Valuing Flexibility in Infrastructure Expansion

Abstract

Infrastructure facilities are generally heavy, fixed, and normally irreversible once construction has been completed. As existing facilities, they may confront economic competition of an increased space demand and the need for future expansion. Due to economic-based irreversibility, the expansion of a constructed facility requires the foundation and, to a lesser degree, columns to be enhanced and options for expansion to be accounted for at the very beginning of construction. Enhancing the foundation and columns represents an up-front cost, but has a return in flexibility for future expansion. This trade-off can be viewed as an investment problem, in that a premium has to be paid first for an option that can be exercised later. A model of the foundations versus flexibility trade-off enables the competing options to be optimized by balancing the expected profits that may arise from future expansion, i.e., the value of flexibility, and the cost of enhancing the foundation. Use of the model is demonstrated for the construction of a public parking garage, with the optimal foundation size determined. The evolution of parking demand is modeled with a trinomial lattice. Stochastic dynamic programming is used to determine the optimal expansion process. A model that does not consider the value of flexibility is compared with two value-flexible models. The value of flexibility in this case study is so significant that failure to account for flexibility is not economical. Valuation modeling such as discounted cash flow analysis with uncertainty modeling is important to capitalize on the worth of flexibility.