4.2 The value of flexibility in decision-making

A standard cost-benefit approach to project evaluation recognises that capital devoted to one project cannot be used for other projects: that opportunity cost of capital is factored into the calculation. And the cost of capital highlights starkly that a benefit 10 years ahead is much less valuable than the same-sized benefit that can be achieved a year from now. However, an important limitation of standard cost-benefit analysis is that it is static. To the extent that it incorporates uncertainty about the future, it will do this by valuing different scenarios, but it contains no formal mechanism for incorporating the implications of the uncertainty that is reflected in those scenarios into the analysis.

In contrast to standard cost-benefit analysis, a prudent investor will incorporate into their investment analysis the fact that uncertainty about the future is pervasive, and that at any point in time the investor has the option to act today, or to delay the action until a future time and wait and see what happens in the meantime. Where uncertainty is pervasive, flexibility will be valuable. Much of the value of flexibility stems from the ability to avoid making large irreversible investments in projects that turn out to be not worthwhile.

When there is substantial uncertainty surrounding the outcome, an alternative to acting immediately can be to delay acting and instead invest resources in learning more about the outcome of particular actions.[6] For example, a roading project can be delayed while research is conducted to reduce the uncertainty surrounding the cost of building the road and/or the uncertainty surrounding demand for the road. If construction begins immediately, then the ability to exercise this so-called learning option is destroyed.

If the present value of benefits from a new road equals B and the present value of the required expenditure equals I, then the net payoff from building the road equals B - I. If the option value of waiting and learning more about the cost of construction equals W, then the payoff from waiting equals W. It is optimal to build the road immediately if and only if B - I is greater than W. Equivalently, B must be greater than I + W.[7] That is, immediate construction is optimal if and only if the benefits of the project, B, are greater than the total cost, I + W. The key insight here is that the cost of constructing the road immediately is the sum of the (present value of) the required capital expenditure and the learning option that is destroyed upon investment. In order for decision-making to result in an optimal allocation of resources, the cost of projects needs to incorporate the full opportunity cost—in this case, capital expenditure and the value of learning options destroyed by investment.

If a firm delays investment and then receives new information that indicates it would have regretted earlier investment (perhaps because demand is insufficient or new technology supporting a different approach to investment has emerged), then the decision to delay has allowed the firm to avoid incurring wasteful expenditure. In contrast, if it delays investment and then receives new information that indicates it would not have regretted earlier investment, then it still has the option to invest. That is, delaying investment does not prevent the firm from undertaking good investments, but it helps it to avoid making bad ones. This is an established result in investment theory—the so-called “bad news principle.”[8] The bad news principle requires that decisions be wholly or largely irreversible (such as in infrastructure), and that there be uncertainty about the future path of costs, technology or demand for the investment.

If the option value of waiting is ignored, irreversible capital investment proposals will consistently underestimate the costs of investment. The private sector incorporates in its analysis of investment the cost of real options destroyed (either through a formal analysis of the real options or “rules of thumb” such as the use of a higher cost of capital in the analysis), but ignoring the value of flexibility will also lead officials consistently to recommend public-sector investment when private-sector investors would wait.