Valuing Real Options by Spreadsheet: Parking Garage Case ... - MIT

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Valuing Real Options by Spreadsheet:Parking Garage Case ExampleRichard de Neufville, 1 L.M. ASCE, Stefan Scholtes, 2 and Tao Wang 3IntroductionA “real option” embodies flexibility in the development of a project. It represents a “right, but notan obligation” to take some course of action that may be advisable either if there is someunfortunate turn of events or some new opportunities. A “real option” thus represents either aform of insurance or a means to take advantage of a favorable situation. The use of real optionsoriginated in the field of finance (Myers, 1984) and has been developed for the use ofmanagement since the early 1990s (see for example Dixit and Pindyck, 1994; Trigeorgis, 1996;Amran and Kulatilaka, 1999; Copeland and Antikarov, 2001).Real options have more recently been applied to the design of infrastructure systems. Forexample, Leviakangas and Lahesmaa (2002) discuss their application to toll roads; and Ford et al.(2002) to strategic planning. Ho and Liu (2003) present a method for evaluating investments inconstruction technology; Zhao and Zheng (2003) provide an alternative approach and apply it toparking garages; Zhao, Sundararajan, and Tseng (2004) extend this work to highwaydevelopment; and de Weck, de Neufville and Chaize (2004) demonstrate how the use of realoptions could lead to major improvements in performance, on the order of 30%.However, real options have not been widely used in engineering practice. This is probably due tothe fact that the standard approaches to their analysis requires an understanding of financialtheory; advanced mathematical techniques (such as trinomial lattice and stochastic dynamic1 Professor of Civil and Environmental Engineering and of Engineering Systems, MIT, Cambridge,MA, 02139, U.S.A. (Corresponding author) Email: ardent@mit.edu2 Professor of Management Science, Judge Institute of Management, Cambridge University,Cambridge CB2 1AG, U.K. Email: s.scholtes@jims.cam.ac.uk3 Doctoral candidate, Engineering Systems Division, MIT, Cambridge, MA, 02139, U.S.A. Email:tao@mit.edu2
programming, Wang and de Neufville, 2004); and statistical data that are inaccessible to mostengineers. Moreover, even when practitioners are skilled in the use of the financial techniquesfor evaluating options, the results they produce are difficult to explain to the senior engineers andmanagers who are ultimately responsible for approving the configuration and design ofinfrastructure systems.To make the use of real options readily accessible to designers, this article proposes a simplespreadsheet model for estimating the value of real options in engineering systems. The modelhas three advantages compared to alternative procedures based on financial mathematics: ituses standard, readily available spreadsheet procedures; is based on data available in practice;and provides graphics that explain the results intuitively.Spreadsheet modelThis valuation of flexibility is based on standard discounted cash flow (DCF) analysis used toevaluate projects (see Riggs and West, 1986; de Neufville, 1990; White et al, 1998; DeGarmo etal, 2000). The process discounts future revenues and expenses to place them on a comparablebasis, typically the present. The sum of these discounted cash flows is the net present value(NPV). Engineers and managers regularly use computer-based spreadsheets, such as Excel®,to value projects.The process of estimating the value of real options using spreadsheets is simple and easy toexecute. Once the basic data have been placed in the spreadsheet, the calculations can be donein minutes. The authors have posted a version of the model at http://ardent.mit.edu/real_options.The process involves 3 steps:1. Set up the spreadsheet representing the most likely projections of future costs andrevenues of the project, and use the Data Table function to calculate its value for a rangeof design parameters to determine the optimum design for this deterministic case. The3
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