Valuing the Warranty Ceiling Clause on New Mexico Highway 44 Using a Binomial Lattice Model
Publication: Journal of Construction Engineering and Management
Volume 134, Issue 1
Abstract
In 1998 the New Mexico State Highway and Transportation Department (NMSHTD) agreed to pay $60 million for a 20-year pavement warranty on their Route 44 project (NM 44, now US 550). The warranty includes a ceiling clause that caps total expenditures at $110 million. As the first long-term highway warranty in the United States, the transaction set a controversial precedent that parties interested in innovative highway contracting, including other state department of transportations (DOTs), the USDOT, sureties, and contractors, view as a test case for evaluating pricing and cost-effectiveness. An interim audit report published by the State of New Mexico [Abbey (2004). Rep. to the Legislative Finance Committee, State Highway and Transportation Department, Santa Fe, N.M.] provides invaluable fiscal projections and challenges the cost effectiveness of the $60 million expenditure. This paper presents an independent analysis of the effectiveness of the warranty clauses. Based upon NMSHTD data, the analysis contends that $60 million was a fair cost of the 20-year pavement warranty at the time of acceptance if the expenditure ceiling is not considered. Furthermore, this paper argues that the ceiling on expenditure can be valuable. Using the real options approach, the paper evaluates the warranty ceiling clause on NM 44 and some policy suggestions are discussed.
Get full access to this article
View all available purchase options and get full access to this article.
Acknowledgments
The writers gratefully acknowledge the support for this research provided by the University Transportation Center for Alabama (UTCA) and the Alabama Contractors’ Fees Fund.
References
Abbey, D. (1999). “Review of statewide transportation improvement plan and related topics.” Rep. to the Legislative Finance Committee, State Highway and Transportation Department, Santa Fe, N.M.
Abbey, D. (2004). “New Mexico Department of Transportation update on state Highway 44/US 550.” Rep. to the Legislative Finance Committee, NMDOT, Santa Fe, N.M.
Amram, M., and Kulatilaka, N. (1999). Real options: Managing strategic investment in an uncertain world, Harvard Business School Press, Mass.
Cox, J., Ross, S., and Rubenstein, M. (1979). “Option pricing: A simplified approach.” J. Financ. Econ., 7, 87–106.
Cui, Q., Bayraktar, M. E., Hastak, M., and Minkarah, I. (2004). “Use of warranties on highway projects: A real option perspective.” J. Manage. Eng., 20(3), 118–125.
Federal Highway Administration (FHwA). (2000). “Data on selected GARVEE bond issuances for briefing on Atlantic Steel project.” Resource Center, ⟨http://www.fhwa.dot.gov/resourcecenter/teamfin_pubs2.htm⟩ (January 3, 2006).
Ford, D., Lander, D., and Voyer, J. (2002). “Real options approach to valuing strategic flexibility in uncertain construction projects.” Constr. Manage. Econom., 20(4), 343–351.
Garvin, M. J., and Cheah, Y. J. (2004). “Valuation techniques for infrastructure investment decisions.” Constr. Manage. Econom., 22(5), 373–383.
Ho, S. P., and Liu, L. Y. (2002). “An option pricing-based model for evaluating the financial viability of privatized infrastructure projects.” Constr. Manage. Econom., 20(2), 143–156.
Hull, J. C. (2000). Options, futures, and other derivatives, 4th Ed., Prentice-Hall, Upper Saddle River, N.J.
May, R., Palmer, W., and Valerio, M. (2003). “NM 44: A case history of long-term warranted performance.” Asph. Paving Technol., 72, 595–634.
Ng, F., Björnsson, H., and Chiu, S. (2003). “Valuing a price cap contract for material procurement as a real option.” Constr. Manage. Econom., 22(2), 141–150.
Trigeorgis, L. (1996). Real options: Managerial flexibility and strategy in resource allocation, MIT Press, Cambridge, Mass.
Yakowenko, J. (2002). “FHwA briefing: Special experimental projects, No. 14, innovative contracting.” ⟨http://www.fhwa.dot.gov/construction/washto02/sep14.htm⟩ (December 19, 2005).
Zhao, T., and Tseng, C.-L. (2003). “Valuing flexibility in infrastructure expansion.” J. Infrastruct. Syst., 9(3), 89–97.
Information & Authors
Information
Published In
Journal of Construction Engineering and Management
Volume 134 • Issue 1 • January 2008
Pages: 10 - 17
Copyright
© 2008 ASCE.
History
Received: Dec 28, 2006
Accepted: Feb 22, 2007
Published online: Jan 1, 2008
Published in print: Jan 2008
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.