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

all-equity 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, geo-technical 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, limited-access 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-finance-operate 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 two-year 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 long-term 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 (βe), 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)

βe= βa (V/E) = 0.4 ($319M/$40M) = 3.2

Using the CAPM, the cost of equity is:

(5) Re = Rf + βe(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 five-year 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 Traffic per Day (# tolled

vehicles) [1]

D - Operating & Capital Projections Toll per Vehicle [2]

E - Operating & Capital Projections Gross Revenue [3]

F - Operating & Capital Projections Operating Expenses [4]

G - Operating & Capital Projections Capital Improvements [5]

H - Operating & Capital Projections Earnings Before Interest

& Taxes [6]

I - Operating & Capital Projections Capital Expenditure [7]

J - Valuation Discount Factor [8]

K - Valuation Discounted EBIT [9]

L - Valuation Discounted Capital Expenditure [10]

A B C D E

F G H

I J K

L

1995 0

(279,000,000) 1.0000

(279,000,000)

1996 1 34,000 2.00 24,820,000

(9,000,000) 15,820,000

0.8880 14,047,841

1997 2 38,760 2.00 28,294,800

(9,450,000) 18,844,800

0.7885 14,859,278

1998 3 44,186 2.00 32,256,072

(9,922,500) 22,333,572

0.7002 15,637,505

1999 4 50,372 2.25 41,368,412

(10,418,625) 30,949,787

0.6217 19,242,879

2000 5 57,425 2.25 47,159,990

(10,939,556) 36,220,434

0.5521 19,997,197

2001 6 65,464 2.50 59,735,987

(11,486,534) 48,249,453

0.4903 23,654,347

2002 7 70,047 2.50 63,917,507

(12,060,861) 51,856,646

0.4353 22,574,913

2003 8 74,950 2.50 68,391,732

(12,663,904) (3,000,000) 52,727,828

0.3866 20,382,837

2004 9 80,196 2.65 77,569,902

(13,297,099) 64,272,803

0.3433 22,062,519

2005 10 85,810 2.65 82,999,796

(13,961,954) (1,700,000) 67,337,842

0.3048 20,525,329

2006 11 91,817 2.65 88,809,781

(14,660,052) 74,149,730

0.2707 20,069,826

2007 12 98,244 2.85 102,198,275

(15,393,054) 86,805,221

0.2403 20,863,299

2008 13 105,121 2.85 109,352,154

(16,162,707) 93,189,447

0.2134 19,888,726

2009 14 112,480 2.85 117,006,805

(16,970,842) (9,400,000) 90,635,962

0.1895 17,176,864

2010 15 120,353 3.00 131,786,612

(17,819,384) 113,967,227

0.1683 19,179,019

2011 16 128,778 3.00 141,011,674

(18,710,354) 122,301,321

0.1494 18,275,979

2012 17 137,792 3.00 150,882,492

(19,645,871) 131,236,620

0.1327 17,414,365

2013 18 147,438 3.00 161,444,266

(20,628,t65) (10,400,000) 130,416,101

0.1178 15,366,923

2014 19 157,758 3.00 172,745,365

(21,659,573) 151,085,792

0.1046 15,808,200

2015 20 168,801 3.00 184,837,540

(22,742,552) 162,094,989

0.0929 15,060,225

2016 21 180,618 3.00 197,776,168

(23,879,679) 173,896,489

0.0825 14,346,824

2017 22 193,261 3.00 211,620,500

(25,073,663) 186,546,837

0.0733 13,666,457

2018 23 206,789 3.00 226,433,935

(26,327,346) 200,106,588

0.0651 13,017,649

2019 24 221,264 3.00 242,284,310

(27,643,714) 214,640,596

0.0578 12,398,985

2020 25 236,753 3.00 259,244,212

(29,025,899) 230,218,313

0.0513 11,809,111

2021 26 253,325 3.00 277,391,307

(30,477,194) 246,914,112

0.0455 11,246,732

2022 27 271,058 3.00 296,808,698

(32,001,054) 264,807,644

0.0404 10,710,606

2023 28 290,032 3.00 317,585,307

(33,601,107) 283,984,200

0.0359 10,199,545

2024 29 310,335 3.00 339,816,279

(35,281,162) 304,535,116

0.0319 9,712,412

2025 30 332,058 3.00 363,603,418

(37,045,220) 326,558,198

0.0283 9,248,119

2026 31 355,302 3.00 389,055,657

(38,897,481) 350,158,176

0.0251 8,805,625

2027 32 380,173 3.00 416,289,554

(40,842,355) 375,447,198

0.0223 8,383,934

2028 33 406,785 3.00 445,429,822

(42,884,473) 402,545,349

0.0198 7,982,095

2029 34 435,260 3.00 476,609,910

(45,028,697) 431,581,213

0.0176 7,599,197

2030 35 465,728 3.00 509,972,604

(47,280,132) 462,692,472

0.0156 7,234,370

2031 36 498,329 3.00 545,670,686

(49,644,138) 496,026,547

0.0139 6,886,781

2032 37 533,212 3.00 583,867,634

(52,126,345) 531,741,289

0.0123 6,555,636

2033 38 570,537 3.00 624,738,368

(54,732,662) 570,005,706

0.0109 6,240,175

2034 39 610,475 3.00 668,470,054

(57,469,296) 611,000,758

0.0097 5,939,671

2035 40 653,208 3.00 715,262,958

(60,342,760) 654,920,197

0.0086 5,653,432

559,725,427

(279,000,000)

Analysis Variables:

Initial Traffic Volume 34,000

Annual Traffic Growth Rate (Index 1-6) 14.00%

Annual Traffic Growth Rate (Index 7-40) 7.00%

Annual Growth Rate of Operating Exp. 5.00%

Weighted Average Cost of Capital 12.62%

Valuation Results: 280,725,427

Net Present Value

Internal Rate of Return 18.27%

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

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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.