A Real Option Framework for Evaluating Infrastructure Investments

Abstract

This paper outlines the use of real options techniques to value infrastructure projects as a remedy to this shortcoming of discounted cash flow (DCF) analysis, which fails to adequately capture managerial flexibility to adapt and -revise later decisions in response to unexpected market conditions. We focus on investments as a way to procure operational capabilities that are more broadly defined than the traditional scope of investments. Through identifying such options, managers can determine an investment strategy that is better aligned with the overall corporate goals than by taking a project-by-project view. We use simulations to illustrate the implementation of our framework. Our results show the significant advantages over conventional DCF methods as a project evaluation too l. Even more importantly, we show the how the appropriate choice of investments can be used to manage the risk profile of projects.