constrains agencies that might otherwise evaluate projects improperly.
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There is a polarity in the literature as to whether companies do or do not postpone investment decisions in the light of regulatory uncertainty. In the case of flexible regulation characterized by a high degree and discontinuous resolution of uncertainty, we show that companies do not necessarily postpone investment decisions. We trace this observation back to three motivations: securing competitive resources, leveraging complementary resources, and alleviating institutional pressure. We connect these motivations to fundamental principles of the resource-based view and institutional theory and further show the existence of a regime where institutionally motivated and resource-based actions are not necessarily decoupled. We base our research on a case study covering 80 per cent of the German power generation industry which faces regulatory uncertainty from the European CO<sub>2</sub> Emission Trading Scheme. Copyright (c) Blackwell Publishing Ltd 2009.
This paper summarizes the findings of the authors' recent survey of 392 CFOs about the current practice of corporate finance, with main focus on the areas of capital budgeting and capital structure. The findings of the survey are predictable in some respects but surprising in others. For example, although the discounted cash flow method taught in our business schools is much more widely used as a project evaluation method than it was ten or 20 years ago, the popularity of the payback method continues despite shortcomings that have been pointed out for years. In setting capital structure policy, CFOs appear to place less emphasis on formal leverage targets that reflect the trade-off between the costs and benefits of debt than on “informal” criteria such as credit ratings and financial flexibility. And despite the efforts of academics to demonstrate that EPS dilution per se should be irrelevant to stock valuation, avoiding dilution of EPS was the most cited reason for companies reluctance to issue equity. But despite such apparent contradictions between theory and practice, finance theory does seem to be gaining ground. For example, large companies were much more likely than their smaller counterparts to use DCF and NPV techniques, while small firms still tended to rely heavily on the payback criterion. And a majority of the CFOs of the large companies said they had “strict” or “somewhat strict” target debt ratios, whereas only a third of small firms claimed to have such targets. What does the future hold? On the one hand, the authors suggest that we are likely to see greater corporate acceptance of certain aspects of financial theory, including the use of real options techniques for evaluating corporate investments. But we are also likely to see further modifications and refinements of the theory, particularly with respect to smaller companies that have limited access to capital markets.
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Nature is the international weekly journal of science: a magazine style journal that publishes full-length research papers in all disciplines of science, as well as News and Views, reviews, news, features, commentaries, web focuses and more, covering all branches of science and how science impacts upon all aspects of society and life.
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