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Applying Game Theory and Real Options to Competitiveness in Construction Businesses

Martha Garcia-Saenz Purdue University North Central

Introduction

Net Present Value (NPV) has been the tool used to decide about the future of many projects for a long time. Refinements in calculations are necessary on a daily basis because of global business competition. Better tools for decision-making are indispensable for managerial flexibility in order to respond quickly to changes. For many years, decision-making was tied to strategies fixed in advance, and when projects finished on time managers were considered good ones. Nowadays, management has to be more active; managers have to look constantly for alternatives in order to know what actions to take when information arrives.

Recently in a global market, managerial flexibility has been linked to financial options, more specifically to Real Options. This brings the strategies of the financial market into real projects and helps managers make better decisions. When two or more builders or developers are ready to start similar projects in the same area for example, a strategic investment has to be analyzed under a competitive environment. If one of the builders does the first move, competitive reactions will follow when the second competitor decides to also build. Two theories: a Real Options Valuation, imported from the stock market, and Game Theory, imported from the industrial organization, can analyze and explain the competitive reaction to the strategic investment and give the owner of the project the flexibility to find the optimal time to build, often ignored by the Net Present Value analysis. NPV accepts or rejects a project without the ability to determine the optimal time to invest when a competitor affects the investment opportunity. Through simple cases, this paper shows the advantages and disadvantages in decision making when NPV value is applied, and when the Real Option valuation and game theory are used to help understand a competitive environment.

Net Present Value (NPV) and Discount Cash Flow (DCF)

For a long period of time, the future of a project has been decided using Net Present Value (NPV) and Discounted Cash Flow. NPV is defined as the present value of all future cash returns, discounted at the appropriate interest rate given by the market, minus the value of the investment. The basic logic of discounted cash flow valuation methodologies is built upon the simple relationship between present value and future value. The concept is:

“Proceedings of the 2004 American Society for Engineering Education Annual Conference & Exposition Copyright © 2004, American Society for Engineering Education”

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Garcia-Saenz, M. (2004, June), Applying Game Theory And Real Options To Competitiveness In Construction Businesses Paper presented at 2004 Annual Conference, Salt Lake City, Utah. 10.18260/1-2--13230