Superiority of Monte Carlo Simulation in Valuing Real Options within Public-Private Partnerships

Abstract

Monte Carlo simulation and geometric Brownian motion are the two methods employed for valuation of guarantees in public-private partnership projects. In this article we argue that any guarantee within the projects that exhibit non-constant growth rate of demand should always be evaluated by using Monte Carlo simulation. Namely, we find that in a typical infrastructure project geometric Brownian motion underestimates cash flows and overestimates the value of the granted guarantee of public partner. In economic terms, our results imply more implemented projects, which are urgently needed, and thus a higher impact on economic well-being. We also contribute to the literature by arguing that proper capture of the growth rate is much more important than the proper capture of volatility, already reported in the field.

Keywords: public-private partnership, real options, infrastructure projects, capital budgeting decisions, guarantees, Monte Carlo simulation, geometric Brownian motion

JEL Classification: G31, H54