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The Long and Winding Road: Valuing Investment under Construction Uncertainty

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  • Jacco J.J. Thijssen

Abstract

This paper presents a model of investment in projects that are characterized by (i) uncertainty over both the construction costs and revenues, and (ii) revenues that accrue only after construction is completed. Both processes are modeled as spectrally negative Levy jump-diffusions. The optimal stopping problem that determines the value of the project is solved under fairly general assumptions. It is found that the threshold for the benefit-to-cost ratio (BCR) beyond which investment is optimal is higher than when investment costs are sunk and upfront. In addition, the current value of the BCR decreases sharply in the frequency of negative shocks to the construction process. This implies that the cost overruns that can be expected if one ignores such shocks are sharply increasing in their frequency. Based on calibrated data, the model is applied to the construction of high-speed rail in the UK and it is found that the economic case for the first phase of High Speed 2 cannot be made and is unlikely to be met in the next 10 years.

Suggested Citation

  • Jacco J.J. Thijssen, 2013. "The Long and Winding Road: Valuing Investment under Construction Uncertainty," Discussion Papers 13/20, Department of Economics, University of York.
    • Handle: RePEc:yor:yorken:13/20
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    References listed on IDEAS

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    1. Alvarez, Luis H. R. & Keppo, Jussi, 2002. "The impact of delivery lags on irreversible investment under uncertainty," European Journal of Operational Research, Elsevier, vol. 136(1), pages 173-180, January.
    2. Roger Vickerman, 2007. "Cost — Benefit Analysis and Large-Scale Infrastructure Projects: State of the Art and Challenges," Environment and Planning B, , vol. 34(4), pages 598-610, August.
    3. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    4. Pohl, Gerhard & Mihaljek, Dubravko, 1992. "Project Evaluation and Uncertainty in Practice: A Statistical Analysis of Rate-of-Return Divergences of 1,015 World Bank Projects," The World Bank Economic Review, World Bank, vol. 6(2), pages 255-277, May.
    5. Sarkar, Sudipto, 2000. "On the investment-uncertainty relationship in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(2), pages 219-225, February.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Investment under Uncertainty; Infrastructure investment; Optimal stopping;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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