A real options-based framework to evaluate investments in river flood control under uncertainty

Making decisions for flood control investment is challenging. This difficulty is because of some of the variables involved in the problem have uncertainty in them. Real Options theory is an approach to handle future uncertainties in risk management by providing flexibility in investment decisions. This work presents a real options-based framework to evaluate the financial value of having flexibility for deciding the time of investment in flood control. The framework considers the uncertainty associated with future water discharge events. Extreme water discharges are responsible of flooding events. The water discharges are considered as the random variable. The historical information of these variables is used to estimate the probability of future events. A lattice of options based in the probability of future events of the random variable is built. The option of delaying the investment is analyzed by calculating the payoffs of cost and benefits of each option. A hypothetical application is presented to validate the effectiveness of the proposed model. The result shows an option with an optimum investment time for flood control.