4.4 Quantifying the value of flexibility
There is now an extensive academic and practitioner literature setting out rigorous methods for estimating the value of flexibility and using the estimated values to inform decision-making.[12] The existing literature mainly, but not exclusively, looks at this from a corporate perspective, so that the decision-maker is a manager who maximizes the present value of the flow of surplus received by a firm's owners. As we explain below, this approach needs to be modified for public-sector project evaluation, where the ultimate objective is to maximize the present value of the flow of total surplus.
In principle, real options analysis is implemented by calculating the present value of the flow of a suitable “net benefit function” for each possible policy that can be adopted by the decision-maker. Of course, there are a very large number of possible policies in all but the simplest multi-decision problems, so in practice dynamic programming is used instead. This technique breaks a complicated multi-period optimization problem into a sequence of simpler two-period optimization problems. Provided this technique is implemented correctly, it yields exactly the same outcome as the more primitive approach of evaluating each possible policy in turn. Furthermore, in many applications the information requirements are not much more stringent than static cost-benefit analysis even though cost-benefit analysis has real limitations in considering risk by comparison with real options analysis.[13]
Even in straightforward commercial operations—where the costs might be clear, and the interests of the owner are also clear—cost-benefit analysis is not always easy. In public-sector projects where direct price signals are often unavailable, the challenges are even greater. But accepting that such analysis is difficult does not change the importance of doing it well, including testing and evaluating credible alternative scenarios, and exposing the analysis and assumptions as far as possible to public scrutiny.
Notes
- [12]See, for example, Dixit and Pindyck (1994), Copeland and Antikarov (2003), and Guthrie (2009a).
- [13]For example, Guthrie (2009b) demonstrates the real options analysis of a multi-stage commercial real estate project that uses only the inputs into a static discounted cash flow analysis of the problem, plus an estimate of the volatility of property prices.
