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

Practical valuation studies of real options and games can be found in Kemna (1993), Nichols (1994), Smit (1997; 2001), and McGahan (1993b). In an interview with the CFO of Merck, Nichols (1994) sheds light on the use of real options and games in practice. McGahan (1993b) studies the tradeoff between commitment and flexibility in the case of the compact disk introduction. By building a large plant, Philips could preempt Sony and other potential competitors from building their own CD plants. McGahan derives a threshold probability of market acceptance that would justify pursuing a wait-and-see strategy.

Although infrastructure investment is an area of general interest, its valuation is not well understood. A key difference between the practical valuation model in this paper and other models in the new options-game literature is that this paper explicitly values the growth opportunities generated by the infrastructure of the firm as a sequential exercise game, instead of focusing on a single project. I estimate the value of a firm's growth opportunities as the sum of the outcomes of repeated expansion subgames along an equilibrium path in the overall game.

II. Infrastructure Investments and Air Traffic Developments

To understand the growth and strategic option value of infrastructure investment, we must first consider the investor's ability to appropriate the value of growth opportunities. (9) By nature, benefits that result from infrastructure are dispersed across operating divisions and, possibly, external players. For instance, there are corporate, network, and regional benefits associated with infrastructure. Corporate growth opportunities result from the fact that infrastructure is a firm-specific asset, in the sense that it can create an advantaged strategic position to expand. Examples of infrastructure investment with corporate benefits are projects in physical infrastructure, such as distribution, service, information technology, communication, and transportation systems; and human capital infrastructure. In short, corporate infrastructure can be viewed as a platform for creating future growth for the enterprise. (10)

Infrastructure investment in new markets and network investments among firms cannot be considered in isolation. Firms must seek out opportunities to complete the investments collaboratively and utilize complementary competencies. Network infrastructure investment is obviously important for airports, but can also be particularly important in industries where innovation entails novel connections between previously unconnected industries, markets, or technologies. For instance, transport and distribution operations can gain cost efficiencies by creating more efficient network connections between firms. The same is true in high-tech industries, where alliances often make value-increasing "pre-investments" to develop and position a common technology standard.

In addition to creating corporate or network opportunities, infrastructure investments can induce growth in a region. Infrastructure investments that generate regional benefits include investments in marine ports, airports, railroads, or electricity networks. Governments play a key role here, both because they establish the regulatory framework and because they often play a role in providing the infrastructure. Thus, part of the growth option value of these investments does not flow to the investor, but is shared with other players in the region where the investment is made.