Using Real Option Valuation Theory to Measure Benefits From Uncertain Costs Reductions

Carlos Alexandre C. de Abreu1 & J.P. Barros Neto2

1Researcher, Department of Structural Engineering and Civil Constructions, Ceará Federal University; Brazil. Phone +55 85 33969607 (30); calexandreabreu@yahoo.com.br
2Professor, Department of Structural Engineering and Civil Constructions, Ceará Federal University; Brazil. Phone +55 85 33669600; jpbarros@ufc.br

Abstract

The aim of this paper is to make an investment evaluation using a Real Option model and demonstrate the differences in investment decision – making process using traditional and Real Option valuation in a construction project. The main objective is to show how the incorporation of cost uncertainty in the economic analysis influences the final result of the evaluation. Financial data of cash flows from a residential building project before construction and other market data are used as inputs for the economic analysis of the project. First we estimate the project’s value using traditional valuation indicator Net Present Value (NPV) with no cost reduction. After that we estimate the NPV simulating possible costs reductions resulting from better internal processes towards a lean construction. The same financial and market data used to estimate the NPV are used in the Real Option Valuation model as inputs. The model’s uncertain variable is the total operational costs which will be considered a random variable governed by a stochastic process. Other variables as income, taxes and market variables remain deterministic in the model.

Keywords

economic evaluation, uncertainty, real options, cost reduction, lean construction

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Reference

Abreu, C.A.C.D. & Neto, J.B. 2008, 'Using Real Option Valuation Theory to Measure Benefits From Uncertain Costs Reductions' In:, Tzortzopoulos, P. & Kagioglou, M., 16th Annual Conference of the International Group for Lean Construction. Manchester, UK, 16-18 Jul 2008. pp 567-576

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