Financial Valuation of Investments in International Construction Markets: Real-Options Approach for Market-Entry Decisions

Abstract

The body of knowledge in decision making about international construction market entry has been primarily focused on identifying risk factors, quantifying risks, and developing risk management strategies for construction firms to be more likely to succeed in international markets (e.g., risk registrars, industry checklists, entry procedures, and quantitative/qualitative risk assessment models). Going international can also be considered as a large-scale investment for a firm because it has all three major characteristics of an investment decision: (1) entering an international market requires a substantial level of initial outlays; (2) this initial capital is not completely recoverable if the firm decides to exit the market; and (3) the success of an international construction business venture is subject to great market uncertainty, which is exogenous to the firm. Traditionally, financial valuation of international construction markets is conducted by net present value (NPV) analysis approach. Although simple, NPV analysis is subject to two major limitations: (1) it does not systematically capture and treat volatility of revenue streams in characterizing the firm’s financial risk profile; and (2) it does not explicitly address the firm’s flexibility in market entry or exit time and its impact on the firm’s investment value. This paper presents a financial valuation model based on the real-options methodology to overcome these limitations. The real-options theory from finance/decision science is applied to evaluate investments in international construction markets and determine the firm’s optimal time to enter or exit a market. The real-options model presented in this paper is used to price two kinds of options typically embedded in the international construction market context: deferring investment and exiting the market. This model can be useful to international contractors because without a proper options pricing model, the significant impact of these flexible options may be overlooked; hence, the value of an investment opportunity may be erroneously computed.