Valuing flexibility in infrastructure developments : the Bogota water supply expansion plan.

Abstract

This thesis aims to aid in the understanding of capital budgeting techniques for infrastructure developments. In particular, it analyzes: Net Present Value (NPV), Decision Analysis (DA) and Real Options Analysis (ROA), and compares these approaches in terms of their treatment of uncertainty, their acknowledgement of flexibility, and their usefulness for strategic decisionmaking. The comparison of these alternative methodologies is based on a literature review highlighting the advantages and disadvantages of each approach, complemented by a system study of the expansion of the water supply system for Bogota, Colombia. This study illustrates the application of each methodology and identifies the policy challenges relevant to infrastructure investment evaluation in Colombia and other emerging economies. The study confirms the hypothesis that NPV is inadequate for the evaluation of projects in uncertain environments, mainly because it does not account for the value generated by flexibility. The study also recognizes that although the ROA approach is theoretically superior in the pricing of flexibility, its implementation requires information usually not available for infrastructure assets. This rends the results of the analyses imprecise and complicates the process of identifying an optimal strategy. The study finds the Decision Analysis approach preferable for the evaluation of Bogota's water supply expansion projects, based on its practicality and ease of communication. The thesis also sets forth a framework for choosing the most appropriate capital budgeting technique for other infrastructure developments. This framework is based on data quality and availability and the objective function of the analysis to be conducted.