Study of Real Options with Exogenous Competitive Entry to Analyze Dispute Resolution Ladder Investments in Architecture, Engineering, and Construction Projects

Abstract

Architecture, engineering, and construction industry participants often find it pragmatic to implement a project-specific dispute resolution ladder (DRL) as a managerial tool to assist in the prompt resolution of claims and change orders (CCOs) that might arise during the project construction phase. This project-specific DRL consists of a single or multiple alternative dispute resolution (ADR) techniques that require capital expenditures to cover the expenses incurred by the owner’s/contractor’s employees and third-party neutrals. If a project-specific DRL is properly chosen, then the capital expenditures are outweighed by the expected benefits from the DRL implementation; namely, prompt resolution of the CCOs without incurring excessive cost overruns on an already financially stressed project budget, as well as avoiding the escalation of the claims to a dispute that requires long protracted litigation for final settlement. Typically, the decision as to which ADR techniques to include in the project-specific DRL is undertaken during the project planning phase prior to the actual occurrence of the CCOs. In this case, the project owner decide to invest in a DRL in exchange for the expected savings in the project. This decision regarding the project-specific DRL is usually done based on the experience of the project parties with the ADR techniques. However, such a decision needs to be guided by a financial tool that allows the project owner to evaluate alternative DRLs and choose the most economically feasible alternative based on the project and ADR characteristics. In this paper, a financial model is developed to evaluate DRL implementations in construction projects by drawing analogies from real option theory with exogenous competitive entry. More specifically, the occurrence of a given CCO will result in a reduction in the value of expected savings in the project due to DRL implementation. This is similar to the reduction in the gross value of a capital investment project in a commercial property due to competitive entry by another similar commercial property developer in the market. At the same time, the CCO resolution due to an effective DRL implementation will allow project owner to recover part of the losses in the expected savings in the project due to the DRL implementation. The model presented in this paper takes into account the characteristics of the various ADR techniques included in the project-specific DRL, and the characteristics of the CCOs occurring during the construction phase of the project. A case study of a real construction project is used to illustrate the practical implementation of the model. The results indicate that for this case project and from a financial point of view, the investment in the chosen project-specific DRL was not worthwhile because of the high uncertainty in the project, and the low effectiveness of the selected DRL. These conditions did not provide the owner with the anticipated advantage of the DRL implementation in reducing the value of the CCOs occurring in the project. At the same time the cost of the DRL implementation exceeded the actual savings attained in the project.