A real options model for the financial valuation of infrastructure systems under uncertainty

Many governments confront a gap between the rising demand for transportation infrastructure systems and the financial resources that they have historically used for meeting this demand. They are seeking innovative solutions to close this growing gap between the cost of much needed transportation infrastructure systems and their available financial resources. The Public-Private Partnership (PPP) model is growingly adopted by governments in order to achieve these objectives. Build-Operate-Transfer (BOT) is a form of PPP model that is commonly used for financing, development, and operations of transportation projects. In a BOT project, the private partner, known as the concessionaire, has the responsibility to finance, design, build and operate a facility for a specific period of time under a concession contract. The concessionaire typically raises return on its investment through the user charges. Moreover, when it comes to the valuation of real options in transportation projects, it is typically impossible to estimate the correct risk-adjusted discount rate that reflects the market risks, unique project risks and asymmetric benefit patterns of options. The existing literature on the application of real options in transportation infrastructure management does not address this problem. Due to these limitations, the application of current real options models to the valuation BOT investments under traffic demand uncertainty does not lead to the determination of market value of real options. Furthermore, the current real options models do not determine the concessionaire’s financial risk profile under traffic demand uncertainty. Finally, the current models cannot characterize the impact of Minimum Revenue Guarantee and Traffic Revenue Cap options on the concessionaire’s financial risk profile. The primary objective of this research is to apply the real options theory in order to explicitly price Minimum Revenue Guarantee and Traffic Revenue Cap under the uncertainty about future traffic demand. This research objective is achieved through the creation of an investment valuation model for BOT transportation projects under traffic demand uncertainty. This model characterizes the long-term traffic demand uncertainty in BOT projects and determines the concessionaire’s financial risk profile under uncertainty about future traffic demand. Moreover, it utilizes a novel method for estimating the project volatility for real options analysis. Further, the model uses a market-based option pricing approach to determine the value of Minimum Revenue Guarantee and Traffic Revenue Cap options. Finally it presents the appropriate procedure for characterizing the impact of Minimum Revenue Guarantee and Traffic Revenue Cap options on the concessionaire’s financial risk profile. In order to illustrate the proposed model and highlight its capabilities of the model presented in this research, it is applied to the Incheon International Airport Highway (IIAH) project in the Republic of Korea. This research contributes to the body of knowledge on the application of real options in transportation infrastructure management. It presents an approach that combines Monte Carlo simulation and the stochastic processes, and can be used for estimating the project volatility. Moreover, it presents a market-based risk-neutral option pricing approach in order to determine the fair value of Minimum Revenue Guarantee and Traffic Revenue Cap mechanisms in BOT projects. The proposed model can help public and private sectors better analyze and understand the financial risk of BOT projects under traffic demand uncertainty. The private sector can use this model to make better entry decisions to BOT highway projects considering their expectations about the costs and risks of the project as well as the level of revenue guarantee provided by the government. The government can use this model to identify the appropriate Minimum Revenue Guarantee and Traffic Revenue Cap thresholds that encourage the private investments without compromising its futu e budgetary strength. (Abstract shortened by UMI. )