Optimal Seismic Upgrade Timing in Seaports with Increasing Throughput Demand via Real Options

Abstract

A real options (RO) formulation is proposed for decision making on the timing to upgrade the seismic performance of existing seaports with increasing throughput demand in earthquake-prone areas. The payoff for the seismic upgrade investment option is estimated based on projected net earnings, repair cost, and downtime for a damaging reference seismic event having a prespecified annual probability of occurrence. These projections inform a discrete-time RO binomial tree, following the American option valuation framework, which propagates the probability of the reference seismic event assuming Poisson temporal distribution of earthquake occurrence. The net present value of the expected annual payoff of the considered investment is used as an index supporting risk-informed decision making discounted by the weighted average cost of capital (WACC). Numerical examples pertaining to decision makers with different capital costs—namely, port authorities and terminal operators—operating in different economic environments typical of developed and developing countries are furnished to illustrate the applicability of the proposed RO formulation. It is found that high WACC and/or low throughput growth bring the optimal seismic upgrade timing forward, while earthquake consequences and upgrade cost have almost no influence on this timing.