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Valuing governmental support in infrastructure projects as real options using Monte Carlo simulation

Listed author(s):
  • Charles Cheah
  • Jicai Liu
Registered author(s):

    In Build-Operate-Transfer (BOT) infrastructure projects, host governments often provide subsidies, guarantees or alternative forms of support as incentives to attract private sector participation. A guaranteed level of minimum revenue, for example, can be specially designed to alleviate the concern of demand risk. Although researchers have generally acknowledged the significance of subsidies and guarantees leading toward successful negotiation, there is a lack of attempt to evaluate these concessions quantitatively. Without a deeper understanding of the value of these concessions, risk and reward may not be equitably matched in the proposed terms and arrangements. In this paper, relevant elements of a contractual package are treated as a form of real options. A proposition is put forward to incorporate the value of such options into the negotiation framework. By relying on simplifying assumptions on risk preferences, these options can be evaluated using Monte Carlo simulation of a discounted cash flow (DCF) model. The methodology is applied to the case of the Malaysia-Singapore Second Crossing, which shows that the value of a guarantee can indeed be significant relative to the basic net present value. The case study also highlights other aspects of flexibility in the design and execution of a project.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/01446190500435572
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    Article provided by Taylor & Francis Journals in its journal Construction Management and Economics.

    Volume (Year): 24 (2006)
    Issue (Month): 5 ()
    Pages: 545-554

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    Handle: RePEc:taf:conmgt:v:24:y:2006:i:5:p:545-554
    DOI: 10.1080/01446190500435572
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    1. Christopher M. Lewis & Ashoka Mody, 1998. "Risk Management Systems for Contingent Infrastructure Liabilities : Applications to Improve Contract Design and Monitoring," World Bank Other Operational Studies 11538, The World Bank.
    2. Klein, Michael, 1997. "Managing guarantee programs in support of infrastructure investment," Policy Research Working Paper Series 1812, The World Bank.
    3. Michael Garvin & Charles Cheah, 2004. "Valuation techniques for infrastructure investment decisions," Construction Management and Economics, Taylor & Francis Journals, vol. 22(4), pages 373-383.
    4. S. Ping Ho & Liang Liu, 2002. "An option pricing-based model for evaluating the financial viability of privatized infrastructure projects," Construction Management and Economics, Taylor & Francis Journals, vol. 20(2), pages 143-156.
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