Optimal investment and abandonment decisions for projects with construction uncertainty

A model of investment in projects with uncertain construction time is presented in which both the cash-flows upon completion and construction progress are modeled as diffusions. The decision maker has three sequential options: (i) to start construction, (ii) to abandon the project during construction, and (ii) to start operations or abandon after completion. Existence of a solution and some of its qualitative properties are proved. A Markov-chain approximation is used to numerically approximate the solution is introduced. The model is applied to a real-world railway project for which it is found that it does not represent value for money (VfM) and is unlikely to do so in the next decade. A comparative statics analysis reveals that the presence of an abandonment option can increase project value substantially and can speed up investment. Finally, it is argued that the commonly-used benefit-to-cost ratio (BCR) is not an appropriate measure to summarize a project’s VfM. Instead, the value ratio (VR) is suggested as an alternative.