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Reaching an Optimal Mark-Up Bid through the Valuation of the Option to Sign the Contract by the Successful Bidder

Author

Listed:
  • João Adelino Ribeiro

    (Faculdade de Economia, Universidade do Porto, Portugal)

  • Paulo Jorge Pereira

    (CEF.UP, Faculdade de Economia, Universidade do Porto, Portugal)

  • Elísio Brandão

    (Faculdade de Economia, Universidade do Porto, Portugal)

Abstract

This paper aims to establish a support decision model by which an optimal mark-up (profit margin) in the context of a bidding process is reached through the valuation of the option to sign the contract assuming the contractor is chosen to perform the project. The price included in the bid proposal remains unchanged from the moment the offer is sealed until the contractor has the right - but not the obligation - to sign the contract, whereas construction costs vary stochastically throughout the period. Contractors should only sign the contract if the construction costs, at that moment, are lower than the price previously defined. We evaluate the option using an adapted version of the Margrabe (1978) exchange option formula and we also assign a probability of winning the bid for each profit margin using a function that respects the inverse relationship between these two variables. We conclude that to the higher value of the option - weighted by the probability of winning the contract - corresponds the optimal mark-up bid. Finally, we consider the existence of penalty costs which makes the model more efficient in explaining what actually takes place in some legal environments; we then conclude that the option to sign the contract and, therefore, the optimal mark-up bid are affected by their existence.

Suggested Citation

  • João Adelino Ribeiro & Paulo Jorge Pereira & Elísio Brandão, 2012. "Reaching an Optimal Mark-Up Bid through the Valuation of the Option to Sign the Contract by the Successful Bidder," CEF.UP Working Papers 1201, Universidade do Porto, Faculdade de Economia do Porto.
    • Handle: RePEc:por:cetedp:1201
    as

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    References listed on IDEAS

    as
    1. R. David Espinoza, 2011. "Contingency estimating using option pricing theory: closing the gap between theory and practice," Construction Management and Economics, Taylor & Francis Journals, vol. 29(9), pages 913-927, July.
    2. Budi Hartono & Chee Meng Yap, 2011. "Understanding risky bidding: a prospect-contingent perspective," Construction Management and Economics, Taylor & Francis Journals, vol. 29(6), pages 579-593.
    3. Hyung Jin Kim & Kenneth Reinschmidt, 2006. "A dynamic competition model for construction contractors," Construction Management and Economics, Taylor & Francis Journals, vol. 24(9), pages 955-965.
    4. Mahdi Mattar & Charles Cheah, 2006. "Valuing large engineering projects under uncertainty: private risk effects and real options," Construction Management and Economics, Taylor & Francis Journals, vol. 24(8), pages 847-860.
    5. C. Y. Yiu & C. S. Tam, 2006. "Rational under-pricing in bidding strategy: a real options model," Construction Management and Economics, Taylor & Francis Journals, vol. 24(5), pages 475-484.
    6. M Skitmore, 2002. "Predicting the probability of winning sealed bid auctions: a comparison of models," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 53(1), pages 47-56, January.
    7. Chung-Li Tseng & Tong Zhao & Chung Fu, 2009. "Contingency estimation using a real options approach," Construction Management and Economics, Taylor & Francis Journals, vol. 27(11), pages 1073-1087.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Optimal bidding; real options; construction projects; price determination;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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