Impact of irreversibility and uncertainty on the timing of infrastructure projects

Abstract

This paper argues that because of the irreversibility and uncertainty associated with Build - Operate - Transfer (BOT) infrastructure projects, their financial evaluation should also routinely include the determination of the value of the option to defer the construction start-up. This ensures that project viability is comprehensively assessed before any revenue or loan guarantees are considered by project sponsors to support the project. This paper shows that the framework can be used even in the context of the intuitive binomial lattice model. This requires estimating volatility directly from the evolution of the net operating income while accounting for the correlation between the revenue and costs functions. This approach ensures that the uncertainties usually associated with toll revenues, in particular, are thoroughly investigated and their impact on project viability is thoroughly assessed. This paper illustrates the usefulness of the framework with data from an actual (BOT) toll road project. The results show that by postponing the project for a couple of years the project turns out to be viable, whereas it was not without the deferral. The evaluation approach proposed therefore provides a better framework for determining when and the extent of government financial support, if any, that may be needed to support a BOT project on the basis of project economics. The analysis may also be applicable to private sector investment projects, which are characterized by irreversibility and a high rate of uncertainty.