1.

Introduction to project evaluation

Project financial evaluation is used to analyse and represent the financial attractiveness of a project (P2Pay, 2011). It looks at all the monetary factors involved in undertaking the project, including the estimates of the projects capital cost, expected output, along with annual revenues, expenses and deductions. It also analyses important variables such as the time frame over which the capital outlays will be recouped and, ultimately, the profits that can be realised. There is a number methodology that can be used in the financial evaluation of a project. According to (Maybee 2010), evaluation methodologies have undergone numerous changes overtime in order to address specific the characteristics of each project under evaluation. It has been found that evaluation techniques can be divided into three main categories: cost approach, market approach and income approach (Lee and Strang 2003a). However, the cost approach fails to recognise the future earnings potential of the project being evaluated while the nature of the minerals industry violates the principle of the market approach. The market approach states that comparable properties must have comparable values but in reality construction projects are rarely alike as previously discussed. As a result, both the cost and market approaches are not applicable to the construction industry. Income approach to project evaluation is therefore widely used in this industry. The first of the income-based evaluation methodologies is Payback Period (PBP). PBP is often used as a sanity check on the evaluation of projects. Essentially PBP tells an investor how long their invested capital will be tied up in the project. However, this method does not provide a platform that is conducive to ranking multiple alternatives that are under evaluation (Lee and Strang 2003a). Another weakness of PBP is that it fails to recognise the time value of money. Finally, it has been observed that PBP provides ambiguous results in situations where the sign of the cash flows from a project switch between positive and negative more than once (Maybee 2010). Recently, there have been a number of improvements to PBP. The first of these is Discounted PBP (DPBP). DPBP is a reformulated evaluation technique that is NPV-compatible and capable of producing results that recognise the entire cash flow process of the project (Hajdasinski 2012). The advantage of DPBP over the traditional PBP method is its ability to convey informative facts for investment decision making purposes. Through this formulation, NPV calculation of the project is required to establish profitability and the existence of multiple payback periods exist is explicitly recognised. The reformulation also provides a means of ranking mutually exclusive alternatives through the evaluation of projects based on their differential cash flows (Maybee 2010). Referencing the work of (Alesii 2006), (Maybee 2010) mentioned another method of computing an updated version of PBP. This method is combines PBP and IRR with real options to enhance value of project options. By studying an investment project in the shipping industry the paper showed that when a project is passively managed (no real options taken into account), PBP and IRR are inconsistent with NPV since the use of such methods may lead to under or overinvestment as a result of misallocation of resources; however, when the same investment is actively managed (including the effects of real options), PBP and IRR provide results consistent with the NPV-based investment decisions. The second income-based evaluation approach commonly used in the construction industry is internal rate of return (IRR). IRR is defined as the rate at which the total present value of cash inflow is equal to the present value of cash outflow. It is used to measure and compare the profitability of investments. The higher the IRR of a project, the more desirable it is. In practice, IRR is often compared against the minimum acceptable rate of return (which is a minimum rate of return set by a company if it is to invest in a project) or the cost of capital; if IRR is higher than its proxy then the

project is considered acceptable. IRR therefore offers valuable insight into the value that a project yields. However, it was found that IRR is conceptually flawed and cannot serve as a valid evaluation criterion by (Hajdasinski 2012). As a result, the true rate of return (TRR) should be used as an alternative rate of return. This method offers an NPV-compatible measure for project evaluation (Hajdasinski 2012). The third and the most widely used income-based evaluation technique is the NPV methodology. NPV enjoys wide acceptance in the construction industry, and has been used as the standard evaluation technique for decades. In this approach, all future cash flows are estimated and discounted to the present days value using an appropriate discount rate to calculate the net present value, which is essentially the sum of all discounted future cash flows. NPV is used for dual purposes: first, as a method to place a value on a project; and second, as a vehicle for managers and decision makers to use as a guide in choosing among different alternatives. For example: if presented by two projects, a company can choose the best option to invest in by comparing NPV of each individual project. The project that has higher NPV will be accepted. Advances in modern finance theory in recent times, together with major developments in decision science, have brought some significant benefits to the management and planning field. Companies in various industries have begun embracing and utilising applications of finance theory more systematically (Walls, 2004; Hall & Nicholls, 2006; Samis et al, 2006; Hoare, 2007; Topal, 2008). Planning groups and business units in companies, especially those in the oil & gas and mining industries, increasingly use innovative techniques such as decision analysis, simulation, portfolio management, and real options analysis to improve the overall decision making and capital allocation process (Smith & McCardle, 1996; Walls, 2004; Dimitrakopoulos & Sabour, 2007; Xie, 2010). With significant improvements in computing power and widespread availability of high performance computers, simulation-based evaluation tools such as Monte Carlo Simulation (MCS) have been widely used in the construction industry. With MCS models, a user can model multiple key variables and evaluate their impact on the value and risk of the project. In addition, correlations between the key variables can be included in a simulation analysis to provide an added level of uncertainty recognition. However, since these simulations are usually built on the NPV valuation technique, they inherit its inflexibility (Maybee 2010). Decision Tree (DT) analysis has its origin from operations research. DT is essentially a flowchart presented by a tree-like graph representing a classification of a system (Topal, 2008). DT models contain all information about projects under investigation. This information can be probabilities of occurrence and possible outcomes for each event, resource required and costs. The eventual utility (often in NPV terms) is presented at the end of each branch. DT method is usually employed in the probabilistic analysis process of complex projects, especially those in the construction or resources sectors, to identify the most appropriate strategy to undertake due its ability to break down large, complicated problems into a series of smaller, simpler ones (Topal, 2008). This allows the decision maker to see the whole project and its possible NPV outcomes. For example, decision trees were used to incorporate the heterogeneous nature of a mineral deposit into an evaluation model (Samis and Poulin (1996) (1998)). The authors considered a project with two zones: one high-grade and one lowgrade, and modelled the development of the high-grade zone. In this study, management was given the option to extend production and develop the satellite low-grade zone when the high-grade had been exhausted. It was shown that managements ability to replace exhausted zones with auxiliary reserves has the potential to add great value to a mine extraction project (Samis and Poulin (1996) (1998); Maybee 2010). However, overall the use of decision analysis (DA) is still built on the NPV

model, and will only evaluate the project cash flows in a static environment, alleviating one shortfall of the NPV model, only to be confined by another. Real option (RO) is often considered as the final stage in the development of evaluation tools (Lee and Strang 2003c). Essentially, RO is an extension and adaptation of corporate finance to real-life decision-making situations. This methodology builds upon, and can integrate with, decision tree and simulation analyses. However, where assessments for future events and occurrences in DT or MCS rely heavily upon the managements preferences, RO uses market data to quantify probability distributions and incorporates learning into the model (Topal 2008). The benefits of RO over previously mention evaluation techniques is in its ability to value the managerial flexibility in a project. It has been found that in many instances, value of well-managed companies exceeds the value of their underlying assets (Macmillan 2000; Lee and Strang 2003c).

2. NPV versus RO 2.1.NPV method

Despite its popularity, it is often found that NPV calculations undervalue projects (Moyen et al, 1996; Samis et al, 2006; Dimitrakopoulos & Sabour, 2007). This is due to a number of factors: first, there is a lack of adjustments for different types of uncertainty and risk involved in construction projects; and second, NPV fails to account for the flexibility inherently exists in the management of risky assets. The lack of adjustment in the NPV methodology is mainly due to the choice of a discount rate used in calculating the value of an investment (Topal 2008). The estimation of a suitable discount rate is often the most difficult and uncertain part of NPV method. It is exacerbated by the fact that the final result of a NPV calculation is very sensitive to the choice of discount rate, i.e. a small change in the discount rate can cause a large change in the NPV value. In practice, when evaluating projects, companies often use a hurdle rate to account for the uncertainty and possible risks that it faces (Dowd 2005). A hurdle rate is an upwardly adjusted single discount rate consisting of a risk-free rate and a risk premium. By using a hurdle rate, future cash flows of construction investments are discounted by both the risk-free and risk premium rates (Moyen et al. 1996). Consequently, future cash flows are discounted by both the risk-free rate and the risk premium. This effect is compounded by each subsequent cash flow, which ultimately results in a much lower NPV than which might be otherwise calculated. Moreover, due to the integration of the time-value-of-money and risk discounting into a single discount rate, the traditional single-rate NPV approach is inherently biased. Of particular concern and relevance in construction is an inherent bias against high-margin, long-life assets with large capital requirements and a bias towards low-margin, short-life assets with low capital investment (Lai & Stange, 2009). To overcome this issue, the certainty equivalent concept can be used to account for the risk premium without compounding its effect on the present values (Pietersz, 2011). Along with the discount rate issue, another important drawback of NPV is in its implicit assumption regarding the certainty of future cash flow over the life of the project (Fox 2008). It is often assumed during the early stages of a project that all cash flow streams are constant throughout the whole project. The reality is that OPEX and CAPEX changes at different stages of the project life. As a consequent, effects of cyclical fluctuation in materials, labour, capital and operating costs are ignored. Even though smoothing these series makes it easy for calculation in the evaluation process, one has to be aware that these factors will change over time and therefore they will affect the value of the project. One possible solution is to calculate a range of NPV values by using different discount rates and forecasts, so that a range of options available to the company can be generated. Options considered often consist of the best, median and worst cases of NPV values. In some instances, Monte Carlo simulations are used to generate a probability distribution of NPVs. These ranges give the

decision makers indications of possible project outcomes. Moreover, they allow project planners to set appropriate contingency plans accordingly. The final pitfall of NPV is the built-in assumption that manager is passive in managing their projects. The NPV method assumes that if a project is undertaken today, it will continue to perform until it is completed. In contrast, the reality is that managers have considerable flexibility in choosing the time to invest in a project (Maybee 2010). Moreover, once the project has commenced, managers have discretions concerning equipment, material and labour. Often, in making investment decisions using NPV, the consensus is to undertake the investments with positive net present values and reject those with negative net present values (Sabour and Poulin 2006). By this immediate accept/reject decision, NPV ignores the value of options such as deference/abandonment or expansion/contraction of the investment. Since the market conditions for construction products are highly uncertain, these flexibility options can add a significant value to the underlying project (Sabour & Poulin, 2006, Sabour & Dimitrakopoulos, 2010; Dimitrakopoulos, 2010). Failures to address the management responses to the supply and demand cycle will result in inaccurate estimates and consequently will lead to wrong decisions (Moyen et al, 1996; Sabour & Poulin, 2006). It must be noted that since NPV was originally designed for evaluating bonds in the financial markets, where future cash flows are relatively easy to identify and quantify, it does have constraints when applied to the minerals industry, where cash flows are less certain (Dowd 2005; Maybee et al. 2010; Maybee 2010). Therefore, one must be careful in using and interpreting results obtained from a NPVbased evaluation method (Fox 2008; Pietersz 2011). To overcome the shortcomings presented by the traditional static NPV method, stochastic methods and multiple scenarios can be used to deal with uncertain variables in the NPV. However, this methodology still possesses the same dilemma as the traditional method in that it focuses on whether or not to invest the project but does not inform the investors of the timing of investment (Yang & Blyth, 2007).

2.2.Real Options
RO has been viewed as a promising technique of valuing investments under uncertainty that is induced by the constant changes in the market place (Dimitrakopoulos & Sabour 2007). Further, such uncertainty can have significant effects on the value of a project, due to the competitive interactions of firms in the market. As a consequence, the expected returns on a project may be drastically different to the actual return that can be realised from the investment itself. It has been observed that under these conditions, RO tends to perform better than the conventional NPV method due to the inclusion of management flexibility (Dimitrakopoulos & Sabour, 2007). Managerial flexibility here arises from the fact that as new information arrives, uncertainty about market conditions and future cash flows is gradually resolved and management has valuable flexibility to alter the companys operating strategy in order to capitalise on favourable future opportunities or mitigate losses by deferring, expanding, contracting, abandoning or otherwise altering the project at different stages of its operating life accordingly (Trigeorgis, 2001). This flexibility allows the managers to modify the project according to changes. Ultimately, the management flexibility inherent in real options provides the company opportunities to maximise the upside potential while limiting the downside losses (Dimitrakopoulos & Sabour, 2007). Like investments made in the electricity oil & gas or mining sectors, building projects has three important characteristics: first, the investment is partially or completely irreversible (once invested, the capital costs become totally or partially sunk); second, there is always uncertainty over the future return from the investment; and finally, both management of a company and investors have the

flexibility in timing the investment (such as options to abandon, expand or contract the operation of the project). However, traditional NPV-based project evaluation methods cannot incorporate these three characteristics (Yang and Blyth 2007). These two methods differ on a fundamental level: RO adjusts for risk within the cash flow components while NPV discounts for risk at the aggregate net cash flow. This seemingly small difference allows RO to differentiate assets according to their unique risk characteristics, while the conventional NPV approach cannot (Samis et al. 2006; Samis et al. 2007). Another advantage of RO over NPV is the way it handles the discount rates: while NPV uses risk-adjusted discount rate, RO utilises a risk-free rate to discount the cash flows in the evaluation of the project (Smith & McCardle, 1996; Walls, 2004; Martinez, 2009). Therefore, when applying discounting procedures, a project estimated by RO yields higher values than that estimated by the conventional NPV method. However, Trigeorgis (2001) and others recommended against crapping the traditional NPV method. Rather it should be seen as a crucial and necessary input to an option-based expanded NPV analysis. Using a case in the mining industry as an example, (Dimitrakopoulos and Sabour 2007) noted of the lack of procedures for testing the usefulness and advantages of RO over the static NPV method in practice. They therefore contend it is not yet clear whether the RO can deal with the complexity of mining projects and whether it can really be applied to making decisions that can improve project value (Dimitrakopoulos and Sabour 2007). Nonetheless, RO could become a useful tool for decision makers and investors to quantitatively analyse the impacts of uncertainty and price uncertainty on construction sector investment (Yang and Blyth 2007). It must be noted that the NPV and RO evaluation methods share many features. Both see assets as portfolios of uncertain cash flows received at a series of times in the future. In the absence of flexibility, the only difference between the two approaches is the manner of accounting for the effect of cash flow uncertainty on asset value. Although the difference in risk-adjustment between the NPV and RO evaluation methods appears to be nuanced but its consequences are potentially large because in the case of the latter, it allows senior management to use market information to determine the underlying structure of risk adjustments for uncertain variables (Sami et al, 2007). The real option valuation technique has been extensively studied in the context of natural resources industries. In mining, RO is widely used to evaluate projects under a wide range of uncertainty and risk. Risk in this industry arises from uncertainty in orebody estimations to operational uncertainty (mining and processing) to economic uncertainty (commodity prices and foreign exchange). For instance, despite recent advances in exploration and ore estimation techniques, the amount of resource within a deposit can never be known with certainty. Further, since the ore quality varies substantially throughout the deposit, the assumption of constant resource extraction rate throughout the lifetime of the mine is an extreme simplification. It has been found that by using RO, mining companies are able to capture the upside potentials while significantly reducing the downside risks in their positions by means of leveraging the managerial flexibility provided by this method (Martinez, 2007). Recently, there have been a number of attempts to apply the real option concept into the construction industry. Chiara et al (2007) studied a case concerning multiple exercise dates in a limited revenue guarantee venture in a Build-Operate-Transfer (BOT) toll road project with a fixed concession period. In this model, they consider a revenue guarantee as a particular type of real options, a discreteexercise option. Discrete exercise options are ones that can be exercised at discrete points over a predetermined time period and generally take one of three forms: European, Bermudan, and simple multiple-exercise options. The decision process in this study is multi-stage with a return associated to each decision and the objective is to determine the optimal decision policy. Once the decision is made, the fair value guarantee, given by the expectation of the sum of the payoffs relative to the optimal stopping time set, is discounted back to the present. Along this line of research, Ford et al

(2001) investigated the strategic flexibility involved in a complex civil project. They found that using a structured real option approach in construction management can increase returns through improved project planning and management.