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

Second, global growth in air traffic has resulted in more passenger demand. The number of flights within Europe is expected to continue to grow during the coming decades despite the development of new and efficient transportation alternatives, such as the expansion of the TGV (Train a Grande Vitesse, or high-speed train) network and the Channel tunnel. Airports face uncertainty in demand growth due to changes in the overall economy. Growth or bankruptcy of the home carrier, and various other factors have great impact on demand in flights for an airport. An unexpected decline in the level of growth could motivate airports to defer their expansion plans. (12)

Third, a small number of European mainports (as the main airports are called) and many smaller airports characterize the industry structure. As a result, European airports are starting to form efficient, star-shaped, "hub-and-spoke" networks, where a central or "hub" airport connects many "spoke" destinations. These networks are expected to influence the relative competitive positions of European airports. A hub-and-spoke system in Europe makes it possible to increase the frequency and variety of destinations relative to the "point-to-point" system, and uses capacity more efficiently. (13) A potential new alliance or merger of the home carrier with a larger partner at a nearby hub can have great impact on the strategic position of an airport. For instance, the merger of KLM, the home carrier of Schiphol, with the larger Air France, the home carrier of Roissy-Charles de Gaulle, could affect the future position of Schiphol airport as a hub, in particular because Roissy-Charles de Gaulle has considerable opportunities to expand. (14)

Finally, there has been a strong tendency recently to deregulate air travel. Deregulation will create new connection opportunities, while increased competition will support efficiency and concentration. (15)

III. Infrastructure Valuation as an Options Game

I value airport expansion in a competitive context as an options game, using a two-step procedure. First, I value the existing base-scale operation without any of the expansion opportunities by using traditional valuation. I then determine the "value added" of the infrastructure-related future expansion opportunities, or the present value of the growth opportunities (PVGO), in a competitive setting. I estimate the PVGO as the present value of the expansion values of the subgames along the equilibrium growth path. The strategic position of the airport and its growth option value will depend on the infrastructure and the timing of the expansion investments under competition.

A. The Value of Assets in Place

I begin the analysis with a "catchment area," which I define as a "local market" for flights. For instance, adjacent airports (Airport A and Airport B) can compete for local or transfer passengers in a certain area, forming a duopoly. [Q.sub.A] and [Q.sub.B] are the yearly demands (measured in flights) for Airports A and B, respectively, with total demand [Q.sub.M] = [Q.sub.A] [Q.sub.B] Current demand for Airport i (i = A or B) equals the current market share, [s.sub.i], times total demand [Q.sub.M]: [Q.sub.i] = [s.sub.i] [Q.sub.M]. (16) Demand for Airport i at time t, [Q.sub.i,t] is uncertain. I assume it follows a binomial process.