Engineering Management Journal

ISSN: 1042-9247 (Print) 2377-0643 (Online) Journal homepage: http://www.tandfonline.com/loi/uemj20

Modeling Government Subsidies and Project Risk

for Financially Non-Viable Build-Operate-Transfer
(BOT) Projects

Fen-May Liou, Chih-Pin Huang & Borliang Chen

To cite this article: Fen-May Liou, Chih-Pin Huang & Borliang Chen (2012) Modeling
Government Subsidies and Project Risk for Financially Non-Viable Build-Operate-
Transfer (BOT) Projects, Engineering Management Journal, 24:1, 58-64, DOI:
10.1080/10429247.2012.11431929

To link to this article: http://dx.doi.org/10.1080/10429247.2012.11431929

Published online: 20 Apr 2015.

Submit your article to this journal

Article views: 6

View related articles

Full Terms & Conditions of access and use can be found at

http://www.tandfonline.com/action/journalInformation?journalCode=uemj20

Download by: [Universite Laval] Date: 23 September 2015, At: 00:24

 Modeling Government Subsidies and Project Risk for
Financially Non-Viable Build-Operate-Transfer (BOT) Projects
Fen-May Liou, Chihlee Institute of Technology, Taiwan
Chih-Pin Huang, National Chiao Tung University, Taiwan
Borliang Chen, National United University, Taiwan
Abstract: Governments encourage private sector participation
in building infrastructure through Build-Operate-Transfer
(BOT) agreements. Large projects may be financially non-viable
despite their net economic benefits for the host society. Host
governments might subsidize initial private investments to create
financial feasibility. Small-scale subsidies might not sufficiently
reduce project risks to attract private investment; however, large
percentage subsidies might result in loose profit structures,
discouraging the pursuit of efficiency. This article applies Monte
Carlo techniques to data from the Taiwanese West Corridor High-
Speed Rail Project to assess the subsidy-risk trade-off relationship.
Downloaded by [Universite Laval] at 00:24 23 September 2015
The results provide guidance for public-private negotiations.
Keywords: Build-Operate-Transfer, Monte Carlo Simulation,
Multiple Regression Model, Net Present Value, Project
Management
EMJ Focus Areas: Economics of Engineering, Strategic
Management
B
uild-operate-transfer (BOT) schemes, commonly
referred to as private participation (PP) or public-private
partnerships (PPPs), are public-infrastructure projects that
employ a particular form of structured financing. The term BOT
is collectively used for: build, operate, and transfer; build, operate,
and own (BOO); build, operate, own, and transfer (BOOT); build,
transfer, and operate (BTO); build and transfer (BT); reconstruct,
operate, and transfer (ROT); and operate and transfer (OT). BOT
projects are public infrastructure projects completed with private
funds. In order to ensure smooth execution, governments must
play a dominant role in such projects. Whether or not funds
originate from public or private sectors, governments must ensure
that each BOT project complies with its efficiency requirements
for use of national resources. The economic feasibility of any
project is more critical than its financial feasibility (UNIDO, 1996).
For projects with economic feasibility that are financially non-
viable, governments typically offer financial assistance including
guarantees, subsidies, and other forms of aid (Wibowo, 2006) to
enhance their financial viability (UNIDO, 1996; OECD, 2007;
Asian Development Bank, 2008). Prior BOT research rationalizes
the need for government subsidies to increase financial feasibility
(e.g., Zhang and Kumaraswamy, 2001) or study the forms of
government assistance or subsidy (e.g., Adefulu, 1999); however,
these papers do not provide suggestions as to how the level of
subsidies is determined so as to encourage private participation
while avoiding discouraging efficiency by loose profit structure.
Research Manuscript accepted by Associate Editor Wilbon.
58
The present article introduces a simulation approach to assess the
subsidy-risk trade-off relationship for BOT projects.
Valuation of physical investment projects involves technical,
legal, economic, social, and financial analysis. Financial feasibility
is much more important for private-participation projects than
for public projects that are fully financed by government budgets;
however, when the government confirms that a public physical
project is economically feasible but financially non-viable, it
might provide subsidies to reduce costs and risk for the private
partners in order to realize the economic benefits. Lower subsidies
than required might be not sufficient to encourage private
sector participation in the BOT project, while higher subsidies
might discourage private investors and financiers from seeking
management efficiency. In order to avoid this moral hazard,
governments and private partners should identify an appropriate
amount of subsidy given mutually agreed upon project risk for the
financially non-viable BOT projects. This article aims to develop
a model that assesses the relationship between project viability
with project risk and government subsidy. This model is useful for
facilitating two-sided partners in the project negotiation process.
This article also addresses the possible effects on financial
feasibility as well as operational efficiency trade-offs that might
occur as a result of government subsidies of non-financially
feasible BOT projects. We introduce the high-speed rail project
in Taiwan as a case study, for which we develop a pro forma
cash flow for the project, and use the Monte Carlo simulation to
generate various combinations of variables and the corresponding
probability distributions of net present value (NPV) to further
estimate the value at risk. Results of multiple regression analysis
are subsequently shown to demonstrate the impact of government
subsidies and risk features on the expected NPV.
Government Subsidies
Direct or indirect government subsidies are common tools to reduce
the downside of the financial failure of a high-risk investment
(White, 2001). Infrastructure is traditionally provided by the
government for free public use. Thus, the concept of “user pays”
takes time to be fully accepted by the general public, particularly
when the service provided by the private sector typically costs
more than that provided by governmental agencies owing to lack of
governmental subsidies (Zhang and Kumaraswamy, 2001). Large-
scale BOT projects often require large sunk investments that take
a long time to recover. In addition to the problems of sunk costs,
such projects are generally more associated with cost overruns,
uncertain economic viability, and social and environmental risks
than with high profitability; therefore, to make projects attractive
despite such risks, governments must offer various forms of
subsidies. Typical subsidies include preferential tax treatment,
investment grants, equity or subordinated debt contributions
Engineering Management Journal Vol. 24 No. 1 March 2012
 for which governments do not expect commercial returns, land
grants, public financing of social and environmental mitigation
measures, and application of state controls in order to restrict
competition (Adefulu, 1999).
Forms of assistances or subsidies that governments offer to
BOT projects that lack self-liquidation capabilities include the
following:
1. Indirect guarantees with which government-run businesses
sign off-take agreements with private businesses to ensure
minimum purchase of their production if revenue falls under
a certain level.
2. Funding based on existing asset yields, such as in the case
of the North-South Highway Project, wherein the Malaysian
government yields all toll income from an existing 300-
kilometer expressway to the concession company. Moreover,
for the Bangkok Second-Stage Expressway Project, the
Thai government proportionally distributes tolls collected
from the first-stage expressway to the concession company
(UNIDO, 1996).
3. Land provision: providing land and bearing construction costs
for access roads, such as in the case of the Euro Disneyland
Downloaded by [Universite Laval] at 00:24 23 September 2015
development project in which the French government offered
1,665 hectares of land below market price for the theme park
resort and related commercial and residential development.
Additionally, it built a 20-km railroad and access roads
from Paris for the development project. Likewise, initial
development of Hong Kong Disneyland involved US $3.6
billion capital in total. Nearly half of its land was provided by
the PRC government (Esty, 2000).
4. Take-or-pay agreements, such as in the case of the
Sydney Harbour Tunnel Project, wherein the Australian
government signed a take-or-pay agreement with the
concession company to guarantee minimum traffic for
the harbor tunnel (UNIDO, 1996). The aforementioned
government-subsidized projects improve financial viability
and successfully realize the provision of economic benefits
through private participation.
Automated Approach to Negotiations of BOT Contracts
The financial models of BOT projects comprise three components:
cost function, revenue function, and decision criteria (Kakimoto
and Senneviratne, 2000). The cash-flow-based valuation model
relies on reasonable assumptions to derive “optimal estimates”
(Savvakis, 1994). Financial variables that determine the success
or failure of a project include: tariffs, concession periods,
financing commitments, initial investment, and operating costs,
of which tariffs, concession periods and financing commitments
are typically the most important during BOT project negotiations
(Tiong and Alum, 1997). Ngee et al. (1997) used multiple regression
models to analyze the effects of different combinations of tariffs
and concession periods on the NPV of a BOT project. Shen
et al. (2002) constructed a risk assessment model to determine
the optimal concession period. To fill the void between these two
papers, Liou and Huang (2008) applied a Monte Carlo simulation
and multiple regression analysis, building an automated contract
negotiation model that considers project risk. While the above
studies aim to build negotiation models with concessional
variables for financially viable projects, for financially non-viable
projects, government subsidy and project risk for the private
sector become central issues in the negotiation stage. As can
be expected, the private sector pushes for maximum subsidy to
Engineering Management Journal Vol. 24 No. 1 March 2012
offset initial investment requirements and thereby maximize its
rate of return. Governments, on the other hand, seek to minimize
their subsidy in an effort to control public fiscal burden. Using
the West Corridor High-Speed Rail Project of Taiwan as an
example, the present article developed a trade-off model between
government subsidy and project risk to facilitate the BOT project
negotiation.
Research Methodology
Discounted Cash Flow Approach
The cash flow approach to investment decision making can
analyze from the perspective of either the equity investors in a
firm (owner’s view) or all stakeholders of the firm. The equity
approach measures the return to equity from the project using
the cash flows expected by equity investors after meeting all
debt obligations, while the return to the firm is calculated using
cash flows that are expected of all investors in the firm including
debt and equity (Ross et al., 2007). Financial costs or interest
expenses affect the project return indirectly through the taxation
because interest expenses reduce taxable income and increase
net cash flows to the project. In order to investigate the effect
of government-offered financial resources on project risk, the
present study applies an equity approach to generate the cash
flows. In addition, NPV used in the investment decision rule is
applied as the evaluation indicator. The NPV of a project refers to
the sum of the present values of its cash flow streams. If NPV is not
less than 0, the project is accepted, and vice versa. In addition, the
possibility rate of negative NPV is a measurement of the project’s
degree of risk (Savvakis, 1994). The general equation for the NPV
rule follows in Equation 1.
CF1 CF2 CFn
NPV  CF0 
  n (1)
(1  r ) (1  r ) 2 (1  r )
where CF0, which is typically negative, represents initial investment
costs and CF1 through CFn represent expected annual net cash
flows during the concessional period; n = concession period; and
r = discount rate = weighted average cost of capital (WACC).
WACC depends on the debt and equity mix used to finance the
project, and is adopted to estimate NPV. The NPV approach is
a point estimate that is easy to understand for decision making
(accept the project when NPV is not less than zero); however, it
does not account for the risks that result from variations in the
basic assumptions of project variables.
Other than NPV, the internal rate of return (IRR)—a
scaled measure—is a popular discounted cash flow indicator for
investment decisions; however, IRR is not used as the decision
rule in the present article due to its limitations. For projects with
more than one negative cash flow during the operating period,
there is more than one IRR; thus it is not clear on which IRR
the decision should depend (Damodaran, 2010). In addition,
the hurdle rate, that is, the WACC, represents the required rate
of return for investors to accept the project. The decision rule is
to accept the project only if the expected IRR is higher than the
hurdle rate; however, WACC changes in the simulation process,
since interest rate is one of the simulating variables. Therefore,
the cutting point for project acceptance varies for each of the
replications. It is hard, therefore, to identify the probability
of success or failure from the IRR distribution generated
from simulation.
59
 Monte Carlo Simulation
Monte Carlo simulation provides a deeper understanding of the
relationship between the assumptions and the NPV value. Rather
than providing a single-point estimate of NPV, Monte Carlo
simulation produces probabilities of achieving certain results
which helps managers to gauge a project’s risk.
Monte Carlo simulation uses random numbers and
probability to solve problems such as those related to games
of chance (Metropolis and Ulam 1949; Hoffman, 1998).
Monte Carlo simulation is a sampling method for iteratively
evaluating a deterministic model using sets of random numbers
as inputs that are generated from probability distributions to
simulate the process of sampling from an actual population.
This simulation method is subsequently used by numerous
industries to resolve deterministic problems that include
random numbers. In particular, risk analysis is performed using
Monte Carlo simulation along with analysis of the uncertainty
and risks of capital investment (Hertz, 1964; Rubinstein, 1981;
Savvakis, 1994).
Monte Carlo simulations iteratively analyze sample
values from an associated range. The accuracy of Monte Carlo
Downloaded by [Universite Laval] at 00:24 23 September 2015
simulation is a function of the number of replications. Denote
the expectation of a function of interest g(θ) as E[g(θ)], of which
a numerical approximation is designated as gn:
whereas,
 g p d ; g
n
E g   n  n 1  g  i
 p d
i 1

In Monte Carlo simulation, a sequence of synthetic i.i.d
random variables { i }in1 is drawn from the probability distribution
proportional to p(θ).
The fundamental rationale for Monte Carlo simulation is
that the limit of gn, in n, is E[g(θ)]. For a number of replications
at 10,000, the standard error due to numerical approximation is
1% of the standard deviation of the posterior distribution of g(θ)
(Geweke, 1988). Typically, Monte Carlo simulation involves over
10,000 evaluations (Wittwer, 2004); however, some computer
software packages, such as RiskEase, suggest fewer runs (Liou
and Huang, 2008) and data generated from the simulation are
presented as probability distributions. During risk analysis of an
investment project, values throughout the given range for each
variable are used to estimate NPVs for the project’s life and, upon
completion, the estimation results in a probability distribution.
Monte Carlo simulation has long been used to simulate
possible combinations of key financial variables in project
Exhibit 1. Monte Carlo Simulation Procedure
Assign type of
Develop cash - Select
distribution and the
flow model of simulating
range for each of the
the project variables
simulating variables
60
valuations, where each combination of financial variables
corresponds to one NPV of a project. After a Monte Carlo
simulation, the probability distribution of NPV, including
expected value and variance of NPV, can be obtained (Arboleda
and Abraham, 2006). Exhibit 1 shows the Monte Carlo simulation
procedure of RiskEase software.
Project Risk Measures
Risk is an expression of the magnitude of harm and probability
of loss associated with an activity executed in an uncertain
environment. Bahill and Smith (2009) group risks into four
interrelated categories, including system risk at the product level
(i.e., performance, cost, and schedule risks); project risk; business
risk at the enterprise level (i.e., financial and resource risks); and
safety, environmental, and public risks. Project risk is defined as
“an uncertain event or condition that, if it occurs, has a positive
or negative effect on a project objective” (Project Management
Institute, 2000) or “an uncertain event or set of circumstances
that, should it occur, will have an effect on the achievement of
the project’s objectives” (Simon, 1997). There are numerous
risk analysis techniques, including quantitative and qualitative
approaches, used to access the impact of risk on project viability
(Vaughan, 1997). The qualitative approach includes information
gathered from risk identification through direct judgment,
ranking options, comparison options, and descriptive analysis.
In contrast, some quantitative risk analysis techniques, such as
sensitivity analysis, scenario analysis, and Monte Carlo simulation,
are statistical analyses to obtain numerical results that evaluate
the potential impact of a project’s risk. In the present article, risk
analysis based on the Monte Carlo simulation technique using a
mathematical model is processed to estimate the impact of risk on
the projected results. Using a mathematical model, the technique
is subjected to a number of simulation runs. Every run represents
a probability of occurrence equal to:
1
p  (2)
n
where p = probability weight for a single run; and n = sample size
Monte Carlo simulation generates the probability distribution
of possible project NPVs and provides risk measures. Risk
measures include expected value, expected loss, expected gain,
expected loss ratio, the variation coefficient, and probability of
loss. Expected value is a probability-weighted average of the
results generated during a simulation run. Since the probability
weight of a single outcome in a simulation is constant (1/sample
Simulate 500 replications from
the cash-flow model for each
level of government subsidy;
simulation procedure and the
values of the key variables are
randomly assigned
Distribution of project
NPV generated from the
cash-flow model
Engineering Management Journal Vol. 24 No. 1 March 2012
 size), the expected value turns out to be the same as the average of
the generated results. The expected loss is the total of all negative
returns times their respective probability while the expected gain
is the total of all positive returns times their probability. Expected
losses and expected gains measure the cost of uncertainty. The
expected loss ratio is a measure indicating the magnitude of the
expected loss relative to the total spectrum of expected outcomes
and is calculated as the absolute value of the expected loss divided
by the sum of the expected gain and the absolute value of the
expected loss. This ratio defines risk as a factor of both the shape
and position of the probability distribution of returns in relation
to the cut-off mark of zero. The coefficient of variation is another
useful summary measure of project risk, which is the standard
deviation of the projected returns divided by the expected value.
Assuming a positive expected value, the lower the coefficient
of variation, the lower the project risk. Probability of loss: If we
generate 500 runs, the probability weight of each run is 0.002,
which is 1 divided by 500. If there are 100 negative NPVs in 500
runs, the probability of a negative NPV (i.e., the probability of
loss) is 20%, which is 100 runs multiplied by the probability weight
(0.002). In the present empirical study, we use the probability
Downloaded by [Universite Laval] at 00:24 23 September 2015
of loss, together with government subsidies, as independent
variables to examine the subsidy-risk trade-off relationship of a
BOT project.
The THSR Project
In Taiwan, BOT projects are a vital approach to executing public
construction. The main purpose of BOT projects is to introduce
efficient management and funding from the private sector into
public construction projects that are urgently needed for national
economic development, but currently lack sufficient budgets.
Since its high-speed rail project of the 1990s, the Taiwanese
government has extensively applied, and continues to apply, the
BOT model to various national infrastructure projects. According
to the Taiwan Public Construction Commission, more than 100
BOT schemes are in the course of execution or in preparation, and
the private sector is expected to continue investing approximately
632.7 billion new Taiwan dollars (NT$) (approximately US $20
billion) in public projects under BOT schemes during the 2009
- 2012 period.
Taiwan High-Speed Rail (THSR) is the first and largest BOT
scheme in Taiwan. Since the THSR became operational in 2007,
its ridership has fallen approximately 30% below expected levels,
and its revenue remains far lower than originally estimated. THSR
had a debt ratio of 81% upon completion of construction in 2006
(THSR Corporation, 2006). During the construction period,
while THSR shareholders were inclined to provide additional
capital to finance cost overruns, the Ministry of Transportation
(MOT) of Taiwan and several state-controlled enterprises offered
funding to THSR as shareholders (Yahoo News). Currently, MOT
and the state-controlled enterprises hold 39.5% in shares, most of
which are preferred stocks with preferential terms on dividends
payments. In addition, THSR’s earnings remain insufficient
to pay the loans’ principals and interest; thus, THSR requested
assistance from the government and negotiated with banks for
loan extensions. Then, after intensive negotiation, MOT appointed
an individual professional manager as the Chairman of THSR
Corporation to replace the one who represented the sponsors.
This project provides a good case study of the effect
government subsidies might have on reducing project risk. In
the present empirical study we assume that the government,
private investors, and lenders all realized during its planning
Engineering Management Journal Vol. 24 No. 1 March 2012
stage that the THSR project was non-financially viable and that
the government subsidized the project to enhance the feasibility
of private investment.
The THSR project is a high-speed rail network that runs along
the west coast of Taiwan. The rail is approximately 345 kilometres
long and runs from Taipei to Kaohsiung City. The THSR project
became operational on January 5, 2007, at a total cost of US $18
billion (THSR Corporation). The THSR’s express train, capable
of running up to 300 km/h, travels from Taipei to Kaohsiung
City in approximately 96 minutes, compared to over four hours
for a conventional train on the western trunk line of the Taiwan
Railway Administration (The Republic of China Yearbook, 2010).
Train frequency increased progressively over time from an initial
38 per day. A maximum of 176 two-way runs is possible per day
with the current 30 train sets. The THSR project transported an
average of 101,200 passengers daily in 2010, up from 43,000 at the
beginning of operations. In 2010, high-speed trains made 46,960
trips with a 99.2% rate of punctuality, carrying more than 36.9
million passengers, an increase of 137% as compared with 2007.
Initially, the high-speed train ran 19 trains per direction, per day,
increasing to 70 trips in each direction by the end of 2010. In
the first year, the THSR project carried 15.6 million passengers;
the second year, passenger numbers nearly doubled; the third
and fourth year, ridership continued to grow and seat occupancy
improved (Exhibit 2).
Exhibit 2. High-Speed Rail Passenger Traffic
Year 2007 2008 2009 2010
Ridership 15,555,660 30,581,260 32,349,260 36,939,600
Seat occupancy 44.91% 43.51% 46.31% 48.97%
Punctuality (5 minute) 99.47% 99.19% 99.25% 99.22%
Source: Bureau of High Speed Rail, MOTC
The THSR concessionaire was granted a concession period of
30 years and was responsible for the construction, operation, and
maintenance of the THSR project during the concession period.
Project sponsors were responsible for transferring ownership
to the government after the specified concession period.
Construction started in 1998, and the operating period began in
2007. Assumed parameters for the THSR project are shown in the
Appendix. The project’s cash outflows include construction costs,
operating and maintenance costs, taxes, and financial payments
while the cash inflows comprise tariffs, government subsidies,
and financial borrowing. The project does not have a residual
value because the property is expected to be transferred to the
government at no cost. Additionally, the Taiwan government
commited to providing concessional loans to the project. The
tariff schemes, duration of concession period, and terms of the
concessional loans were financial variables subject to negotiation
between the two parties and approval from the host government.
Empirical Study
We first built a pro forma cash flow for the project as the base
case, which was founded on the assumptions given in the final
report of the feasibility study (AmDec-CECI, 1990) provided by
the international consultant group mandated by the Institute of
Transportation of Taiwan. A Monte Carlo simulation was then
used to generate possible outcomes and their associated variables,
which formed the data set as input variables. Multiple regression
61
 analysis was subsequently conducted to demonstrate the impact Exhibit 4. Variable Input Ranges in Monte Carlo Simulation
of government subsidies and risk features on the expected NPV.
NPV is an appropriate indicator for financial feasibility Parameters Base Value Range
because the empirical study considered here is characterized as a
long-term project investment. According to the cash flow, NPV is Tariff 3.11 2.0 ~ 4.22
calculated using Equation 1 and the point of view of the owner is Borrowing interest rate (%) 4.08 0.2 ~ 8.0
NT$ -133,380 million, which is less than zero indicating that the
project is financially unviable for the base case. Inflation rate (%) 2.1 0.0 ~ 4.1
Evaluation risk software, RiskEase, offers a simulation Cost of equity (%) 13.0 5.1 ~ 20.9
procedure to analyze project risk. The software provides the
probability distribution of NPVs as well as the probability of loss Note: Currency unit is NT dollars; the upper range for the interest rate is
(NPVs<0) for the subject project. We used RiskEase to perform 8%, which is the highest interest rate the THSR bears during the 2002-2006
simulations to generate the distribution of the project NPV based period.
on the cash-flow model of the project. Key variables (including
tariffs, borrowing interest rates, inflation rates and cost of Fifty-one sample data were used as inputs of the regression
equity) were randomly assigned value within their respective model between NPV (dependent variable) with government
assumed ranges. Each key variable was assumed to have a normal subsidies ratio and probability of loss (independent variables) as
distribution. We assumed that all variables presented a normal follows:
distribution for two reasons: (1) the central limit theorem
states that means of an arbitrary finite distribution are always NPVs = β0 + β1 GS + β2 PL + ε
distributed according to a normal distribution, provided that
Downloaded by [Universite Laval] at 00:24 23 September 2015

the number of observations for calculating the mean is large
enough; and (2) normal distribution is widely used as a first
approximation to describe real-valued random variables that
tend to cluster around a single mean value. Various simulation
tools provide users distribution choices, including triangular,
uniform, discrete, and step distribution. Exhibit 3 summarizes
the risk analysis (simulation) results after 500 replications for the
base case. Assumed parameter ranges are shown in Exhibit 4.
More replications were conducted with the government
subsidies varying from 0-50% in steps of 1% to generate 51 data
points for regression analysis. Five hundred runs were conducted
for each of the scenario simulations. The RiskEase software
generates a set of statistics for each scenario, including expected
NPV, standard deviation, minimum, maximum, coefficient of
variation, probability of loss, expected loss, expected gain and
expected loss ratio. Additionally, correlation of risk factors was
considered in this case to be close to reality (Ye and Tiong, 2000).
We assumed that the correlation between the inflation rate and
cost of equity was 0.13 as obtained from Kuo (2003) and that the
inflation rate and tariff was 0.25.
Exhibit 3. Base Case Risk Analysis Results
where NPV=net present value, which is a function of GS and PL;
GS=the government subsidize ratio; PL=probability of loss; β0 =
constant term; β1 , β2 = coefficients of independent variables; and
ε = random error.
Results show that the residuals of the model follow a
normal distribution (Shapiro–Wilk test p>0.05) and there is no
multicollinearity among independent variables (condition index
<30 and variance inflation factor <10). Exhibit 5 reveals that 99.6%
of the variation of the project NPVs derived from the government
subsidies ratio and probability of loss are presented by the
independent variables in the regression model. The relationships
between the project NPV and the government subsidies ratio are
positive, while the probability of loss is negative. Results show
that government subsidies ratio (GS) (p<0.001) and probability
of loss (PL) (p<0.05) insignificantly affect project NPV. This
finding suggests that when initial investment subsidies from the
government are fewer (more), private investors bear more (less)
of the project’s operational risks.
Exhibit 5. Regression Analysis Results (Dependent Variable: Project
NPV)

Regression model: NPVs = β0 + β1 GS + β2 PL + ε

Statistics Analysis NPV Value
Parameter
Expected NPV -140,977 Variable t value p value
Estimate
Standard deviation 55,376
Intercept −125,332 −17.96 0.0001a
Minimum -316,771
Government subsidies ratio (GS) 266,572 42.35 0.0001a
Maximum 10,195
Probability of loss (PL) −13,232 −2.07 0.0434b
Coefficient of variation -0.393
R2=99.6%
Probability of loss (%) 99.8 a
p<0.001. bp<0.05
Expected loss 140,998
Implications for Engineering Managers
Expected gain 20
Investment in infrastructure is a prerequisite for continued and
sustainable economic growth. Large infrastructure projects
Note: All figures in millions of NT dollars. Expected loss is the total sum of all
tend to be risky when market demand is uncertain and a long
negative returns times their respective probability while expected gain is the
period of time is necessary to recover initial cost. BOT projects
total sum of all positive returns times their respective probability.
with negative NPVs denote that the desired combinations of

62 Engineering Management Journal Vol. 24 No. 1 March 2012

 service and tariff levels do not result in sufficient cost recovery
and, hence, the project is not financially feasible. The conclusion
for a project with negative NPV would be to “drop” the project
if it were solely a private investment project; however, public
projects typically aim to achieve economic or social benefits,
e.g., promotion of industrial growth or to bring public services
to residents in remote areas. Thus, “…the economic rather than
financial viability of a BOT project should be the overriding
concern for the government” (UNIDO, 1996). It should be noted,
however, that although government subsidies can be used to
make a BOT project commercially viable from the perspective of
private operators, this “will only make sense if the aggregate cost
to the government under PPP (including subsidy) is lower than
the cost to the government of operating the service fully under
the public sector or the cost of not providing the service at the
required service levels” (Asian Development Bank, 2008).
For BOT projects based on cooperative partnerships
among various public and private parties, win-win negotiation
solutions are particularly essential for all parties. The objective
of the private investors involved in a BOT scheme is to recover
their investment costs and obtain reasonable returns from the
Downloaded by [Universite Laval] at 00:24 23 September 2015
project. An essential issue concerning non-financially viable BOT
projects is determining the government subsidy needed to reduce
the project’s risk sufficiently to realize private participation. The
level of risk that the private sector is willing to incur depends on
the potential returns from the project. Government contributions
such as subsidies or income guarantees, associated with project
variables, including concessional periods and tariffs of the subject
product, are focal variables at the negotiation stage. Favorable
project variables, including longer concessional durations and
higher tariffs, reduce project risk; accordingly, fewer government
subsidies are required. On the contrary, higher project risk is
associated with lower tariffs and shorter concessional periods;
thus, more government subsidies are required in this scenario. The
first option, which mitigates financial risk by using more public
investment, is typically an unpopular policy choice since users
have to pay higher tariffs for the product or services delivered
by the project. The second option is publicly popular but places
a larger strain on the fiscal budget. The solution to this trade-off
issue is subject to the negotiation of all parties involved in the
BOT project. The present article applies a popular simulation
technique to help identify possible combinations of critical policy
variables in order to facilitate enhanced negotiations between
government and the private investors using an approach that is
practical and easy to conduct.
Identification of an optimal solution for the above trade-off
problem is a complex, multi-objective issue that is beyond the
scope of this research. Rather, this research provides a mechanism
for determining the appropriate government subsidy at each
risk level so as to facilitate BOT negotiations. Since government
subsidies increase project returns and reduce risk simultaneously,
when the level of project risk that is acceptable to both parties is
obtained, the minimum amount of government subsidy can be
determined automatically, given that the expected NPV is non-
negative. For example, if the probability of risk acceptable to both
parties is 20% (i.e., there is an 80% probability that the expected
NPV is positive), the parameters in Exhibit 5 implies that the
government subsidy ratio would be 48% (0 = −125,332 + 266,572
× subsidy ratio − 13,232 × 20%) given an expected NPV of 0 and
the amount of subsidy would be US$ 8.64 billion (= 48% × US$
18 billion).
For financially non-viable BOT projects, the government
Engineering Management Journal Vol. 24 No. 1 March 2012
subsidy should be sufficiently large to attract private sector
participation while avoiding moral hazard. The amount of
government subsidy can be determined by the given project
risk acceptable to both the potential private investors and the
government. Using the THSR project in Taiwan, we examine
the relationship between government subsidies to the initial
investment and risks of BOT projects. The multiple regression
model reveals the relationships between government subsidy and
project risk and can be used to form a decision space for BOT
contract negotiations.
Other than the simulated variables in our model, numerous
project variables such as market demand, initial investment,
and completion date heavily impact financial viability. The latter
two are managerial variables, which depend on the managing
capability of the execution entity. These two variables may also
be violated by inefficient government administrative processes.
For example, the government’s failure to issue work licenses
typically forces the execution entity to postpone its construction
schedule. In addition, demand for the public goods or services
provided by the project, ridership in this case, can be affected by
the government’s policy. For example, regulations or measures to
restrict or decrease private vehicle use through the project’s route
may encourage citizens to use a public transportation system.
These financial variables can be incorporated to formulate the
subsidy-risk trade-off model if the host government is willing to
share part of the project’s risks that result from these variables.
Provided that NPV is the most preferred tool over IRR and
all other capital budgeting tools among the Fortune 1000 Chief
Financial Officers (Ryan and Ryan, 2002), the debate about which
criterion is better has lasted more than 100 years. A recent study
(Osborn, 2010) indicates that “the traditional approach to IRR
focuses on only one rate, thereby ignoring information from the
cash flows conveyed by the other, unorthodox rates of interest”. To
solve the problem of inconsistent rankings of mutually exclusive
projects, Osborn proposes a new equation to incorporate multiple
IRRs into NPV estimation. His analysis, however, supports the
academic preference for NPV and suggests that “the margins of
all possible IRRs over the cost of capital are the only components
of NPV”. The NPV-IRR debate is out of the scope of this article
and can be addressed in future research.
References
Adefulu, Adeoye, Downstream Energy Financing in Developing
Countries: Are BOTs the Answer, The Centre for Energy, Petroleum
and Mineral Law and Policy, University of Dundee (1999).
AmDec-CECI, West Taiwan High Speed Rail Feasibility Study,
Institute of Transportation, Ministry of Transportation (1990).
Arboleda, Carlos A., and Dulcy M. Abraham, “Evaluation of
Flexibility in Capital Investments of Infrastructure Systems,”
Engineering, Construction and Architectural Management,
13:3 (2006), pp. 254-274.
Asian Development Bank, Public-Private Partnership Handbook,
Asian Development Bank (2008).
Bahill, A.T., and Eric D. Smith, “An Industry Standard Risk
Analysis Technique,” Engineering Management Journal, 21:4
(December 2009), pp. 16-29.
Damodaran, Awash, Applied Corporate Finance, John Wiley &
Sons, Inc. (2010).
Esty, Benjamin C., Chase’s Strategy for Syndicating the Hong
Kong Disneyland Project Loan, Harvard Business University
(2000).
Geweke, John, “Antithetic Acceleration of Monte Carlo Integration
63
 in Bayesian Inference,” Journal of Econometrics, 38:1-2 (May-
June 1988), pp. 73-89.
Hertz, D.B., “Risk Analysis in Capital Investment,” Harvard
Business Review, 42 (January-February 1964), pp. 95-106.
Hoffman, Paul, The Man Who Loved Only Numbers: The Story of
Paul Erdos and the Search for Mathematical Truth, Hyperion
Press (1998).
Kakimoto, Ryuji, and Prianka N. Seneviratne, “Financial Risk of
Port Infrastructure Development,” Journal of Waterway, Port,
Costal, and Ocean Engineering, 126:6 (November-December
2000), pp. 281-287.
Kuo, Wei Y., “The Determinants of Short-Horizon Stock
Returns in Taiwan Stock Market—Market Sentiment V.S.
Fundamentals,” Working Paper (2003).
Liou, Fen M., and Chih P. Huang, “Automated Approach to
Negotiations of BOT Contracts with the Consideration
of Project Risk,” Journal of Construction Engineering and
Management, 134:1 (January 2008), pp. 18-24.
Metropolis, Nicholas, and S. Ulam, “The Monte Carlo Method,”
Journal of the American Statistical Association, 44:247
(September 1949), pp. 335-341.
Downloaded by [Universite Laval] at 00:24 23 September 2015
Ngee, Loh, Robert, L.K. Tiong, and Jahidul Alum, “Automated
Approach to Negotiation of BOT Contracts,” Journal of
Computation in Civil Engineering, 11:2 (April 1997), pp. 121-128.
OECD, OECD Principles for Private Sector Participation in
Infrastructure, Organisation for Economic Co-Operation
and Development (2007).
Osborne, Michael J., “A Resolution to the NPV–IRR debate?”
The Quarterly Review of Economics and Finance, 50:2 (May
2010), pp. 234-239.
Project Management Institute, A Guide to the Project Management
Body of Knowledge, USA: Project Management Institute
(2000).
Simon, P., Project Risk Analysis and Management (PRAM) Guide,
UK: The Association for Project Management (1997).
Ross, S. A., R.W. Westerfield, J.F. Jaffe, and B.D. Jordan, Core
Principles and Applications of Corporate Finance, McGraw
Hill (2007).
Rubinstein, Reuven Y., Simulation and the Monte Carlo Method,
John Wiley & Sons (1981).
Ryan, Patricia A., and Glenn P. Ryan, “Capital Budgeting Practices
of the Fortune 1000: How Have Things Changed?” Journal of
Business and Management, 8:2 (Winter 2002), pp. 321-329.
Savvakis, Savvides C., “Risk Analysis in Investment Appraisal,”
Project Appraisal Journal, 9:1 (March 1994), pp. 3-18.
Shen, L.Y., H. Li, and Q.M. Li, “Alternative Concession Model for
Operate Transfer Contract Projects,” Journal of Construction
Engineering and Management, 128:4 (July-August 2002), pp.
326-330.
Taiwan High Speed Rail Corporation, 2006 Financial Report.
Available via http://www.thsrc.com.tw/download/tc/file/02/
report_95.pdf  Massachusetts at Amherst, USA. His research interests lie
Taiwan High Speed Rail Corporation, Company Overview. Available
via http://www.thsrc.com.tw/en/about/ab_comp.asp  management, and project management.
The Republic of China Yearbook, Chapter 12 Transportation and
Telecommunications, ROC Government Information Office
(2010). Available via http://www.gio.gov.tw/taiwan-website/5-
gp/yearbook/12Transportation&Telecommunications.pdf
Tiong, Robert, L.K., and Jahidul Alum, “Final Negotiation in
Competitive BOT Tender,” Journal of Construction Engineering
and Management, 123:1 (March-April 1997), pp. 6-11.
UNIDO, Guidelines for Infrastructure Development through Build-
64
Operate-Transfer (BOT) Project, United Nations Industrial
Development Organization (1996).
Vaughan, E.J., Risk Management, John Wiley & Sons (1997).
White, Craig G., “Disruptive Technologies and the Tax Law,”
Engineering Management Journal, 13:3 (September 2001),
pp. 21-26.
Wibowo, Andreas, “CAPM-Based Valuation of Financial
Government Supports to Infeasible and Risky Private
Infrastructure Projects,” Journal of Construction Engineering
and Management, 132:3 (March 2006), pp. 239-248.
Wittwer, J.W., “Monte Carlo Simulation Basics,” From Vertex42.
com. Available via <http://vertex42.com/ExcelArticles/mc/
MonteCarloSimulation.html> (accessed June 1, 2004).
Yahoo News, Available via http://tw.news.yahoo.com/article/url/
d/a/090921/1/1rj3z.html
Ye, Sudong, and Robert, L.K. Tiong, “NPV-at-Risk Method in
Infrastructure Project Investment Evaluation,” Journal of
Construction Engineering and Management, 126:3 (May-June
2000), pp. 227-233
Zhang, X.Q., and Mohan M. Kumaraswamy, “Procurement
Protocols for Public Private Partnered Projects,” Journal
of Construction Engineering and Management, 127:5
(September/October 2001), pp. 351-358.
Appendix: Financial Parameters of THSR Project
Debt/equity ratio＝ 81/19
Concession period＝ 30 years
Borrowing interest rate＝ 4.08%
Business income tax rate＝ 25%
Cost of equity＝ 13%
Inflation rate＝ 2.1%
Weighted average cost of capital (WACC) =
Debt/ (Debt+Equity) × Borrowing interest rate × (1-t) + Equity/
(Debt+Equity) × Cost of equity = 4.95%
Grace period ＝ 12 years
Operating period ＝ 21 years
Construction period ＝ 9 years
Start/end year of construction period ＝ 1998~2006
Start year of operating period ＝ 2007
About the Authors
Fen-May Liou earned her PhD from National Chiao Tung
University, Taiwan. She has been involved in project appraisal
and management in developing countries for more than 10
years.
Chih-Pin Huang received his Masters of business
management from Yuanpei University, and his PhD in
management science from National Chiao Tung University,
Taiwan. He has been involved in project appraisal and
management and valuation of intangible assets.
Borliang Chen received his PhD from University of
in structural dynamics, fracture mechanics, construction
Contact: Chih-Pin Huang, Department of Management
Science, National Chiao Tung University, 1001 Ta Hsueh
Rd., Hsinchu 300, Taiwan, ROC; phone: 886-3-571-2121;
cphuang.ms96g@g2.nctu.edu.tw
Engineering Management Journal Vol. 24 No. 1 March 2012