Valuing large engineering projects under uncertainty: private risk effects and real options
In all large engineering projects, valuation constitutes an important step during the initial stage as each stakeholder assesses the prospect of his or her investment. The complexity of valuation increases dramatically in the face of uncertainty especially when the risks are dynamic and stochastic in nature. The usual classification in finance theory divides risks into either market or unique. In this research, a new notion of private risk is introduced. A private risk may either be correlated with the market or be unique, but in addition it represents a substantial portion of an investor's wealth and is not tradable due to agency costs or other strategic reasons. The principles of pricing would differ according to the treatment of these different types of risks. Methods that are currently in vogue for pricing private risks are first evaluated, followed by a study of the effect of private risks in real option problems. Through a classic oil and gas exploration and development example, it is demonstrated that the methods chosen for pricing private risks can lead to decisively different real option values, exercise strategies and development policies. Effectively, the difference in real option values can be interpreted as a form of private risk premium.
Volume (Year): 24 (2006)
Issue (Month): 8 ()
|Contact details of provider:|| Web page: http://www.tandfonline.com/RCME20|
|Order Information:||Web: http://www.tandfonline.com/pricing/journal/RCME20|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Jensen, Michael C. & Ruback, Richard S., 1983. "The market for corporate control : The scientific evidence," Journal of Financial Economics, Elsevier, vol. 11(1-4), pages 5-50, April.
- Eric Pickles & James L. Smith, 1993. "Petroleum Property Valuation: A Binomial Lattice Implementation of Option Pricing Theory," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2), pages 1-26.
- James E. Smith & Robert F. Nau, 1995. "Valuing Risky Projects: Option Pricing Theory and Decision Analysis," Management Science, INFORMS, vol. 41(5), pages 795-816, May.
- Lander, Diane M. & Pinches, George E., 1998. "Challenges to the Practical Implementation of Modeling and Valuing Real Options," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 537-567.
- David Ford & Diane Lander & John Voyer, 2002. "A real options approach to valuing strategic flexibility in uncertain construction projects," Construction Management and Economics, Taylor & Francis Journals, vol. 20(4), pages 343-351.
- Saman Majd & Robert S. Pindyck, 1985.
"Time to Build, Option Value, and Investment Decisions,"
NBER Working Papers
1654, National Bureau of Economic Research, Inc.
- Majd, Saman & Pindyck, Robert S., 1987. "Time to build, option value, and investment decisions," Journal of Financial Economics, Elsevier, vol. 18(1), pages 7-27, March.
- Michael R. Walls & James S. Dyer, 1996. "Risk Propensity and Firm Performance: A Study of the Petroleum Exploration Industry," Management Science, INFORMS, vol. 42(7), pages 1004-1021, July.
- 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.
- Greenwald, Bruce C & Stiglitz, Joseph E, 1990.
"Asymmetric Information and the New Theory of the Firm: Financial Constraints and Risk Behavior,"
American Economic Review,
American Economic Association, vol. 80(2), pages 160-65, May.
- Bruce C. Greenwald & Joseph E. Stiglitz, 1990. "Asymmetric Information and the New Theory of the Firm: Financial Constraints and Risk Behavior," NBER Working Papers 3359, National Bureau of Economic Research, Inc.
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 479-508, August.
- Michael Garvin & Charles Cheah, 2004. "Valuation techniques for infrastructure investment decisions," Construction Management and Economics, Taylor & Francis Journals, vol. 22(4), pages 373-383.
- Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
- Ronald A. Howard, 1988. "Decision Analysis: Practice and Promise," Management Science, INFORMS, vol. 34(6), pages 679-695, June.
When requesting a correction, please mention this item's handle: RePEc:taf:conmgt:v:24:y:2006:i:8:p:847-860. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael McNulty)
If references are entirely missing, you can add them using this form.