rational under-pricing in bidding strategy-a real options model

Rational under-pricing in bidding strategy-a real options model

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Rational under-pricing in bidding strategy: a real options model C. Y. YIU 1 * and C. S. TAM 2 1 Department of Building and Construction, City University of Hong Kong 2 Department of Building and Real Estate, The Hong Kong Polytechnic University Received 3 August 2004; accepted 11 January 2006 Under-pricing in construction tenders is a common phenomenon and is commonly explained by the need of cash flows and penetration strategy. However, these explanations involve profit cutting and therefore are not plausible in explaining a long-term persistent phenomenon of under-pricing. A real options model is proposed and using the binomial lattice method a real-life construction project tender was analysed to examine how management flexibility and uncertainty provide real options value. When uncertainties of cost items in a tender exist and choices are available to defer and switch modes of construction, then a valuable option is available to the bidders. It amounts to about 4% of the lump sum tendered in our case. The under-priced portion is the options value which the bidder is willing to pay for the flexibility and the uncertainty. These findings enable contractors to be more competitive and to estimate construction costs more accurately in devising their bid strategies. Keywords: Real options, pricing, bidding strategy, tendering Introduction Estimation of construction costs is very important in bidding strategy. Ferry et al. (1999) highlight the importance of cost estimation models in the construc- tion industry and Newton (1991) reviews more than 60 cost models, including the regression approach. Elhag and Boussabaine (1999) and Emsley et al. (2002) develop neural network models for building costs estimation. Harding et al. (1999, 2000) analyse and compare the two approaches. They argue that neural network model can determine implicitly non-linear relationships. However, almost all of the previous studies on building cost estimation are based on either a deterministic approach or a probabilistic approach. Mok et al. (1997) report that 92% of the respondents use deterministic approaches to prepare cost estimates. There have been several suggestions in dealing with the uncertainty of construction costs. For example, Newton (1992) and Chau (1995a, 1995b, 1997) study the Monte Carlo simulation of construction costs in triangular density function, while Perry and Greig (1975) and Fellows (1996) propose PERT formulae. Xu and Tiong (2001), on the other hand, estimate construction costs by an expected value model using subjective assessment of probability. Nevertheless, Edwards and Bowen (1998) challenge the subjective identification of the probability distribution function (pdf) of construction costs. Furthermore, these prob- abilistic approaches do not recognise the value of uncertainty and therefore cannot explain the common phenomenon of under-pricing in construction tenders.
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Rational under-pricing in bidding strategy-a real options model

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