Valuing Flexibility in Infrastructure Expansion
Publication: Journal of Infrastructure Systems
Volume 9, Issue 3
Abstract
Infrastructure facilities are generally heavy, fixed, and normally irreversible once construction has been completed. As existing facilities, they may confront economic competition of an increased space demand and the need for future expansion. Due to economic-based irreversibility, the expansion of a constructed facility requires the foundation and, to a lesser degree, columns to be enhanced and options for expansion to be accounted for at the very beginning of construction. Enhancing the foundation and columns represents an up-front cost, but has a return in flexibility for future expansion. This trade-off can be viewed as an investment problem, in that a premium has to be paid first for an option that can be exercised later. A model of the foundations versus flexibility trade-off enables the competing options to be optimized by balancing the expected profits that may arise from future expansion, i.e., the value of flexibility, and the cost of enhancing the foundation. Use of the model is demonstrated for the construction of a public parking garage, with the optimal foundation size determined. The evolution of parking demand is modeled with a trinomial lattice. Stochastic dynamic programming is used to determine the optimal expansion process. A model that does not consider the value of flexibility is compared with two value-flexible models. The value of flexibility in this case study is so significant that failure to account for flexibility is not economical. Valuation modeling such as discounted cash flow analysis with uncertainty modeling is important to capitalize on the worth of flexibility.
Get full access to this article
View all available purchase options and get full access to this article.
References
Bailey, N. T. J. (1964). The elements of stochastic processes with applications to the natural sciences, Wiley, New York.
Copeland, T. E., Koller, T., and Murrin, J. (1990). Valuation: Measuring and managing the value of companies, Wiley, New York.
De Neufville, R. (1990). Applied systems analysis, McGraw-Hill, New York.
Dixit, A. K., and Pindyck, R. S. (1993). Investment under uncertainty, Princeton University, Princeton, N.J.
Fine, C. H., and Freund, R. M.(1990). “Optimal investment in product-flexible manufacturing capacity.” Manage. Sci., 36(4), 449–466.
Ford, D. N., Lander, D. M., and Voyer, J. J.(2002). “A real options approach to valuing strategic flexibility in uncertain construction projects.” Constr. Manage. Econom., 20, 343–351.
Ho, S. P., and Liu, L. Y.(2003). “How to evaluate and invest in emerging A/E/C technologies under uncertainty.” J. Constr. Eng. Manage., 129(1), 16–24.
Hull, J. C. (1999). Options, futures, and other derivatives, 4th Ed., Prentice-Hall, Upper Saddle River, N.J.
Hull, J. C., and White, A.(1993). “One-factor interest-rate models and the valuation of interest-rate derivatives securities.” J. Financial Quant. Anal., 28(2), 235–254.
Kulatilaka, N.(1993). “The value of flexibility: The case of a dual-fuel industrial steam boiler.” Financial Manage., 22(3), 271–279.
Kumar, R. L.(1995). “An options view of investments in expansion-flexible manufacturing systems.” Int. J. Prod. Econ., 38(2-3), 281–291.
Leviäkangas, P., and Lähesmaa, J.(2002). “Profitability evaluation of intelligent transport system investments.” J. Transp. Eng., 128(3), 276–286.
Longstaff, F. A., and Schwartz, E. S.(2001). “Valuing American options by simulation: A simple least-squares approach.” Rev. Financial Stud., 14(1), 112–147.
Luenberger, D. G. (1998). Investment science, Oxford University Press, New York.
Newell, G. F. (1982). Applications of queueing theory, 2nd Ed., Chapman & Hall, London.
Trigeorgis, L. (1996). Real options: Managerial flexibility and strategy in resource allocation, MIT Press, Cambridge, Mass.
Tseng, C. L. (2001). “Chapter 7: A stochastic model for price-based unit commitment problem and its applications on short-term generation asset valuation.” The next generation of unit commitment models, B. Hobbs, M. Rothkopf, R. O’Neill, and H.-P. Chao, eds., Kluwer Academic, Boston.
Tseng, C. L., and Barz, G.(2002). “Short-term generation asset valuation: A real options approach.” Oper. Res., 50(2), 297–310.
Information & Authors
Information
Published In
Journal of Infrastructure Systems
Volume 9 • Issue 3 • September 2003
Pages: 89 - 97
Copyright
Copyright © 2003 American Society of Civil Engineers.
History
Received: Mar 2, 2002
Accepted: Feb 21, 2003
Published online: Aug 15, 2003
Published in print: Sep 2003
Authors
Metrics & Citations
Metrics
Citations
Download citation
If you have the appropriate software installed, you can download article citation data to the citation manager of your choice. Simply select your manager software from the list below and click Download.