Reaching an Optimal Mark-Up Bid through the Valuation of the Option to Sign the Contract by the Successful Bidder

João Adelino Ribeiro (), Paulo Jorge Pereira () and Elísio Brandão ()
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João Adelino Ribeiro: Faculdade de Economia, Universidade do Porto, Portugal
Paulo Jorge Pereira: CEF.UP, Faculdade de Economia, Universidade do Porto, Portugal
Elísio Brandão: Faculdade de Economia, Universidade do Porto, Portugal

CEF.UP Working Papers from Universidade do Porto, Faculdade de Economia do Porto

Abstract: This paper aims to establish a support decision model by which an optimal mark-up (profit margin) in the context of a bidding process is reached through the valuation of the option to sign the contract assuming the contractor is chosen to perform the project. The price included in the bid proposal remains unchanged from the moment the offer is sealed until the contractor has the right - but not the obligation - to sign the contract, whereas construction costs vary stochastically throughout the period. Contractors should only sign the contract if the construction costs, at that moment, are lower than the price previously defined. We evaluate the option using an adapted version of the Margrabe (1978) exchange option formula and we also assign a probability of winning the bid for each profit margin using a function that respects the inverse relationship between these two variables. We conclude that to the higher value of the option - weighted by the probability of winning the contract - corresponds the optimal mark-up bid. Finally, we consider the existence of penalty costs which makes the model more efficient in explaining what actually takes place in some legal environments; we then conclude that the option to sign the contract and, therefore, the optimal mark-up bid are affected by their existence.

Keywords: Optimal bidding; real options; construction projects; price determination (search for similar items in EconPapers)
JEL-codes: D81 G31 (search for similar items in EconPapers)
Pages: 21 pages
Date: 2012-05
New Economics Papers: this item is included in nep-cfn and nep-ppm
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