Reaching an Optimal Mark-Up Bid through the Valuation of the Option to Sign the Contract by the Selected Bidder

30 Pages Posted: 17 May 2013 Last revised: 24 Jun 2013

See all articles by João Adelino Ribeiro

João Adelino Ribeiro

Universidade Autónoma de Lisboa Luís de Camões

Paulo Jorge Pereira

Universidade do Porto - Faculdade de Economia (FEP)

Elisio Brandao

Universidade do Porto - Faculdade de Economia (FEP)

Date Written: May 16, 2013

Abstract

Reaching an optimal mark-up value in the context of bidding competitions has been a research topic for more than 40 years. The model herein proposed aims to contribute to this debate by identifying and evaluating a specific real option: the option to sign the contract and perform the construction project by the selected bidder. This option constitutes a real option because (i) the construction costs are uncertain, i.e., the input prices vary stochastically from the moment the bid price is established and the bid results are publicly available and the selected bidder is invited to sign the contract; (ii) flexibility is present since the selected bidder may refuse to enter into contract and execute the project if the construction costs, at the moment the contract has to be signed, are higher than the price included in the bid proposal and (iii) construction costs are, at least, partially irreversible. Since this real option is only available to the selected bidder, its value must be weighted by the probability of winning the bid. A maximization problem that considers the value of the option to sign the contract and the probability of winning the bid is proposed and the model's outcome is the result of this maximization problem. The model is later extended in order to consider the existence of penalty costs, borne by the selected bidder if he or she declines the invitation to sign the contract. Under these conditions, the selected bidder should only exercise the option if the difference between the price and the construction costs, at that moment, is greater than the penalty costs. Results reached using a numerical example demonstrate that the optimal price is higher when penalty costs are present.

Keywords: real options, optimal bidding, construction projects, price determination

JEL Classification: G31, D81

Suggested Citation

Ribeiro, João Adelino and Pereira, Paulo and Brandão, Elísio Fernando Moreira, Reaching an Optimal Mark-Up Bid through the Valuation of the Option to Sign the Contract by the Selected Bidder (May 16, 2013). Available at SSRN: https://ssrn.com/abstract=2265862 or http://dx.doi.org/10.2139/ssrn.2265862

João Adelino Ribeiro (Contact Author)

Universidade Autónoma de Lisboa Luís de Camões ( email )

Lisbon
Portugal

HOME PAGE: http://autonoma.pt

Paulo Pereira

Universidade do Porto - Faculdade de Economia (FEP) ( email )

Rua Roberto Frias
s/n
Porto, 4200-464
Portugal

Elísio Fernando Moreira Brandão

Universidade do Porto - Faculdade de Economia (FEP) ( email )

Rua Roberto Frias
s/n
Porto, 4200-464
Portugal

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