Valuation of Governmental Guarantee in BOT Project Finance with Real Option Analysis
Jun, Jae Bum
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The limitation of public funds available for infrastructure projects has induced governments to attract private entities to participate in long-term contracts for financing, constructing, and operating huge infrastructure projects through Public Private Partnerships (PPPs) to reduce debt, constrain taxation, and share financial risks and rewards between the public and private sectors. Because these projects have such complicated risk evolutions, diverse contractual forms for project members to hedge their risks are necessary. Hence, the Build-Operate-Transfer (BOT) model has been considered as a very popular type to accomplish PPPs with the characteristic of a shared-ownership. For the government to attract private sector?s participation, they have used incentive systems such as debt payment guarantee, Minimum Revenue Guarantee (MRG), or direct cash support. These incentive systems have been important critical success factors in BOT projects yet they have remained unfavorable in bidding process by failure of the traditional capital budgeting theory, Net Present Value (NPV) analysis, in evaluating the guarantee values. This is because NPV analysis can not reflect the guarantee agreements? contingent characteristic. For this reason, ?Real Option Concept? imported from ?Option Pricing Theory? in finance has been used as an effective way in estimating the guarantee value during the construction and operation of the project. However, there are still open issues in identifying, formulating, and calculating the guarantee agreements? contingency due to the complexity of option pricing theory and in considering the uncertainty of the underlying asset. Furthermore, in recent real option-related research that evaluate BOT investment projects, the volatility of rate of return in underlying asset (project value) is assumed to be just given or too simplified in its calculating process despite its significant impact on the guarantee value. The purpose of this research is to develop the binomial real option model to better evaluate the MRG value by complementing existing real option models without violating the option pricing theory. To do so, the developed model in this research is to formulate the MRG agreement as a put option, consider the uncertainty of the underlying asset, and use the more detailed level of volatility with a Monte Carlo simulation approach. To verify the applicability of the developed model, the model is applied to three different BOT project case studies, then, the results are compared with those by NPV analysis, Cheah and Liu (2006)?s real option model, and option pricing theory derived from Black-Scholes model. Finally, based upon the results and analyses, the developed real option model appears to provide a practical and theoretical framework to quantitatively evaluate the MRG agreement under the BOT scheme and help the government establish better BOT policies and help the developer make appropriate bidding strategies in its investment.