Volume 39, Issue 6 (November 2011)
The Valuation and Strategy of Foreign Operations Under Stochastic Price: A Real Options Model
Many multinational firms are facing diminishing profit margins in their home countries and, as a result, may move their manufacturing facilities to foreign countries to seek the benefits of lower labor costs and tax rates. Inspired by the real option models of Moon (2010) and Wu (2010), we propose a framework to explore how the fluctuations of price, cost reduction, and tax benefit factors affect the timing and the valuation of foreign investments. The sensitivity towards corporate value (real option value) and price threshold is then analyzed in illustrations. The results indicate that price drift and price volatility have opposing effects on corporate value and price threshold. In addition, the effects of tax and cost reduction factors on price threshold depend on the range of price elasticity in the demand. This study confirms that multinational firms would always seek domestic or foreign investment opportunities with relatively lower costs, tax rates, and reduced market risks as they relate to profit maximization in a global setting. Finally, this work suggests that the decision rules for the optimal entry of foreign operations significantly depend on the price elasticity of demand.