Flexibility to switch project size: A real option application for photovoltaic investment valuation

Solar energy projects contribute to smart city goals by reducing pollution and assisting cities to become self-sustaining. However, these projects, characterised by their sequential nature, require a huge amount of irreversible investment, especially in the case of large-scale photovoltaic projects (MW). This aspect could make solar projects unattractive for potential investors. To mitigate the risks of financial losses the investor could invest in small-scale solar projects and switch to large-scale investment projects only if the market conditions are favourable. This paper aims to embed this managerial flexibility of changing investment size during the project lifetime into its valuation. To accomplish this, we use a compound options approach with a switch and call options models to reliably price these projects by considering their riskiness and, their stochastic and multi-stage nature. We also consider the determination of the optimal investment time like an American option. We also propose a case study that shows that considering the managerial flexibility value in the project valuation makes them attractive and financially profitable.