A Real Options Approach to the Valuation of a Forestry Investment

The theory of real options is used to model the optimal tree harvesting decision. The value of the option to harvest is estimated using a dynamic programming approach and a general numerical solution technique suitable for any type of stochastic process for prices. The conditions under which the optimal harvest time is independent of price are examined. In addition, the impact of assuming future lumber prices are mean reverting is considered. It is found that option value and optimal cutting time are significantly different under the mean reversion assumption compared to geometric Brownian motion.