Bidding with Options Real

Privatization of Real Options

Enrico Pennings*

Erasmus University Rotterdam and Tinbergen Institute

Abstract

This paper examines the government’s sale of a real option in a simple setting without information asymmetries but with uncertainty surrounding the value of the asset. It is shown that requiring a combination of pledged investments and upfront cash payment when privatizing the option to invest generates less revenue for the government than a cash only payment. Compulsory investments in addition to the upfront payment or retained government shareholding, however, can increase the government’s revenue.

Key Words: Privatization, Real Options

JEL-Codes: P21, G13, G31, D92

* Erasmus University Rotterdam

Applied Economics H13-31

Burg. Oudlaan 50

3062PA Rotterdam, Netherlands

E-Mail: Pennings@few.eur.nl

Phone: +31 10 4082166

Fax: +31 10 4089141

1. Introduction

Privatization, the process of government divestiture of its holdings in state-owned companies, has received enormous attention by both scholars and policy makers in order to determine its effect on both individual companies and on governments (Megginson and Netter, 2001). Auctions are generally employed for the sale of a publicly held asset with unknown value for two reasons. First, it is believed that private firms can make more efficient use of an asset than a government can. Second, governments are concerned with maximizing the revenues from privatization (Lopez-de-Silanes, 1997). An auction is generally perceived as an efficient instrument to allocate a former state owned firm to the firm with the highest valuation and to extract as much revenue as possible (Schmidt and Schnitzer, 1997).[1]

Though some governments opt for gradual transitions to market economies with restructuring actions prior to privatization, almost all transition governments decide to rapidly privatize through a so-called big bang approach (Svejnar, 2002). Not only legal systems and...