Infrastructure investment as a real options game: the case of European airport expansion

Financial Management (Financial Management Association), Winter, 2003 by Han T.J. Smit

This article analyzes the optional and strategic features of infrastructure investment. Infrastructure investments generate other investment opportunities, and in so doing change the strategic position of the enterprise. A combination of real options theory and game theory can capture the elusive value of a strategic modification of a firm's position in its industry. My model focuses in particular on an analysis of European airport expansion. Airports with infrastructures that are less constrained by growth regulations capture more value, because they are in a better position to exercise growth options available in the airport industry.

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For a firm with growth opportunities, infrastructure sets the stage and creates the strategic context in which the firm can flourish. Although the nature of infrastructure development--investment in land, distribution, communication, human capital, or technology--depends on the type of business, its defining characteristic is that it generates other investment opportunities. By setting the path for investments to follow, infrastructure development helps create the necessary platform for the firm's growth potential and thus shapes the strategic position of the enterprise.

Few investment opportunities, whether they strengthen core capabilities or access new geographical locations, exist in a vacuum, and they should therefore be considered in their strategic and competitive context. Because such opportunities are often contingent on follow-on investments, they can be viewed as a bundle of real options. By integrating real options valuation with game theory principles, we can make a more complete assessment of strategic growth option value in an interactive competitive setting.

I focus on European airport expansion, taking a detailed look at a specific application and validating the more general option games approach. I explain developments in the European airport industry by considering the infrastructure of each airport as a firm-specific asset (platform) that generates a set of sequential expansion options in a context of competitive responses and changing market conditions. Such investments in land, terminals or runways are typically indivisible or "lumpy" which introduces an important tradeoff between flexibility and commitment in an airport's growth strategy. (1) However, limited overall growth or local growth restrictions might foreclose exercising certain expansion options in the chain of sequential investments. When local growth becomes restricted for large airports, it is still possible to invest in regional airports or international strategic network acquisitions that can create value by jointly exploiting economies of scale or other core competencies.

Although I apply the option games approach to the airport industry, it can be generalized to infrastructure investment in other industries. For instance, it can be applied in the context of corporate infrastructure, platform, or R&D investment in volatile industries such as information technology, electronics, and pharmaceuticals.

Models combining game theory and options are typically based in continuous time and are developed from a theoretical perspective. Often, researchers assume that firms have the same costs or produce only one unit forever (if they are active in the market), and that the inverse demand curve is generic. Although interesting theoretical issues are investigated through these continuous-time models, the models are not readily applicable for practical valuation purposes. In practice, firms are not generally homogeneous. The underlying stochastic variables are seldom likely to follow a geometric Brownian motion, in particular for applications other than in natural resources. The firm must choose not only the optimal timing of an expansion but also the optimal capacity to install. It is much easier to handle asymmetries between competitors and to define alternative stochastic processes with a discrete time approach. Such an approach is thus better suited for the practical application of the options-game approach to investments in real markets. The resulting analysis is also more accessible for corporate managers, since it does not require in-depth knowledge of stochastic calculus and differential equations. Therefore, for simplicity and accessibility, I present my application of a sequential exercise game in discrete time.

The paper is organized as follows. Section I describes the relevant literature. Section II examines infrastructure investment and developments in European air traffic. Section III presents the valuation model for infrastructure investment strategies. Section IV applies the model to the expansion possibilities of European airports. The final section summarizes the insights gained and discusses relevant implications.

I. The Real Options Game Literature

An important contribution of real options theory to the valuation literature is that it shows that the optimal trigger value at which a firm should invest must be well above the investment cost (i.e., there should be a large positive NPV) due to the option value inherent in a "wait-and-see" approach (McDonald and Siegel, 1986; Dixit and Pindyck, 1994). In the early literature on real options, researchers either ignored competitive entry or assumed that it was exogenous. (2) However, if there is (the threat of) competition, whereby each firm's payoff is affected by the actions of other players, competitive interaction can again change the optimal investment criterion. (3) Only recently have strategic considerations, particularly with regard to imperfect competition, been treated in a formal and rigorous fashion in the financial economics literature. (4)