Option Value of Contingent Finance Support in Transportation Public–Private Partnership Projects

Abstract

Uncertainties about construction cost and operational revenues are two major risks in transportation public–private partnership (P3) projects. These uncertainties put projects at risk of being unable to fulfill annual debt repayment obligations. When a project generates insufficient cash flow to service the debt in a certain year, it normally has to go for short-term financing by borrowing short-term loans. With the help of revenue risk-sharing mechanisms, supported projects may be able to get rid of unexpected interest disbursement. The objectives of this paper are twofold: ( 1 ) evaluate the refinancing cost of P3 highway projects caused by cash flow shortage; and ( 2 ) critically examine the option value of contingent finance support and compare it with the option value of minimum revenue guarantee on saving refinancing cost for debt repayment. An integrated real options valuation model is created that utilizes utility method for pricing the technical project risk (e.g., construction cost overruns), and utilizes a risk-neutral option pricing method for pricing the market risk (e.g., future traffic). The proposed model has good transferability in relation to involving various risk factors, no matter technical risks or market risks, random variables or random processes. The proposed model helps stakeholders better understand and measure the burden of assuring annual debt repayment under uncertain cash flow. The stakeholders can use the proposed model to evaluate the value of the revenue risk-sharing mechanisms on reducing refinancing cost.