Using real option and decision analysis to evaluate investments in the architecture, construction and engineering industry

Many architecture, engineering and construction (AEC) professionals would like to use real option (RO) and decision analysis (DA) to evaluate alternatives in investment in the face of uncertainty. However, they have difficulty deciding which one to use and many are not aware of the subtle differences in assumptions and techniques between the two methodologies. We explain how DA and RO can be applied in complete and incomplete markets and what implicit assumptions we need to be aware of in each scenario. Through a toll road example, it is shown that, in a complete market, DA and RO give the same valuation regardless of the choice of the utility function. A formula is provided for pricing any investment in a complete market. The paper also discusses why the values calculated using DA and RO differ in an incomplete market and when DA is more appropriate than RO and vice versa.