Quantitative Framework to Evaluate Alternative Dispute Resolution Investments in Architecture Engineering and Construction Projects Using Option and Real Option Theory

Abstract

An economic feasibility model that incorporates two main concepts from financial engineering to account for the uncertainty in the initial estimates of the project characteristics and ADR properties is developed. The first concept involves drawing an analogy from financial and real market options to account for the uncertainty in estimating the different cash flows generated from the DRL implementation during the construction phase of a project. The second concept correlates the effect of CCO's on the expected cost savings in a project from a given DRL implementation with exogenous competitive entry and its effect on the gross value of a capital project being evaluated using real option theory. In this case, the occurrence of a CCO during the construction phase of the project reduces the owner's expectations of the cost savings associated with the chosen DRL. If the DRL is successfully initiated at CCO occurrence, then part of the reduction in the expected cost savings might be recovered depending on the effectiveness of the ADR techniques implemented to resolve the issue. In addition to the theoretical contribution of this research, a system to evaluate cost-benefit tradeoffs of a given DRL implementation in a construction project is developed. This system allows project participants to develop a project-specific DRL from a built in library of ADR techniques available for implementation at the different levels of escalation of a CCO. Based on the chosen project-specific DRL, an investment plan that will allow the owner and the contractor to monitor deviations in the expected costs when the DRL is implemented as CCO's arise during the construction phase of a project is determined by the system. This plan will also allow both parties to decide how far they want to go in the dispute based on the projected costs of resolution.