Option Pricing Model to Analyze Cost–Benefit Trade-Offs of ADR Investments in AEC Projects

Abstract

Alternative dispute resolution (ADR) techniques are adopted by architecture, engineering, and construction project participants to help achieve reasonable settlement of claims and change orders (CCOs) that arise during a project’s life cycle without having to resort to protracted litigation for final determination of merit. Since such ADR techniques require resources to prepare, review, and resolve CCOs, the managerial decisions regarding the investments for these resources need to be economically justified. The application of the net present value approach to determine the value of any ADR investment is limited because the future cash flows resulting from such an investment cannot be estimated a priori as they will vary with the nature of the CCOs, the amounts claimed, and the effectiveness of the ADR in addressing these CCOs. This paper presents a conceptual and mathematical model to evaluate ADR investments by drawing an analogy from theories of financial and real option pricing. The objective is to provide the owner with a decision framework that accounts for the uncertainty in estimating the ADR investment cash flows during the project planning phase, and provides realistic results regarding the value of this investment. The model presented in this paper is applied to a real case study involving a seismic retrofit of a bridge project to demonstrate the parameter estimation and the practical application of the model.