Options, uncertainty and sunk costs:

Abstract

In a real-option model of land conversion incorporating return uncertainty and sunk costs, optimal conversion thresholds are significantly higher than those from expected net present value models not accounting for these factors. Empirical tests of conversion from agriculture to forest suggest that landowners value the option to convert when making conversion decisions. Higher uncertainty in returns to all potential uses and lower correlation between shocks to agricultural and forest returns decreases the likelihood of conversion. Estimates indicate a significant impact on conversion decisions, with approximations of option values ranging from 7% to 81% of the expected value of the land asset.