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ANALYSIS OF THE DULLES GREENWAY

The provision of highway infrastructure has since the middle of this century been considered a public responsibility in the United States. Development of the Interstate Highway System (IHS) from 1956 to 1990 was fueled by direct federal funding mechanisms. The enacting legislation in 1956 authorized up to 90% of the cost of urban, primary, and farm-market roads to be paid by the federal government. Since inception, approximately $40 trillion has been spent on building and maintaining nearly 40,000 miles of highway systems (Miller [2000]). While the IHS program proved successful for some time, dwindling federal resources and growing demands on the maintenance, rehabilitation, and continued development of the system over the past two decades have placed a tremendous strain on the condition and performance of one of the nation's most vital resources. Consequently, public officials recently have explored the use of alternative finance and project delivery strategies that leverage private capital for public purposes. These alternative strategies include build-operate-transfer (BOT), design-build-finance-operate (DBFO), design-build-operate (DBO), turnkey, and others described by Miller [1999]. Typically, these private highway project arrangements transfer property control and cash flow rights from the public to the private domain for a specified concession period. Property control rights may be limited to the transportation corridor or may include parcels of land adjacent to the corridor. Cash flow rights most often involve user fees (tolls), receipts from the lease or sale of adjacent properties, or in some cases "shadow tolls."(*) Special legislation and "innovative" contract mechanisms generally are employed to balance the risks among the public and private participants. Market risk, or the eventual demand for the highway system based on established toll rates, is among the most significant of these project risks. Private sponsors must balance toll rates with demand (or traffic volume) to recover large capital costs, pay ongoing expenses, and service debt. The critical issue to these private participants is generating an appropriate return on equity and ensuring that the project is a viable concern. Indeed, it can be argued that the public sector should have an equal interest in the private participants' profitability if privatization is to remain a viable mechanism for the long-term sustainment of American infrastructure. To this end, the public sector often provides direct funding subsidies or indirect funding incentives in the way of tax relief, development rights to properties located in proximity to the highway project, and other means. These indirect incentives and other project contingency features, such as waiting and learning before investing and making follow-on investments if the initial investment succeeds, create investment opportunities that are often ignored by the strict application of traditional valuation methods. This article retrospectively examines the investment decision of a recently developed private highway project using traditional valuation methods and a simple option valuation model. The latter model is developed to clarify the market uncertainty confronting this project, to approximate the value of waiting and acquiring more information to

resolve this uncertainty, and to demonstrate an improved technique for investment decision-making. Development of this model emphasizes the significance of recognizing the risk associated with future revenue and the irreversibility of the investment decision, both of which are characteristic of large--scale private highway projects. The article begins with a review of asset-backed financing, traditional valuation methods and associated shortcomings, and managerial flexibility employed in infrastructure development. BACKGROUND Project Financing and Risk Asset-based (or project) financing is an alternative to conventional financing that permits private sponsors to shift financial risks from their own balance sheets to the assets of the project. Project financing is commonly used with alternative project delivery approaches, such as BOT, DBFO, DBO, and their variants, where private capital is at stake over a long horizon. Project financing is considered viable when an infrastructure facility can function as an independent economic unit. Highways are an example of infrastructure assets that can function independently to generate revenues from tolling arrangements that offset ongoing costs, dividend payments, debt service, and investment outlays. Private sponsors typically form a limited-life business structure (e.g., corporation, limited liability company, partnership, joint venture) to oversee the development, financing, construction, and operation of the facility. The sponsor company then can raise capital on a project basis by issuing equity and debt securities that are self-liquidating from the revenues derived from project operations. In this arrangement, a number of firms with unique expertise may unite as the project sponsor company to distribute risks to those best able to manage them without burdening their own balance sheets. A critical aspect of infrastructure development is the determination, allocation, and management of project risks. In the case of project financing, lenders, equity participants, and other stakeholders are concerned with the ability of the infrastructure facility to provide a sufficient return for the risks they are asked to bear. The analysis and evaluation of a project's technical feasibility, creditworthiness, and economic viability must be addressed to the satisfaction of these stakeholders for the project to proceed. Technical feasibility accounts for new technologies, environmental factors, construction risks, and the operational performance of the project. Creditworthiness refers to the ability of project revenues to adequately cover operating costs and debt service requirements over the life of the project. It is of particular concern in asset-based financing, especially to lenders, since their only recourse is the project and its associated assets and cash flows. Economic viability depends mainly on the stability of profits over the life of a project. Profitability may be compromised initially by rising capital costs during construction. During operations, profitability is sensitive to market conditions that impact the price of, and demand for, a project's output. Price and demand are interdependent variables that ultimately determine the revenues generated by a project. Increasing operating costs or declining revenues reduce a project's creditworthiness and ability to provide an attractive rate of return to equity investors.

Thus, pricing strategies in private highway tolling arrangements and eventual traffic volume present a significant uncertainty that must be appropriately analyzed and evaluated in the initial planning stages of development. Traditional Valuation Methods Economic viability is the crux of the investment (or capital budgeting) decision, which seeks to find whether a project generates benefits that are worth more than its costs. The use of discounted cash flows (DCF) to determine net present value (NPV) is the preferred method for establishing the value of a project that is not established in an active market, such as infrastructure projects (see Brealey and Myers [1996], pp. 85-106). Miller and Evje [1997] demonstrate the use of these techniques in investigating procurement strategies for infrastructure projects. The capital budgeting decision is followed by the capital financing decision, which aims to determine appropriate levels of equity and debt required for the project. In this way, the investment decision is simplified and evaluated as an allequity project prior to adding the complexity of the financing decision. Finnerty [1996] explains the use of discounted cash flows in analyzing and planning project financing strategies. Shortcomings of Traditional Valuation Methods Amram and Kulatilaka [1999], Trigeorgis [1999], Dixit and Pindyck [1994], Myers [1984], and others point to the shortcomings of discounted cash flows in valuing flexibility. The deficiencies center around two implicit assumptions of DCF. First, investment is considered reversible. That is, the initial investment is assumed recoverable in the event that a negative outcome occurs. In fact, large-scale infrastructure projects are typically quite the opposite. Initial investment is generally irreversible in that planning, design, and construction expenses are usually sunk costs. Second, if the investment is irreversible, then it must occur immediately, as the opportunity to invest later does not exist. In effect, these assumptions imply that managers are passive bystanders and are not able to respond to new information. But in reality, managers often employ flexibility throughout the development process in order to respond to new information and limit exposure to downside events, while seizing upside opportunities. They also usually have the option to delay investment. Oftentimes the more relevant decision is not whether to invest, but when. Luehrman [1997] and Myers [1984] suggest that traditional valuation methods are adequate for investment decisions regarding existing operations (or assets-in-place). In these cases, ongoing operations generate relatively safe cash flows and are held for this reason, not for less tangible strategic purposes. They also work well for typical engineering investments, such as equipment replacement, where the main benefit is cost reduction. However, when capital investment creates future growth opportunities (e.g., follow-on development if product demand is favorable) or contingency possibilities (e.g., delay project or abandon project), DCF methods understate the value of this flexibility. Exhibit 1 (adapted from Luehrman [1997]) illustrates this argument. In the left pane, the investment decision is made a priori to the resolution of future outcomes. In the right pane, uncertain outcomes are known

before the investment decision is made. In this case, the investment can be deferred or abandoned if the future state is unfavorable. Thus, future losses are averted resulting in a higher present value. Valuing Flexibility Large scale, significant capital costs, and a long useful life generally characterize infrastructure investment. As a result, development usually proceeds in a series of stages that aim to better define project scope and discover unknown information. Moreover, flexibility often is incorporated as an intuitive managerial approach to deal more effectively with uncertainty. Preliminary planning and feasibility studies, such as environmental impact studies, geotechnical surveys, and traffic volume analyses, can reveal information that may alter further investment and development decisions. Flexible design permits infrastructure projects to adapt more readily to changing conditions such as an increase or decrease in expected demand for the project's output. Staged construction can afford decision-makers the opportunity to gain more information as market conditions become more certain. In short, flexibility can effectively reduce the life cycle costs of a project by allowing a more timely and less costly response to a dynamic environment. Flexibility adds value; it is implicitly used as a hedge (or insurance) or coping mechanism against uncertain outcomes. However, flexibility comes at a cost in terms of money, time, and complexity. The added value of flexibility must be weighed against its cost. Traditional evaluation methods do not adequately support such analyses. The following case serves to illustrate this point. CASE STUDY: DULLES GREENWAY Project Background In 1987, the Virginia Department of Transportation (VDOT) began planning studies for extending the existing Dulles Toll Road from the Dulles International Airport westward to the junctions of Routes 7 and 15 in Leesburg, Virginia. The road extension would connect a growing residential population in rural Loudoun County to expanding work centers in northern Virginia and Washington, D.C. At the time, only two major east-west arterial roads, State Routes 7 and 50, linked the two regions. The typical western commuter on these routes experienced increasing congestion and frequent stops at traffic lights. The Dulles Toll Road extension aimed to greatly improve this commute and spur economic growth in Loudoun County. Facing a deficit of $7 billion for transportation improvement needs, the Virginia General Assembly passed legislation authorizing the private development of toll roads in 1988. This enabling statute was followed one year later by an application from a group of private investors to design, build, finance, and operate the Dulles Toll Road extension. The private development group was a partnership comprised of the Shenandoah Greenway Corporation (formed by the Bryant/Crane family of nearby Middleburg, Virginia), Autostrade International (an Italian toll road developer and operator), and Kellogg Brown & Root (a large American construction firm based in Houston, Texas). The developers, who would eventually be known as the Toll Road Investors Partnership II (TRIP II), were approved by the state and granted a certificate of authority in 1990.

Project scope and financing. Under TRIP II, the Dunes Toll Road extension became the Dulles Greenway. Three years of planning, design, and arranging financing resulted in the state's approval of a four-lane, limitedaccess highway with seven interchanges. Two future interchanges would be added when traffic volume reached appropriate levels. Located within 250 feet of right of way, the project was designed to accommodate future lane expansion. Electronic toll collection technology was included in the design to maintain steady traffic flow. The project originally was scheduled to start construction in 1989 and operations in 1992, but difficulties in securing financing and environmental permits caused delay. Construction commenced in September 1993 and ended six months ahead of schedule in September 1995. TRIP II contributed up to $40 million in equity and arranged for another $46 million in lines of credit to cover potential revenue shortfalls during operations. The Shenandoah Greenway Corporation contributed $22 million, while the other partners accounted for the balance. The bulk of the project's financing, $258 million in long-term fixed-rate notes, was provided by a consortium of 10 institutional investors. The three lead debt investors were CIGNA Investments Inc., Prudential Power Funding Associates, and John Hancock Mutual Life Insurance Company. A bank group consisting of Barclays Bank, NationsBank, and Deutsche Bank provided a portion of construction financing and a $40 million revolving credit. TRIP II's entire right, title, and interest in the highway project secured the financing. Traffic demand and initial project operations. As a completely private venture, the Dulles Greenway would provide some 40 years of cash flows to its investors and debt holders without public subsidies. Revenues were dependent on the interrelationship between average daily traffic demand and established toll rates. Independent consultants conducted traffic forecasts prior to construction as a basis for planning and investment analysis. These traffic forecasts were based on a construction start in 1989 and operations beginning in 1992. Moreover, the forecasts relied, in part, on the healthy economic conditions of the late 1980s and did not account for the economic downturn in 1991, particularly in the commercial and residential real estate markets. Approximately 20,000 vehicles per day were projected for the first year of operation at a fixed toll rate of $1.50. By 1995, the daily traffic demand was forecasted to be 34,000 based on the same toll rate. The four-year schedule slip between actual operations and traffic projections was accounted for by using the daily ridership forecast of 34,000 (see Pae [1995]). Within six months of opening in late 1995, the project was in financial distress. Average daily traffic demand was an abysmally low 10,500. Toll rates were reduced from an initial $1.75 to $1.00 by March 1996, and future toll hikes were deferred in an attempt to increase ridership. Furthermore, the state legislature increased the speed limit on the highway to 65 mph (miles per hour). By July 1996, road usage increased to 21,000 daily travelers, averaging 1% to 2% monthly growth. However, the net effect on projected revenues was marginal, as decreased toll rates offset the increase in ridership. TRIP II officials began discussions with the project's creditors in the summer of 1996 to work out a plan for deferring debt payments and restructuring loan contracts (see Bailey [1996]).

Significant Issues The Dulles Greenway was among the nation's first highway projects to be delivered with a design-build-financeoperate franchise since the nineteenth century, when the U.S. commonly relied upon the private sector for infrastructure development. Consequently, the project presents a number of significant issues, which in retrospect are worth re-examination. These issues include the lack of public funding participation and subsequent alignment of incentives, the unsolicited sole-source nature of the procurement strategy, and the potential workout strategies for restructuring current debt obligations. This case, however, focuses on revenue risks caused by uncertain traffic demand. The initial investment decision is reconstructed and analyzed with traditional valuation methods. Then, a simple option valuation technique is applied to illustrate its potential impact on the initial investment decision. INVESTMENT DECISION ANALYSIS Traditional valuation model. The investment analysis is reconstructed from an ex ante perspective using cash flow estimates and construction costs from financial models submitted to the state (see Toll Road Corporation of Virginia [1993]). To simplify the analysis, pre-construction, construction, and other development costs are combined as $279 million and assumed to occur in one year in 1995. Actual construction, including financing, cost $326 million and was accomplished in a twoyear period. Financing, taxes, depreciation, and other costs are ignored as the focus of this analysis is on the investment decision, specifically from the private developer's viewpoint. The investment decision from a public vantage might include other social benefits, such as property tax increases from new development, federal and state taxes paid by project operations, and savings in state transportation funds. The cash flows analyzed are earnings before interest and taxes (EBIT), which occur annually over a 40-year period (see Exhibit 2). In this case, EBIT is calculated as follows:

(1) EBIT = Gross Revenue - Operating Expenses - Capital Improvements (2) Gross Annual Revenue = Average Daily Traffic x Average Toll Rate x 365 days per year

Average daily traffic demand begins at 34,000; it is assumed to grow at a rate of 14% annually for the first six years of operation. Demand growth tapers off to a rate of 7% per year for the remaining 34 years. The schedule of average annual toll rates begins at $2.00 and gradually rises to $3.00 by the fifteenth year of operation. Note that the interdependence between traffic demand and toll rates is not modeled. These assumptions roughly match those of TRIP II'S financial model. Operating expenses include operations and maintenance costs, various fees, police costs, lease payments, and other expenses from the TRIP II financial model. Operating expenses start at $9 million per year and grow at a constant rate of 5% annually. Capital improvements include major planned repaying and road widening activities. Follow-on construction of two key interchanges at a cost of $38 million is not incorporated in the model. It is assumed that these interchanges will be added only if demand and subsequent revenue materializes; otherwise, they are not required and are not considered in the initial investment decision. The next step is to estimate an appropriate discount rate for the project using the weighted average cost of capital (WACC). According to the WACC, the return on assets (Ra), or discount rate, is a function of the weighted average of the cost of equity (Re) and the cost of debt (Rd). The amount of debt (D) and equity (E) are used in the project sum to determine a project value (V). In theory, this value represents the market value of the project, and equity is backed out (E = V - D). However, in this case, highway projects do not have a market value per se, so book values are used instead. The cost of debt is then approximated as a composite of the rates from the multiple longterm notes used for the project. Equation 3 illustrates the WACC and the variables defined thus far.

(3) Ra = Re(E/V)+Rd(D/V), where V = E+D = Re ($40M/$319M) + 10% ($279M/$319M)


The last variable, cost of equity (Re), is estimated using the capital asset pricing model (CAPM). According to the CAPM, the cost of equity is a function of the risk-free rate of interest (Rf), the project's equity beta (e), and an appropriate equity risk premium (Rm - Rf). The risk free rate is determined from yields on the 30-year bond in 1993, approximately 7.25%. The equity risk premium is based on typical premiums (differences between equity market returns and risk free returns) for the early 1990s, approximately 7.4%. The equity beta is then estimated using a weighted average of risk, where the asset beta is assumed to be 0.4 for the transportation industry and the debt beta 0. The equity beta is calculated as follows:

(4) e= a (V/E) = 0.4 ($319M/$40M) = 3.2

Using the CAPM, the cost of equity is: (5) Re = Rf + e(Rm - Rf) = 7.25% + 3.2(7.4%) = 30.9%
Returning to the WACC in Equation 3 and plugging in the cost of equity, the project's discount rate is 12.6%. Traditional valuation analysis. Using the spread-sheet in Exhibit 2, the project's present value of the net earnings is $560 million; with a capital expenditure of $279 million, the project's net present value (NPV) can be readily determined as $281 million, and the decision to invest is clear. However, recognizing the uncertainty of traffic demand, a simple sensitivity analysis of the project NPV to demand, while holding other variables constant, illustrates the critical points that change the investment decision (see Exhibit 3). Mainly, traffic demand below 19,868 results in a negative NPV and alters the investment decision. Examining the sensitivity of NPV in combination with the project's discount rate and traffic demand further refines the analysis. Exhibit 4 displays varying discount rates as vertical gridlines emanating from the bottom horizontal axis. Starting with 6%, each gridline represents a 50 basis point (0.5%) increment up to 18% on the far right. The horizontal gridlines represent traffic demand, which increases from 10,000 at the bottom in increments of 2,500. The shaded gray area (upper left) depicts a positive project NPV, while the white area (lower bottom) portrays a negative project NPV. Using this figure, the discount rate can be fixed and the corresponding vertical gridline followed up to the point where the investment decision changes (where the gray area meets the white area). Reading across then reveals the critical traffic demand value. For example, at 15% the critical demand value is between 22,500 and 25,000. Traffic demand can be fixed as well and the critical discount rate determined. If the expected demand is 34,000, the decision appears insensitive to the range of discount rates considered. The key conclusion of this analysis is that the investment decision is subject to change for demand values below 33,244 and discount rates above 6.88%. Based on the initial assumptions of the case, the private sponsor has a relatively large comfort zone in choosing to invest. Initial demand would have to decline by over 41% (from 34,000 to 19,868) before the decision would be altered, and the discount rate is inconsequential at this expected demand level. Simple option valuation method. A new investment model is now developed using a simple binomial tree. The intent of this model is to recognize more explicitly the uncertainty of initial traffic demand and its effect on the value of the project. Moreover, this model is constructed to provide a rough estimate of the value of acquiring more information to help resolve initial demand uncertainty. The following general assumptions serve to bind the investment decision model.

First, the option to wait to build the highway is limited to five years, because the public sector will pursue transportation alternatives for the region with its own resources beyond that horizon. Furthermore, the length of the concession remains the same regardless of when construction begins. Second, traffic demand uncertainty can be resolved (or at least narrowed) by observing demographic growth patterns and other key variables in the regions connected by the highway project. Third, initial demand is the critical variable. Demand growth thereafter increases in a relatively consistent and predictable manner. Presuming that the highway will spur economic growth and subsequent traffic in the regions and that competing transportation means are eliminated by contract during the concession period further supports this assumption. Fourth, the value of the project is represented by the present value of net earnings over the 40-year operations period less the cost of construction, or NPV. Fifth, there is no direct cost to waiting. That is, the present value of net earnings and costs in five years' time would be similar to the value today if the project were executed immediately. Inflation is therefore ignored here for simplicity. Nonetheless, the evaluation model still caters for the opportunity costs of asset appreciation by discounting the cash flow realized in the future by the risk-free rate. The model sets up benefits from the ex post performance of the project in that it is now known that the expected traffic demand for the first year of operation was overly optimistic. However, Pae [1995] and others point to the critical fact that the private sponsors relied on an outdated traffic forecast that did not account for an economic downturn in 1991. This forecast might easily have been updated or further traffic analysis conducted prior to construction. Thus, it is assumed for this case that the expected demand could have been revised ex ante to at least 20,000, which matches the private sponsors' traffic study for the first year of operation, albeit four years out of date. The model further assumes a high demand of 34,000 and a low demand of 10,000. Again, recognizing such uncertainty ex ante seems reasonable, although potentially overly volatile in terms of up and down movements. Exhibit 5 shows the basic setup of the model. The spreadsheet in Exhibit 1 is used to generate project PVs of net earnings given the three states of demand. The PV based on expected demand occurs in period 0 (year 1995), while the other two PVs are realized in period 5 (year 2000). The PVs are calculated using the same project discount rate (12.6%) determined in the traditional valuation model, and each represents 40 years of cash flows. A risk-neutral probability (p) is then calculated using a risk-free rate of interest (assumed to be 7.25% over the fiveyear period) to equate the possible PVs five years forward with the expected PV in period 0. Thus, in a risk-neutral world, where all assets are assumed to appreciate at the risk free rate and investors' risk attitudes do not matter, the probabilities of high demand and low demand are 0.665 and 0.335 respectively.

These risk-neutral probabilities now can be used to evaluate the value of the project embedded with the deferral option. Because the capital expenditure to develop the project is $279 million and the PV of net earnings in the down state (demand = 10k) is only $83 million, it is better to abandon the project in the case of a down state instead of pursuing a negative NPV project. This scenario is represented by Exhibit 6 in determining the expected value of the project (using risk-neutral probabilities) as valued in period 0. The base case NPV with the expected demand value of 20,000 is $3M [$282M - $279M]. Traditionally, the private sponsor would have invested immediately in the project in period 0. However, this approach ignores the additional value of waiting to build and acquiring more information to resolve the demand uncertainty. Since the value of the project with deferral option is $132M, which is substantially greater than the NPV of $3M from immediate project execution, it justifies that the private sponsor should at least wait for some of these uncertainties in traffic demand to resolve. Specifically, the difference of $129M between the two analyses is driven by the large volatility in the traffic demand (swinging from 10,000 to 34,000) as typically the case in most transportation development. If this volatility is minuscule, similar evaluation with the deferral option could be less than the base case NPV and it would then be justified to start the development immediately. Discussion of Results The above analysis illustrates how uncertainty and choice of timing can alter an irreversible capital investment decision. Recognizing the value of these effects necessitated looking beyond traditional discounted cash flows and NPV. In this case, NPV is not replaced; rather, it is augmented by a very simple model that explicitly recognizes the revenue risks caused by uncertain demand for the project's output. Dulles Greenway's private sponsors faced an investment opportunity with the option to exercise now or later in exchange for the value of nearly 40 years of cash flows. Given that some probability existed for the investment to result in a loss suggests that the opportunity to delay and acquire better information had value. From the above analysis, this value was substantial, given that the volatility of demand is huge. A more rigorous option valuation method may provide greater precision than the binomial model. The exact value of the project with deferral option is even greater than what has been calculated because the private sponsor really has the flexibility to exercise its option in years 1, 2, 3, and 4, rather than constraining its choice to year 5. This would require solving a continuous-time model that is substantially more complicated. However, the aim of this case was to demonstrate simply how infrastructure investment opportunities could be treated as options and how the role of uncertainty could be clarified. There are several implications from this simple analysis:

First, investment irreversibility and uncertainty create an incentive to wait and learn. In private high-way development, resolution of uncertainty is a circular problem to some degree. That is, building the road generates growth and subsequent demand, thereby resolving uncertainty. On the other hand, demand uncertainty must be resolved within reasonable limits to ensure the project's economic viability. In this case, the costs of acquiring better traffic demand information are more than justified. Second, delay has value, and it should be considered in the NPV analysis. That is, building the highway immediately "kills" the option to wait, thus reducing the project's NPV. Third, planned highway corridors that are appropriate for privatization are worth more than might otherwise be determined by traditional NPV. This case illustrates other interesting option features. The private sponsors made a "modular" investment in designing and building the highway to be easily expanded beyond its original four lanes. Purchasing 250 feet of right-of-way provided the investors with an option to expand without further land acquisition and environmental permitting. Furthermore, they staged construction of all interchanges, leaving the final two for future completion. The highway itself might also be considered a growth option in that the largest equity investor, Shenandoah Greenway, was also a large landowner in the region. The equity investment in the highway may positively influence local land values, thereby increasing the broader holdings of the investor. Finally, the private sponsors have an abandonment option in that they can elect to default on debt obligations and surrender their interest in the project. While the accompanying transaction costs may prove prohibitive, the option to limit further losses is nonetheless valuable. Post Mortem Early troubles continued. Compounding the Greenway's initial financial problems, the Virginia Department of Transportation (VDOT) began widening Route 7, a competing free road, in the summer of 1996. TRIP II and the project's creditors were obviously upset by this government action and protested it to no avail. Infrastructure Finance reported that many of those at VDOT who were active in the formative stages of the toll road were, at best, ambivalent about the Greenway project (see Bailey [1996]). Michael Crane, CEO of TRIP II, commented, "We wouldn't do it as a totally private infrastructure project, if we had to do it again. These projects are only successful as public-private partnerships. The developer must have the full support of the state." Restructuring the debt. With its financial troubles mounting, TRIP II began efforts in earnest during the latter stages of 1996 and early 1997 to restructure its debt. In March of 1997, the Washington Post reported that the owners and creditors were close to structuring a new deal. In May, TRIP II reached an agreement with its creditors to avert foreclosure and forego remaining quarterly interest payments of $7 million each for the remainder of 1997

in exchange for a toll rate increase on the facility. At this point, the project had failed to make four quarterly debt payments totaling more than $28 million. Throughout the remainder of the year, the project continued to struggle, but traffic volumes did increase. In October of 1998, the owners filed a plan to restructure the project's debt with the Virginia State Corporation Commission. The entirely private deal, fashioned by Bear, Stearns & Co., would replace roughly $250 million of the original bank and insurance company debt with approximately $360 million in insured, zero-coupon bonds that would mature on January 1, 2036, the end date for the franchise. The proposed plan would minimize debt service for the first 10 years to match reduced revenue projections while increasing principal and interest payments overall by $575 million to $1.43 billion, with over two-thirds of the payments occurring in the final 20 years. In addition, the Bryant/Crane family would exit the owners group (see PWF [1998]). While the state reviewed the plan, TRIP II instituted in November of 1998 a "VIP Miles Frequent Rider Program" that would pay cash rebates to riders who reached established mileage requirements. By the following spring, in 1999, the state had granted its approval of the restructuring deal, and the Greenway had experienced its first 40,000-vehicle weekday. Even though the facility took nearly four years before it reached its expected initial traffic volume, the timing could not have been better for the pending bond issue. In April, TRIP II sold approximately $320 million in mostly zero-coupon bonds in the 144a market, thanks to a boost from insurer MBIA's Aaa rating; Standard & Poor's rated the issue at triple-B-minus while Moody's rated it as Baa3. All rating agencies cited the project's recent strong performance (TRIP IIa [1999]). A key condition of the issue, however, according to Fitch IBCA (now Fitch), was the execution of releases by TRIP II partners of any claims, rights, or damages. In exchange for claims related to construction and original financing, the owners also offered $56.9 million in first tier and $29 million in second tier subordinated, compound interest revenue bonds (see PWF [1999]). All three original partners retained ownership of the Greenway. According to Public Works Financing, the Shenandoah Greenway Corporation and Autostrade International Equity had invested roughly $105 million during and after construction. In addition, partner letters of credit had been drawn to $80 million for overdue principal and interest on the original loans. Brighter horizons? With a new deal for the project's debt and increasing traffic and toll revenues, the future of the Greenway is not nearly as dismal as it once was. In fact, TRIP II announced plans in December of 1999 to expand the highway by adding an additional eastbound lane from Exit 6 at Route 772 to the Mainline Toll Plaza (TRIP IIb [1999]). Estimated cost of the five-mile expansion is $8.5 million. In the same month, the owners also projected that they would pay roughly $125,000 in rebates to members of its "VIP Miles" program (TRIP IIc [1999]). Most recently, TRIP II instituted a toll increase of $0.25 for vehicles with two axles and $0.50 for vehicles with three or more axles in April of 2000 to help pay for the expansion. Tolls for an end-to-end weekday trip on the Greenway now stand at $2.00 for cars and $4.00 for vehicles with three or more axles; weekend trips are $1.50 and $3.00 (TRIP II [2000]).

CONCLUSIONS Recognizing and valuing the inherent flexibility of an infrastructure project permits a more robust approach to making investment decisions. As demonstrated in the Dulles Greenway case, the application of a simple option valuation model is a valuable supplement to traditional financial valuation methods and more appropriately accounts for the uncertainty and irreversibility related to large-scale infrastructure investment. Indeed, in the Dunes Greenway case, such an analysis might have clued its private sponsors and creditors that waiting and acquiring better traffic information was a more prudent decision than building immediately. This option is even more valuable when the transaction costs associated with financial distress (i.e., debt restructuring, additional credit draws, and equity infusions) and toll rate decreases are considered. Broader conclusions for private infrastructure development may further be induced from this case. Flexibility is common in large-scale infrastructure investment. Flexibility describes management opportunities that are often the key to making strategic investment decisions. The managers of real assets intuitively act to take advantage of favorable conditions and mitigate the results of unfavorable situations. While recognized for its strategic importance, this managerial flexibility is often considered among the "intangibles" when analyzing financial forecasts and choosing among investments. Traditional valuation techniques using discounted cash flows implicitly assume that real assets are passively managed, and they fail to account for the value of this flexibility. However, where precision is not required, relatively simple techniques can be applied to augment traditional methods in estimating the value of project option features. The emerging application of real option valuation may prove beneficial to both public and private infrastructure planners in the realization and analysis of additional project value and the ultimate structuring of development strategies based on this added value. ENDNOTE (*) "Shadow tolls" are a fee charged to private entities (landowners and businesses) along the transportation corridor that benefit through increased property value and/or increased access. The term may also apply to public entities (local or state governments) that benefit from a highway project and subsequently guarantee or subsidize portions of that project to maintain minimum levels of revenue streams (see Tillman [1998]). DIAGRAM: EXHIBIT 1 Valuing Assets-In-Place versus Opportunities and Contingencies EXHIBIT 2 Dulles Greenway Base Case Valuation

Legend for Chart: A - Year B - Index

C - Operating & Capital Projections vehicles) [1] D - Operating & Capital Projections E - Operating & Capital Projections F - Operating & Capital Projections G - Operating & Capital Projections H - Operating & Capital Projections & Taxes [6] I - Operating & Capital Projections J - Valuation Discount Factor [8] K - Valuation Discounted EBIT [9]

Traffic per Day (# tolled Toll per Vehicle [2] Gross Revenue [3] Operating Expenses [4] Capital Improvements [5] Earnings Before Interest Capital Expenditure [7]

L - Valuation Discounted Capital Expenditure [10] A B C F I D G J E H K L

1995

0 (279,000,000) 1.0000 (279,000,000)

1996

34,000 (9,000,000)

2.00 0.8880

24,820,000 15,820,000 14,047,841 28,294,800 18,844,800 14,859,278 32,256,072 22,333,572 15,637,505 41,368,412

1997

38,760 (9,450,000)

2.00 0.7885

1998

44,186 (9,922,500)

2.00 0.7002

1999

50,372

2.25

(10,418,625) 0.6217 2000 5 57,425 (10,939,556) 2.25 0.5521 2001 6 65,464 (11,486,534) 2.50 0.4903 2002 7 70,047 (12,060,861) 2.50 0.4353 2003 8 74,950 (12,663,904) 2.50 (3,000,000) 0.3866 2.65 0.3433 2005 10 85,810 (13,961,954) 2.65 (1,700,000) 0.3048 2006 11 91,817 (14,660,052) 0.2707 2007 12 98,244 (15,393,054) 2.85 0.2403 2008 13 105,121 2.85 2.65

30,949,787 19,242,879 47,159,990 36,220,434 19,997,197 59,735,987 48,249,453 23,654,347 63,917,507 51,856,646 22,574,913 68,391,732 52,727,828 20,382,837 77,569,902 64,272,803 22,062,519 82,999,796 67,337,842 20,525,329 88,809,781 74,149,730 20,069,826 102,198,275 86,805,221 20,863,299 109,352,154

2004

80,196 (13,297,099)

(16,162,707) 0.2134 2009 14 112,480 (16,970,842) 2.85 (9,400,000) 0.1895 3.00 0.1683 2011 16 128,778 (18,710,354) 3.00 0.1494 2012 17 137,792 (19,645,871) 3.00 0.1327 2013 18 147,438 (20,628,t65) 3.00 (10,400,000) 0.1178 3.00 0.1046 2015 20 168,801 (22,742,552) 0.0929 2016 21 180,618 (23,879,679) 3.00 0.0825 2017 22 193,261 3.00 3.00

93,189,447 19,888,726 117,006,805 90,635,962 17,176,864 131,786,612 113,967,227 19,179,019 141,011,674 122,301,321 18,275,979 150,882,492 131,236,620 17,414,365 161,444,266 130,416,101 15,366,923 172,745,365 151,085,792 15,808,200 184,837,540 162,094,989 15,060,225 197,776,168 173,896,489 14,346,824 211,620,500

2010

15

120,353 (17,819,384)

2014

19

157,758 (21,659,573)

(25,073,663) 0.0733 2018 23 206,789 (26,327,346) 3.00 0.0651 2019 24 221,264 (27,643,714) 3.00 0.0578 2020 25 236,753 (29,025,899) 3.00 0.0513 2021 26 253,325 (30,477,194) 3.00 0.0455 2022 27 271,058 (32,001,054) 3.00 0.0404 2023 28 290,032 (33,601,107) 3.00 0.0359 2024 29 310,335 (35,281,162) 0.0319 2025 30 332,058 (37,045,220) 3.00 0.0283 2026 31 355,302 3.00 3.00

186,546,837 13,666,457 226,433,935 200,106,588 13,017,649 242,284,310 214,640,596 12,398,985 259,244,212 230,218,313 11,809,111 277,391,307 246,914,112 11,246,732 296,808,698 264,807,644 10,710,606 317,585,307 283,984,200 10,199,545 339,816,279 304,535,116 9,712,412 363,603,418 326,558,198 9,248,119 389,055,657

(38,897,481) 0.0251 2027 32 380,173 (40,842,355) 3.00 0.0223 2028 33 406,785 (42,884,473) 3.00 0.0198 2029 34 435,260 (45,028,697) 3.00 0.0176 2030 35 465,728 (47,280,132) 3.00 0.0156 2031 36 498,329 (49,644,138) 3.00 0.0139 2032 37 533,212 (52,126,345) 3.00 0.0123 2033 38 570,537 (54,732,662) 0.0109 2034 39 610,475 (57,469,296) 3.00 0.0097 2035 40 653,208 3.00 3.00

350,158,176 8,805,625 416,289,554 375,447,198 8,383,934 445,429,822 402,545,349 7,982,095 476,609,910 431,581,213 7,599,197 509,972,604 462,692,472 7,234,370 545,670,686 496,026,547 6,886,781 583,867,634 531,741,289 6,555,636 624,738,368 570,005,706 6,240,175 668,470,054 611,000,758 5,939,671 715,262,958

(60,342,760) 0.0086

654,920,197 5,653,432

559,725,427 (279,000,000) Analysis Variables: Initial Traffic Volume Annual Traffic Growth Rate (Index 1-6) Annual Traffic Growth Rate (Index 7-40) Annual Growth Rate of Operating Exp. Weighted Average Cost of Capital Valuation Results: Net Present Value Internal Rate of Return
GRAPH: EXHIBIT 3 Sensitivity of NPV to Traffic Demand GRAPH: EXHIBIT 4 Sensitivity of Project NPV to Discount Rate and Average Daily Traffic Demand DIAGRAM: EXHIBIT 5 Binomial Model for Establishing Risk-Neutral Probabilities DIAGRAM: EXHIBIT 6 Project Value with Deferral Option REFERENCES

34,000 14.00% 7.00% 5.00% 12.62% 280,725,427

18.27%

Amram, Martha, and Nalin Kulatilaka. Real Options: Managing Strategic Investment in an Uncertain World. Boston: Harvard Business School Press, 1999. Bailey, Elizabeth. "Driving Up the Learning Curve." Infrastructure Finance, July-August 1996, pp. 9-10. Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance, 5th ed. New York; McGraw Hill, 1996.

Dixit, Avinash K., and Robert S. Pindyck. Investment Under Uncertainty. Princeton, NJ: Princeton University Press, 1994. Finnerty, John D. Project Financing: Asset-Based Financial Engineering. New York: John Wiley & Sons, 1996. Luehrman, Timothy A. "What's It Worth? A General Manager's Guide to Valuation." Harvard Business Review, MayJune 1997, pp. 132-142. Miller, John B. Principles of Public and Private Infrastructure Delivery. Norwell, MA: Kluwer Academic Publishers, 2000. -----. "The Practical Application of Delivery Methods to Project Portfolios." Construction Management and Economics, Vol. 17, No. 5 (September 1999), pp. 669-677. Miller, John B., and Roger H. Evje. "Life Cycle Discounted Project Cash Flows: The Common Denominator in Procurement Strategy." Proceedings of the 1st International Conference on Construction Industry Development, Vol. 2, Singapore, 1997, pp. 364-371. Myers, Stewart C. "Finance Theory and Financial Strategy." Interfaces, Vol. 14, No. 1 (January-February 1984), pp. 126-137. Pae, Peter. "Drivers Put the Brake on Toll Road's Promise." Washington Post, December 26, 1995, pp. A1, A18, A19. -----. "Agreement Buys Time for Dulles Greenway." Washington Post, May 29, 1997. Public Works Financing. "Credit Enhancer for Dulles Greenway Debt?" November 1998, pp. 6-8. -----. "Dulles Greenway Refinancing Closed." April 1999, pp. 12-13. Tillman, Raymond. "Shadow Tolls." Civil Engineering, April 1998, pp. 51-53. Toll Road Corporation of Virginia. "Financial Model for the Final Financing." Application to the Virginia State Corporation Commission for Dulles Greenway, Exhibit 3, Case No. PUA900013, 1993. Toll Road Investors Partnership II, L.P. (TRIP IIa.) "Dulles Greenway Obtains Triple-A Bond Rating in $350 Million Refinancing Project." Press release, April 29, 1999. -----. (TRIP IIb.) "Dulles Greenway Constructing Additional Lanes." Press release, December 6, 1999.

-----. (TRIP IIc.) "Dulles Greenway Projects over $125,000 to Be Distributed through Frequent Rider Plan." Press release, December 28, 1999. -----. "Dulles Greenway Raises Toll to Aid Roadway Expansion." Press release, March 17, 2000. Trigeorgis, Lenos. Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge, MA: The MIT Press, 1999.
To order reprints of this article please contact Ajani Malik at amalik@iijournals.com or 212-224-3205. ~~~~~~~~ By Stephen C. Wooldridge; Michael J. Garvin; Yuen Jen Cheah and John B. Miller STEPHEN C. WOOLDRIDGE is a major with the U.S. Army, Europe Regional Medical Command in Heidelberg, Germany. MICHAEL J. GARVIN is an assistant professor in the Department of Civil Engineering and Engineering Mechanics at Columbia University in New York. garvin@civil.columbia.edu YUEN JEN CHEAH is a Ph.D. candidate in the Department of Civil and Environmental Engineering at MIT in Cambridge, MA. JOHN B. MILLER is an associate professor in the Department of Civil and Environmental Engineering at MIT in Cambridge, MA.