International Conference on Applied Economics – ICOAE 2008 217 Highway project management through real option F. Cucchiella, I. D’Adamo and M. Gastaldi Department of Electric and Information Engineering, Faculty of Engineering, University of L’Aquila, Monteluco di Roio, 67040 L’Aquila, Italy, Email: federicacucchiella@ing.univaq.it , gastaldi@ing.univaq.it Abstract Many project management decisions involve analyzing the tradeoffs between a fixed and certain capital investment and an uncertain stream of future cash flows. Discounted cash flow (DCF) analysis is the most common method for valuing projects in a company, but an increasing number of practitioners are now using real options methodology to get a truer description of the value of a project. In fact the use of the real options methodology may be a way for solve the problem; some projects indeed carry a positive value when the options value is taken into account. In this paper the attention is focused on a highway project; a highway system development involves huge irreversible investments, and requires rigorous modelling and analysis before that the implementation decision is made. This decision-making process is embedded with multiple uncertainties due to changes in political, social, and environmental contexts. In this paper, we present a multistage stochastic model for decision making in highway development, operation, expansion, and rehabilitation. Key Words: real option, risk management, public investment 1. Introduction The theory of the Real Options is become gradually an evaluation technique and a new way to manage the decisional and valuation process related to choices on the public expense (Benaroch et al. 2006; Chen 2006; Cucchiella and Gastaldi 2006; Yang and Blyth 2007). Initially this theory has been applied especially at the private sector, but, in the last years, also an extension to public investment can be remarked (Han 2003; Cheah and Liu 2005; Bellamy and Sahut 2006). The attention of this paper is focused around a public investment management, for this reason it is necessary to individualize an approach useful for the judgment of the investments selection in public sector and, more specifically, an infrastructural investment will be analyzed. The paper has twofold objective: • to develop a Selective Infrastructural Analysis to gain some strategic suggestions; • to apply the Real Option Analysis or Extended Costs-Benefits Analysis to the infrastructural investment data to quantify the economic convenience of the project. After this introduction in section 2 the multicriteria analysis will be introduced. This tool is useful for define the strategic convenience of a project and, based on multicriteria analysis, in section 3, the selective infrastructural analysis (that can be applied at the infrastructural investment under analysis) is developed. This first tool allows to define only the strategic convenience of the investment, nothing it is defined about the economic convenience. With this respect two methodologies are applied: the first one is based on the traditional Cost Benefit Analysis (section 4) and the second is based on Real Option Analysis (section 5 and 6). Some concluding remarks close the paper. 2. Multicriteria analysis Multicriteria analysis is appeared in the 1960s as a decision-making tool. It is used to make a comparative assessment of alternative projects or heterogeneous measures. With this technique, several criteria can be taken into account simultaneously in a complex situation. The method is designed to help decision-makers to integrate different options, reflecting the opinions of the actors concerned, into a prospective or retrospective framework. Participation of the decision-makers in the process is a central part of the approach. The results are usually directed at providing operational advice or recommendations for future activities. Multicriteria evaluation can allow to produce single synthetic conclusion at the end of the evaluation or, on the contrary, to produce conclusions adapted to the preferences and priorities of several different partners. Multicriteria analysis is similar to the techniques adopted in the field of organisational development or information systems management and also resembles to cost-benefit analysis. Its purpose is to structure and combine the different assessments to be taken into account in decision-making, whereby decision-making is made up of multiple choices and the treatment given to each of the choices influences the final decision. Multicriteria analysis is used to highlight the reasoning and subjective convictions of the different stakeholders on each particular question. It is usually used to synthesise the opinions expressed, in order to determine the priority structures, to analyse conflictual situations, or to formulate recommendations or operational advice. The choice of evaluation criteria, their definition and their weighting constitute a useful contribution to multicriteria analysis. It is relatively easy to transfer criteria, scoring scales and weightings to the project selection system if this system is also organized on the basis of scoring-weighting. If with respect at the measures evaluation, the projects selection is based on the same logic, the chances of stimulating and funding projects which contribute effectively to the program priorities are increased. Multicriteria analysis allows to compare several points of view, and therefore is particularly useful during the formulation of a judgment on complex problems. The analysis can be used with contradictory judgment criteria (for example, comparing jobs with the environment) or when a choice between the criteria is difficult. In general, this technique is mainly used in ex ante evaluations of public projects and their variations (the layout of a highway, the construction of a new infrastructure, etc.). Less commonly however, multicriteria analysis is also applied to the intermediate or ex post evaluations of programs. In the next section a new approach, based on multicriteria analysis, is presented; it can be useful for Public Administration to define both strategic and social convenience of an infrastructural project.