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Volume Uncertainty in Construction Projects: a Real Options Approach

Author

Listed:
  • João Adelino Ribeiro

    (Faculdade de Economia, Universidade do Porto, Portugal)

  • Paulo Jorge Pereira

    (cef.up, Faculdade de Economia, Universidade do Porto, Portugal)

  • Elísio Brandão

    (Faculdade de Economia, Universidade do Porto, Portugal)

Abstract

The levels of uncertainty surrounding construction projects are particularly high and construction managers should be aware that adequately managing the effects of the different types of uncertainty may lead to an increase in the project’s final Net Present Value (NPV). The model proposed focus on the impact that a specific type of uncertainty - volume uncertainty - may produce in the project’s expected NPV. Volume uncertainty is present in most construction projects since managers do not know, during the bid preparation stage, the exact volume of work that will be executed during the project’s life cycle. Volume uncertainty leads to profit uncertainty and the model integrates a discrete-time stochastic variable, designated as “additional value”, i.e., the value that does not directly derive from the execution of the tasks specified in the bid documents, and which can only be quantified with precision by undertaking an incremental investment in human capital and technology. The model determines that, even only recurring to the skills of their own experienced staff, contractors will produce a more competitive bid, provided that the expected amount for the additional profit is greater than zero. However, construction managers often need to hire specialized firms and highly skilled professionals in order to quantify, with accuracy, the expected amount of additional value and, hence, the precise impact of such additional value in the optimal bidding price. Based on the option to sign the contract and to perform the project by the selected bidder, identified and evaluated by Ribeiro et al. (2013), the model’s outcome is the threshold value for this incremental investment. A decision rule is then reached: construction managers should invest in human capital and technology provided that the cost of such incremental investment does not exceed the predetermined threshold value. The model also proposes new forms of reaching the optimal bidding price, considering solely the effects of the non-incremental investment and also considering the possible impact of the incremental investment in human capital and technology.

Suggested Citation

  • João Adelino Ribeiro & Paulo Jorge Pereira & Elísio Brandão, 2013. "Volume Uncertainty in Construction Projects: a Real Options Approach," CEF.UP Working Papers 1309, Universidade do Porto, Faculdade de Economia do Porto.
    • Handle: RePEc:por:cetedp:1309
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    References listed on IDEAS

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    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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