Valuing governmental support in infrastructure projects as real options using Monte Carlo simulation

Abstract

In Build-Operate-Transfer (BOT) infrastructure projects, host governments often provide subsidies, guarantees or alternative forms of support as incentives to attract private sector participation. A guaranteed level of minimum revenue, for example, can be specially designed to alleviate the concern of demand risk. Although researchers have generally acknowledged the significance of subsidies and guarantees leading toward successful negotiation, there is a lack of attempt to evaluate these concessions quantitatively. Without a deeper understanding of the value of these concessions, risk and reward may not be equitably matched in the proposed terms and arrangements. In this paper, relevant elements of a contractual package are treated as a form of real options. A proposition is put forward to incorporate the value of such options into the negotiation framework. By relying on simplifying assumptions on risk preferences, these options can be evaluated using Monte Carlo simulation of a discounted cash flow (DCF) model. The methodology is applied to the case of the Malaysia-Singapore Second Crossing, which shows that the value of a guarantee can indeed be significant relative to the basic net present value. The case study also highlights other aspects of flexibility in the design and execution of a project.Build-operate-transfer, concessions, infrastructure projects, negotiation, real option,

Balancing Public and Private Interests Through Optimization of Concession Agreement Design for User-Pay PPP Projects

“…It should be large enough to make PPP projects financially feasible in order to attract potential private partners (Song et al 2015). And it should also be frugal enough to avoid public's accusations of misuse or waste of public funds (Cheah, Liu 2006). In a sense, the financial subsidy provided by government can be regarded as a risk-mitigating method that reduces the adverse effects of future project risks taken by private sectors (Takashima et al 2010).…”

Appraisal of Combined Agreements in Bot Project Finance: Focused on Minimum Revenue Guarantee and Revenue Cap Agreements

“…Conversely, if the project revenue is excessively surpassing the initially pre-determined level agreed on, in turn, the developer can enjoy the surplus way over it must deserve, the government should have a way to ask claim for excessive benefit so as to quit or mitigate averse situations of the revenue exploitation. This practice is called RCP agreement that stipulates the payment from the BOT developer to the government (Cheah and Liu, 2006). By nature, the exercise of both of the MRG and RCP agreements relies on the specific conditions of whether or not the projected project revenue is higher than the realized project revenue.…”

“…Otherwise, the government should compensate for the revenue shortfall by paying the BOT developer. As an MRG value, the government's obligation to pay in each year i, SF i , would depend on the relative value between projected cash flow at year i, CF ip , and realized cash flow at year i, CF ir , as shown in Equation (7) (Cheah and Liu, 2006). Where, FCF e is free cash flow on equity at year i.…”

“…The combined effect of both of "uncertainty" and "managerial flexibility" may generate an asymmetric payoff condition called "contingent claim" where the project's revenue drastically shift and the fact one of the most popular capital budgeting theories, the NPV (Net Present Value) analysis, is limited to assess the value change caused by these asymmetric payoffs makes people seek alternations to resolve this issue. Among various asymmetric payoffs take place in a BOT project, the MRG (Minimum Revenue Guarantee) and RCP (Revenue Cap) agreements are regarded as the most representative "risk-reward" concept by being complementary applied in a BOT project (Cheah and Liu, 2006;Jun, 2008). The MRG agreement as a kind of incentive system is used to address the concerns of the private sector and to attract investor's participation in financing the project while RCP agreement is applied to protect the government from the developer's revenue exploitation in a BOT project.…”

“…The MRG agreement as a kind of incentive system is used to address the concerns of the private sector and to attract investor's participation in financing the project while RCP agreement is applied to protect the government from the developer's revenue exploitation in a BOT project. Although the MRG and RCP agreements are often chosen in BOT projects by both of the government and the BOT developer, the financial impact of these agreements are not well identified because the NPV analysis is not proper to evaluate these contingent claims (Cheah and Liu, 2006;Jun, 2008). However, it is fortune to have an effective alternation, the option pricing theory, in assessing the complexly combined asymmetric payoffs in real assets (Amram and Kulatilaka, 1999;Insley and Wirjanto, 2006).…”