The optimal timber rotation: An option value approach

Abstract

Previous analyses of the timber rotation problem under price uncertainty find that timber owners can increase the expected values of their stands by using a reservation price policy that exploits stochastic variations in prices. This result is found when the process governing prices is stationary and with nonstationary prices when there are fixed costs. This paper highlights the rote of option values in influencing the optimal timing of harvests. In this context, the option value is a premium over the expected net present value of a timber stand reflecting the opportunity cost of harvesting now and foregoing the option to delay harvest until information on future stand values is revealed. With stationary prices, option values arise from two sources of forthcoming information: the level of the stumpage price relative to the long-term mean and the stand value relative to fixed costs. With nonstationary prices, option values are associated only with the latter information. This paper demonstrates analytically that reservation price policies act as a mechanism for incorporating the option value into the calculus of the optimal rotation length. Numerical simulations provide further insights into the effects of option values on rotation lengths, expected stand values, and reservation prices.