Evaluating Demand Guarantee for PPP Projects by Real-Option Pricing

Public–private partnerships (PPPs) have been widely used in infrastructure development across the world. However, the high level of market uncertainty in many projects might bring financial risks to the private sector. Hence, it is a common practice for hosting governments to offer demand guarantee in order to better alleviate financial risks and attract the private sector. Accurate evaluation of demand guarantee is therefore beneficial to both the public and private sectors. Free cash flow to equity (FCFE) is chosen as a criterion to assess the value of a PPP project with the discounted cash flow method. The Monte Carlo simulation is used to assess the value of a compound option (a minimum demand guarantee and a maximum demand ceiling) based on the real-option theory. Using sensitivity analysis, this paper also discusses how the combination of demand volatility and guarantee extent will influence the real option value of a PPP project and the risk of bankruptcy of the associate project company.