Profitability Evaluation of Intelligent Transport System

Investments
Pekka Leviäkangas1 and Jukka Lähesmaa2
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Abstract: The objective of this study was to consider evaluation methods for intelligent transport system 共ITS兲 investments, to point out
some shortcomings of traditional methods 共mainly benefit-cost analysis兲, to develop alternative methods, and to make recommendations
for how the profitability of ITS investment should be evaluated. The results can be used when ITS investments are compared with each
other and also when ITS investments are compared with road building investments. This work identifies the fundamental differences
between ITS and road infrastructure investments and how they impact on the profitability evaluation. The conclusion is that traditional
cost-benefit analysis 共BCA兲, which was developed for investments in physical infrastructure, does not capture all the benefits or costs
related to ITS. Economic evaluation methods for ITS investments need improving. This work illustrates how BCA could be used to take
into consideration the option value of ITS investment and risks caused by, for example, different time horizons of investments. The work
also discusses and demonstrates the use of multicriteria analysis in profitability evaluation. It illustrates how a method called analytical
hierarchy process could be utilized to evaluate other risks that do not have specific monetary values and to compare the results of different
profitability analyses. These evaluation methods can be used within the project assessment framework in the transport sector to highlight
different aspects of the profitability and efficiency of transport investments. None of the methods themselves can reflect all aspects in
decision making, but by using a suitable set of different methods depending on the decision situation and by comparing the results, a wider
and more realistic picture of investments can be obtained.
DOI: 10.1061/共ASCE兲0733-947X共2002兲128:3共276兲
CE Database keywords: Intelligent transportation systems; Profits; Investments; Benefit cost ratios.

Introduction ing better access to more advanced technology and applications,

Future of Intelligent Transport Systems
Transport authorities and infrastructure managers are investing
increasingly in intelligent transport systems 共ITS兲, also often re-
ferred to as advanced transport telematics 共ATT兲. This is a result
of several overlapping and correlated trends. First, the new tech-
nology has matured to the point where it begins to expand in-
creasingly to other fields of society, such as transport and infra-
structure, apart from military and consumer goods. Second, with
the markets becoming more saturated, the real prices of new tech-
nology have plummeted. Mobile wireless communication is one
of the key technologies applied to ITS, and, for example, there
was a 85% drop in the wholesale market price of mobile phones
within 10 years 共Finnish Electronics Wholesalers Association
1999兲. Third, because of market saturation, with more people hav-
1
Senior Research Scientist, VTT Building and Transport 共Technical
Research Center of Finland兲, P.O. Box 18021, FIN-90571 Oulu, Finland.
E-mail: pekka.leviakangas@vtt.fi
2
Management Consultant, SysOpen IT Business Consulting,
Valimopolku 4, FIN-00380 Helsinki, Finland. E-mail:
jukka.lahesmaa@sysopen.fi
Note. Discussion open until October 1, 2002. Separate discussions
must be submitted for individual papers. To extend the closing date by
one month, a written request must be filed with the ASCE Managing
Editor. The manuscript for this paper was submitted for review and pos-
sible publication on August 21, 2000; approved on September 25, 2001.
This paper is part of the Journal of Transportation Engineering, Vol.
128, No. 3, May 1, 2002. ©ASCE, ISSN 0733-947X/2002/3-
276 –286/$8.00⫹$.50 per page.
users are increasingly accustomed to different types of services
provided by new communications technology. Consumer accep-
tance is therefore more readily achieved than a decade ago. In
summary, the market for ITS is growing rapidly, and there seems
to be both a supply push and a demand pull for this growth. As an
example, Fig. 1 shows how the U.S. Department of Transporta-
tion 共USDOT兲 and ITS America predict the ITS market to de-
velop.
While investments in ITS are growing, by comparison those in
conventional physical infrastructure seem to be falling 共as well as
compared to traffic demand兲. This is especially the case in the
industrialized world where the ageing infrastructure badly needs
rehabilitation. For instance, the Finnish Ministry of Transport and
Communications 共Ministry 1998, p. 21兲 has estimated that the
upgrading and rehabilitation of the substructures of road networks
can only be done every 100 years if road budgets are kept at their
present levels. This is too long an interval for the infrastructure to
maintain its service level. The Ministry does not see any possi-
bilities for radical increases in infrastructure budgets in the fore-
seeable future. At the same time, capacity enhancement is seen as
a conflicting goal to sustainable mobility 共and requiring too much
capital that is needed elsewhere兲. Therefore, ITS provides a natu-
ral solution for utilizing the existing infrastructure capacity more
efficiently and in an environmentally acceptable manner.
Fig. 2 shows that ITS is slowly increasing its share of invest-
ments, although the figures are still very modest 共8.40 million
euros estimated for 1999兲. Upgrading and replacement invest-
ments seem to be outweighing capital investments, currently 218
million euros, and capital investments have fallen to 134 million
euros. Hence, ITS combined with other upgrading measures is

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J. Transp. Eng. 2002.128:276-286.


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Fig. 1. Government, commercial and consumer ITS U.S. market
growth up to 2015 共Hardison and Mudge 1997兲
expected in the future to solve many of the existing capacity and
safety problems faced by the Finnish National Roads Administra-
tion 共Finnra兲. In other words, ITS is increasingly replacing tradi-
tional investments, at least to some extent. By the year 2010, ITS
investments and maintenance will probably play a key role in
Finnra’s expense budget if current trends continue.
Problems with Current Profitability Evaluation Methods
Economic evaluation methods have not evolved apace with new
approaches to developing and improving infrastructure. The need
for alternative evaluation methods was recognized in the report
Development Needs of Project Assessment in the Transport Sec-
tor 共Niskanen et al. 1998兲. The report proposed the use of multi-
criteria analysis and verbal descriptions to supplement benefit-
cost analysis 共BCA兲 within the project assessment framework in
the transport sector. This principle was also included in the guide-
lines for the evaluation of ITS projects 共Kulmala et al. 1998兲.
However, these guidelines do not include recommendations on
which methods should be used to perform alternative analysis,
although the need to develop such guidelines and methods was
emphasized 共Kulmala et al. 1998兲.
At the moment, road investments are still, by and large, evalu-
ated on the basis of traditional BCA. Given that the alternative
methods are few, this is understandable. However, traditional
BCA does not capture the entire essence of ITS investments.
There are two main reasons for this.
Fig. 2. Finnra’s investment expenses for public roads. Expense fig-
ures for 1998 and 1999 are budget estimates.
JOURNAL OF TRANSPORTATION ENGINEERING / MAY/JUNE 2002 / 277
J. Transp. Eng. 2002.128:276-286.
1. BCA is just one tool among many, although it has gained
wide acceptance as the de facto standard evaluation method;
thus, it provides just one view of the profitability of the
investment in question.
2. BCA has been applied for so long and in such a uniform
manner for infrastructure investment evaluation that its im-
provement has been neglected; in other words, it has been
more or less stagnant for several decades, at least for those
who apply it in practice.
It should be emphasized, however, that BCA is probably still
the best available tool for socio-economic profitability evaluation,
as other methods are virtually nonexistent. Therefore, the authors
wish not to be overly critical toward BCA but rather to provide
some alternative aspects for profitability evaluation and economic
analysis of ITS investments, especially where ITS and traditional
investments are seen as excluding alternatives.
Objectives and Structure of this Work
The objectives of this study are as follows:
• The first objective is to provide a deeper insight into the prof-
itability and economic evaluation of ITS investments in the
particular situation where it must be contrasted with traditional
engineering measures.
• Second, to present some potential alternative tools for project
profitability evaluation, with a view to enabling traffic profes-
sionals to view the project from another angle in addition to
traditional BCA. It must be emphasized that ready-made, in-
stantly applicable tools are not presented but rather some
methods which can be applied in various ways to support prac-
tical decision making.
• Finally, the objective is to contribute to future and ongoing
research concerning the profitability and economic evaluation
of road and other infrastructure and ITS investments.
Case examples will be presented from the road sector, where
the authors feel there is great potential for ITS, which to date has
drawn the mainstream of transport telematics profitability re-
search in Finland. However, other traffic modes must not be for-
gotten, as analyses of profitability are most often at the project
level and deal with a single mode only. The case examples are
also from Finland, and any conclusions drawn from them must be
viewed cautiously if applied to other countries with different cir-
cumstances.
This work summarizes some of the relevant findings of a study
initiated by the Finnish Ministry of Transport and Communica-
tions and carried out by the authors 共Leviäkangas and Lähesmaa
1999兲 as part of a larger transport telematics research and devel-
opment program 共Kulmala 1998兲. That report is downloadable
from the Internet from www.vtt.fi/rte/projects/tetra 共click the
Finnish pages’ project no. 5, and go to the end of the proceeding
page兲.
Fundamental Differences between Intelligent
Transport System Investments and Conventional
Investments in Physical Infrastructure
Introductory Remarks
Bristow et al. 共1997兲 argued that because ITS is now an actual aid
for improving transportation networks, ITS project appraisal
needs to be developed to the same level as the appraisal of con-
ventional transport infrastructure investments. However, based on
their review of ITS evaluation procedures, they argued that ap-

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Fig. 3. Fictitious cash flows of physical infrastructure 共panel A兲 and
ITS 共panel B兲 investments
propriate methods for ITS have not yet been established. It seems
necessary to develop evaluation guidelines specifically for ITS
projects because existing appraisal techniques may not be appro-
priate for dealing with the specific features of ITS applications.
The USDOT has acknowledged that the financing of ITS is
different from conventional infrastructure for at least three rea-
sons 共Haynes et al. 1995兲
1. Conventional infrastructure finance aims mainly to support
the government led provision of basic amenities to the pub-
lic. ITS financing aims to improve the present performance
of transportation infrastructure with greater participation by
the private sector.
2. One of the main drivers in the ITS concept is the ability to
reduce adverse environmental effects, such as air pollution,
which were externalized in conventional transportation sys-
tems.
3. Conventional infrastructure finance is based on known tech-
nologies; whereas, ITS financing is oriented to performance
improvements by the implementation of new technologies.
The cash flow profile for ITS and traditional investments is
radically different. The cash flows of fictitious ITS and physical
infrastructure investments are illustrated in Fig. 3. 共Here the term
‘‘cash flow’’ means the flow of benefits and costs that are usually
expressed in monetary terms. From society’s point of view, these
are not pure cash flows.兲 What is obvious from cash flow profiles
is the heavy front-end loading of costs and back-end loading of
benefits in traditional investments. This makes the time value of
money an extremely important factor, because a long time span is
Table 1. Differences between Intelligent Transport System 共ITS兲 and Physical Infrastructure Investments
Costs ITS investment
Investment cost Relatively small 共e.g., 2– 4 million euros兲
Life time Short/Medium 共e.g., 5–10 years兲
Salvage value after full depreciation Usually no value
Operating costs of the system Significant to total costs
Effect on other costs of the road Sometimes indirect effects, for example on the
authority efficiency of winter maintenance
User costs Accident and time costs often cancel each other out
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J. Transp. Eng. 2002.128:276-286.
needed for the benefits to recover the costs. The higher the time
value of money, that is, the discounting rate, the more difficult
this task becomes. For telematics investments, the time value is
not that important because the time span is shorter, also in a
technical sense. What is critical for them is whether the benefits
will exceed the costs in the medium run 共5–10 years兲. Conse-
quently, when comparing investment alternatives with traditional
BCA, telematics investments need proportionally higher benefits
compared with investment cost in order to compete in the profit-
ability contest. The differences between the investments are fur-
ther characterized in Table 1.
Impact of Differences on Investment Risk
In regard to comparisons between traditional road infrastructure
investments and ITS investments, Leviäkangas 共1998兲 argued that
many other aspects exist to investment evaluation besides tradi-
tional BCA. For example, in a case where the road authority is
considering whether to build a new road link or to upgrade the
existing piece of infrastructure, the value of the real option in the
latter alternative is neglected in the comparison process. In this
case, the real option comes with the fact that by upgrading the
existing road 共by traditional engineering solutions, ITS, or both兲
the road authority reserves a valuable option to build the new link
later if traffic demand so indicates in the future. Investing heavily
in the present situation could be a mistake, provided there is un-
certainty related to the socioeconomic profitability of the invest-
ment. This uncertainty could be due to the difficulties of obtaining
reliable traffic forecasts. Another shortcoming of BCA pointed out
by Leviäkangas 共1998兲 is that BCA does not recognize risk-return
trade-off, which is one of the cornerstone principles of modern
investment theory. According to this principle, the higher the risks
of the project, the higher should be the required return on it.
Despite this fact, most transport authorities worldwide apply fixed
discounting rates when ranking projects.
Leviäkangas 共1998兲 continues his arguments by identifying
different risk profiles for traditional infrastructure investments
and ITS/upgrading investments. The first effecting factor is the
different sheer volume of ITS and traditional infrastructure invest-
ment. Clearly, an investment of hundreds of millions carries an
entirely different risk loading than an investment of some mil-
lions, especially from the viewpoint of the investor, which in this
case is the road authority representing ultimately the taxpayer.
Secondly, the length of time for capital investments impacts on
risk is the time during which an investment is expected to pay for
itself and possibly be upgraded or salvaged. Again, it should be
obvious that tying down the capital for, say, 30 years is riskier
than doing so for 10 years. Consequently, if risk adjustment of
discounting rates is also seen to be appropriate for these types of
Physical infrastructure
investment
Usually high 共e.g., 100–200 million euros兲
Long 共e.g., 30–50 years兲
Significant value 共e.g., 20% of investment cost兲
No operating costs 共or at least these costs
are insignificant兲
Usually direct effects, for example, on repair and
maintenance costs
Usually all user costs decrease
 Table 2. Investment Behavioral Patterns with Different Approaches and Preferences for Risk.
Risk⇒impact
Sunken cost⇒unrecoverable investment
Technological⇒unrealized benefits, operating
costs, operating errors
Strategic/forecasting error⇒unrealized
benefits
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Investment behavior in different investment alternatives
Traditional Intelligent Transport System
Risk-taker, low preference in liquidity and Risk-averse, high preference in liquidity and
opportunity cost of capital opportunity cost of capital
Risk-averse, conservative Risk-taker, pioneer
Risk-taker, deterministic, low preference for Risk-averse, preference in flexibility, high
time value of money time value preference

Environmental risk⇒higher sunken cost,
bad image, time delays
Uncertainty of impacts on drivers and
environment⇒unrealized benefits
User acceptance⇒consumer dissatisfaction
Risk-taker, low image preference Risk-averse, high image preference
Risk-averse, conservative Risk-taker, pioneer, experimenting
Risk-averse, conservative, demand-driven, Risk-taker, pioneer, proactively market driven
market adaptive

investments, the two arguments shift the required return to a
higher level for traditional investments and to a lower one for
ITS.
One should also look at the risks related to ITS investments
共implicitly, the risks of traditional upgrading measures are consid-
ered here as insignificant兲
• ITS solutions are still in their infancy and have not undergone
the same degree of technological evolution as other engineer-
ing solutions 共i.e., conventional measures for infrastructure,
tested and improved upon for decades兲. They therefore carry a
certain risk related to their reliability and the impacts they
have on traffic. ITS can fail and malfunction or may not have
the desired impacts to generate the expected benefits. Few re-
search results are yet available on the actual effects of ITS
solutions.
• Many ITS solutions may still not be fully accepted by motor-
ists. Thus, ITS carries a consumer-acceptance risk, which in
turn entails the risk of not achieving the desired impacts.
It would seem, however, that the risks of ITS are diminishing
with time. On average, today’s computers, mobile phones and
other high-tech applications are more reliable than ever before.
Some of the improvement is due to organizational, and some are
due to technological learning and evolution. When these discus-
sion and arguments are reflected in investment behavior, different
behavioral patterns can be identified, as shown in Table 2.
Benefit-Cost Analysis for Intelligent Transport
System
Introduction
Benefit-cost analysis is a widely used method for measuring the
profitability of different kinds of investments in the transport sec-
tor. Since the 1970s, Finnra has provided instructions on how to
make road transport sector investment calculations and what val-
ues to use for user costs. Later, other transport modes in Finland
adopted Finnra’s methods, in which the user costs are time, ve-
hicle, accident, exhaust fumes, and noise costs. Usually in the
case of road building investments, all these user costs will fall and
benefit society. The total benefits are then compared with invest-
ment costs, and a conclusion is drawn as to whether the invest-
ment is profitable. Typically, time savings are the most important
factors dictating profitability.
The Evaluation Process for Road Transport Telematics study
共EVA study兲 produced a manual for an evaluation process for road
transport informatics, but the manual could also be used more
broadly to evaluate different kinds of ITS applications. EVA pro-
vided guidelines for the benefit-cost evaluation process, proposed
what criteria 共costs and benefits兲 should be included in the BCA,
and gave recommendations on the valuation of criteria 共Bobinger
et al. 1991兲. Later, the CORD project gave specific guidelines on
the evaluation of different ITS application areas, like urban traffic
management and information or in-vehicle information systems
共Zhang and Kompfner 1993兲. The CORD guidelines gave recom-
mendations on the evaluation process of ITS impacts in general,
but did not give guidelines for carrying out BCA.
Two levels of analysis can be identified in the use of BCA. The
first concerns systems or subsystems, such as road weather infor-
mation systems within a country or region. The second has to do
with specific projects, such as building a weather-controlled speed
limit system on a stretch of road.
The majority of known international ITS BCA concerns the
utilization of different ITS applications as a whole, not with spe-
cific investment objects. Lind 共1996兲 has estimated what might be
the possible effects and benefit-cost ratios of certain ITS sub-
systems in the Gothenburg region based on two different sce-
narios for the year 2020. In the United Kingdom, a BCA of ITS
applications from eight application areas was performed during a
review of the potential benefits of road transport telematics
projects 共Perrett and Stevens 1996兲. Relatively similar BCAs have
also been performed in Canada 共Zavergiu 1996兲 and Australia
共Booz Allen Hamilton 1998兲. Armstrong et al. 共1993兲 investigated
and evaluated the conclusions and methodologies of selected ITS
benefit-cost studies in the United States.
Finnish Experience
In Finland, BCAs have been performed only for individual
telematics systems. The socio-economic profitability of the E18
weather-controlled motorway between the cities of Kotka and
Hamina was estimated before the system was built 共Lähesmaa
1995兲. Subsequently, once the actual effects of the system on
traffic had been studied, the benefit-cost calculations were re-
peated 共Lähesmaa 1997兲. The benefit-cost ratios of nine case ITS
investments were estimated in a study of the best telematics ap-

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Fig. 4. Analytical hierarchy process comparing telematics solutions 共Lähesmaa et al. 1998兲
plications when these were set in rural areas in southeastern Fin-
land 共Lähesmaa et al. 1998兲. The main concern of the applica-
tions was to improve traffic safety.
The results from these studies showed that the benefit-cost
ratio of rural area ITS investments is likely to remain relatively
low. More specifically, the benefit-cost ratio of the E18 motorway
was approximately 0.5, and the benefit-cost ratio of all nine case
investments was less than 1, which means that the applications
are not profitable. In some cases the benefit-cost ratio was even
found to be negative.
The benefit-cost ratios were poor because of the significance
of time and vehicle costs in the socioeconomic calculation meth-
ods used by Finnra. With the use of telematics applications, travel
times would have increased on average by 1–2 s at intersections
and by no more than 1 min on road sections. These small changes
often increased time and vehicle costs more than they reduced
accident costs. In sensitivity analysis, it was found that invest-
ments would become profitable only if speeds were increased by
the telematics application, even though this would mean a con-
siderable rise in the number of accidents. Quite explicitly, the
current Finnish evaluation framework prefers time savings over
traffic safety.
Multicriteria Analyses
Introduction to Multicriteria Analyses (MCA)
There exist a number of different evaluation and decision tech-
niques that could be regarded as multicriteria analysis. Common
Table 3. Examples of Analytical Hierarchy Process Comparison
Step
共1兲 Pair-wise comparisons of the cases regarding each criterion
共2兲 Creation of the ranking order based on each criteria by
combining the pair-wise comparisons of the five experts
共3兲 Pair-wise comparisons of the criterion
共4兲 Creation of the weights for each criteria by combining the
pair-wise comparisons of the five experts
共5兲 Creation of the final ranking order by combining the
individual ranking orders
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to all of them is their ability to deal with two or more criteria
measured in different units. Three main reasons for the use
of multicriteria analysis to evaluate ITS investments are as
follows:
1. Many of the benefits of ITS investment do not have mon-
etary value 共e.g., service to drivers, comfort兲.
2. The shortcomings of traditional BCA can be avoided, so that
the results of the comparison process reflect the preferences
of decision makers.
3. Criteria, such as a substantial difference in required capital
outlays between ITS and road building investments and risks
related to the investments, can be considered in the compari-
son.
The EVA manual includes guidelines for using multicriteria
analysis in the ITS project evaluation. EVA deals with several
MCA techniques and gives recommendations on how to build
MCA comparison and assign priorities to the criteria. However, it
does not recommend any specific MCA method 共Bobinger et al.
1993兲.
Lähesmaa et al. 共1998兲 used a multicriteria analysis method
called analytical hierarchy process 共AHP兲 to compare telematics
solutions with each other and with road building investments in
two cases. AHP starts with the building of the hierarchical tree,
relating main objectives to subobjectives in several layers of de-
tail. Next, the decision makers assign a degree of importance or
weight to the criteria and alternatives in the tree based on the
numerical facts or their own opinions and appreciation 共Saaty and
Kearns 1985兲.
Examples of interpretation
When sense of security is considered, Case 4 is more preferable
than Case 14.
When operational risks are considered, the weights of the cases
are the following: Case 2, 0.054; Case 4, 0.16; Case 5, 0.15;
Case 6, 0.08; Case 8, 0.06; Case 13, 0.41; Case 14, 0.07. So,
Case 13 is most preferred and seems to carry the smallest risk.
‘‘Risks’’ is slightly less important criterion than ‘‘service to the
road user.’’
The weights for the criteria are following: Service to the road
user, 0.33; financial parameters, 0.12; importance of the site,
0.38; risks, 0.16. So, importance of the site was considered the
most important criterion.
The final ranking order of the cases as shown in Fig. 6
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Fig. 5. Relative ranking order of cases based on financial parameters 共benefit-cost ratio of case 13 is equal to 1.兲
Comparison of Intelligent Transport System
Investments
The AHP hierarchy shown in Fig. 4 was designed to compare
telematics solutions 共Lähesmaa et al. 1998兲. The comparisons
were based on financial parameters of investments, the knowledge
of decision makers, and preferences regarding the effects on ser-
vice provided to road users, on risk incurred by investments, and
on the importance of different road sections and intersections.
Six promising cases of different types of transport telematics
solutions were compared in the AHP process. For the criterion,
financial parameters, the ranking was based on the cost-benefit
ratios and return on investment 共ROI兲 of each case. Rankings by
other criteria were based on experience and opinion. Five deci-
sion makers from Finnra’s southeastern region were interviewed,
and the results were used in the AHP hierarchy to assign priorities
to the alternatives and criteria. Table 3 presents an example of
how the steps in the AHP comparison were taken as well as how
the values were assigned to the hierarchy.
Fig. 5 shows the order of cases based on financial parameters,
and Fig. 6 shows the ranking order based on the AHP process. In
Fig. 6, the white bars show the standard deviation; the smaller its
value the more consistent are the opinions of the decision makers.
These figures show a substantial difference in the ranking
order. For example, if the decision was based solely on BCA,
Case 4, variable speed limits at the Käyrälampi intersection
would receive top priority. The investment is inexpensive and
would increase traffic safety relatively well without interfering
with traffic too much during construction. However, in the AHP
process, Case 4 was the last one to be selected, because there is
far less traffic at this intersection than in other case locations, and
traffic problems are not that severe. For these reasons, the deci-
sion makers felt that this solution would serve road users less than
other case solutions and that spending money on this intersection
Fig. 6. Relative ranking order of cases based on analytical hierarchy process
JOURNAL OF TRANSPORTATION ENGINEERING / MAY/JUNE 2002 / 281
J. Transp. Eng. 2002.128:276-286.
was less important than where traffic problems are more critical.
Consequently, the AHP hierarchy 共i.e., the preferences of decision
makers兲 puts the most emphasis on the absolute efficiency of
investments rather than the relative ratio between benefits and
costs.
Comparison of Intelligent Transport System and Road
Building Investments
The AHP method was also used to compare telematics and road
building investments. One case was an intersection area near the
city of Lappeenranta 共Finnra 1996兲. The main direction is along a
two-line highway, which has two intersections close to each other
with high traffic volume. Weekdays have typical morning and
evening peak hours, with cars commuting to and from work. In
summer, there is tidal traffic on Friday and Sunday evenings.
However, hourly traffic is relatively low the rest of the time 共Lä-
hesmaa et al. 1998兲.
In the telematic solution, variable speed limits and information
boards would be used to lower speeds in the main direction dur-
ing peak hours. This would ease access to the highway at inter-
sections and increase overall capacity. Traffic safety would also
improve slightly. However, no significant improvement was ex-
pected in accident rates as most accidents do not occur during
peak hours. The investment cost of this telematic solution was
estimated at around 0.50 million euros. An alternative solution
was to build a new graded interchange at the location, at a cost of
some 15.10 million euros. If the decision were based on BCA, a
new interchange would be built. This would decrease travel time
and increase safety, and the benefit-cost ratio of the investment
would be about 1.5 共Finnra 1996兲. The telematic solution would
increase travel time in the main direction during periods when
speed limits are lowered because of high traffic volumes. Even if
 this increase of travel time were on average only 1 to 2 s per
vehicle and the solution had positive effects on access to the
highway and on traffic safety, the value of time costs would be so
significant that the benefit-cost ratio of the telematics application
would be less than 1 共Lähesmaa et al. 1998兲.
The AHP hierarchy in Fig. 7 was used to compare the building
of the interchange and telematics investments. In this case, the
BCA was done totally using the AHP method. This made it pos-
sible to assign the priorities of decision makers to the evaluation
process concerning how the benefits of different impacts are seen
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and how the substantial difference in investment costs is valued in
the comparison.
The same decision makers from Finnra’s southeastern region
compared interchange and telematics investments based on each
criterion on the AHP hierarchy. Next, they also assigned degrees
of importance to the criteria. This comparison showed that
telematics investment was seen as modestly more preferable to
the interchange investment. Compared with traditional BCA there
were two major differences. With the AHP method, the disadvan-
tages of the telematics solution regarding travel time in the main
direction were not considered as important compared to the ad-
vantages, as they were in BCA. On the other hand, savings in
investment costs of the telematics solution were felt to be more
important than mere numerical differences, principally because
many similar problem locations in the area also need urgent im-
provements. If telematics were chosen, some funds could be used
to improve other locations. Channeling lots of money into this
one intersection would create serious funding difficulties for other
targets of development.
Opinions on use of Multicriteria Analyses
A modified AHP method was used earlier in Detroit to create
preference weights for transportation planning goals of the FAST-
TRAC operational field test. On the basis of that study, Levine
and Underwood 共1996兲 argued that in an environment such as that
of ITS, in which policy goals are diverse and potentially conflict-
ing, MCA methods can aid in policy and system design by gaug-
ing the relative preferences of strongly interested individuals and
groups.
In the Finnish studies, the authors found remarkable differ-
ences in decisions based solely on BCA or MCA. The main dis-
advantages of using the AHP method in these cases were the
following:
• The AHP method is subjective, and the set of criteria selected
for the hierarchy cannot be wholly complete. Even if the cri-
Fig. 7. AHP hierarchy comparing telematics and road building investments 共Lähesmaa et al. 1998兲
282 / JOURNAL OF TRANSPORTATION ENGINEERING / MAY/JUNE 2002
J. Transp. Eng. 2002.128:276-286.
teria are selected to avoid double counting, some of this will
occur because decision makers subconsciously connect vari-
ous facts anyway.
• A comparison with AHP is always on a case-by-case basis.
The results cannot be compared with other investments. New
comparisons have to be made if new alternatives are to appear.
Therefore, the authors suggest that MCA alone should not be
used to make final decisions but only as an aid in structuring the
process. Furthermore, MCA provides an opportunity to take into
account many important factors affecting the decision that have
no explicit monetary or other numerical value. On the other hand,
there is always the question of utility the investor pursues. It is the
definition of utility that very much dictates the tools that are avail-
able for use. If the utility is defined as net present value of dis-
counted benefits, then the traditional BCA is a good tool 共BCA
maximizes the net present value of benefits under constrained
budget兲. When we have benefits which cannot be valued and thus
discounted to the present, we simply must adopt different meth-
ods and tools. Here is where MCA can provide some help.
Analyses based on Financial Theory
Risk-Adjusted Discounting Rates
Arrow and Lind 共1994兲 discuss the risk and uncertainty in public
investment decisions and conclude that risk adjustment of dis-
counting rates is appropriate if the uncertain costs and benefits
共i.e., the risks兲 of the particular investments are borne by private
individuals 共or a specified group of people or organizations兲. On
the other hand, if the public body representing the investor is able
to distribute the risks evenly across the population, risk adjust-
ment lacks justification. Thus the question is by no means simple.
Arrow and Lind 共1994兲 used an irrigation project as an example,
where the farms’ income is dependent to some extent on the suc-
cessfulness of the project. In a case like this, risk adjustment
should be done. In road projects, which are also limited geo-
graphically 共only the areas and people within the vicinity of the
road are affected significantly兲 as well as user-wise 共only the mo-
torists using the road are affected significantly兲, the benefits are
directed to a specific group. Hence, there is some argument for
risk adjustment. But, as stated by Stiglitz there are no simple,
definite answers to the question of the right discounting rate.
‘‘The value of the social rate of discount depends on a number of
factors, and indeed I have argued it may vary from project to
project depending, for instance, on the distributional conse-
 quences of the project. These results may be frustrating for those
who seek simple answers, but such are not to be found.’’ 共Stiglitz
1994, p. 155兲.
Arrow and Lind 共1994, p. 161兲 also point out that the time and
risk preferences relevant for government action could simply be
established as matter of national policy. The rate of discount and
attitude toward risk could be specified by the appropriate authori-
ties, and the procedures for evaluation would incorporate these
time and risk preferences. This approach relieves the authorities
from too much theoretical consideration, which in the end only
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blurs the decision-making rules.
Taking the risk into account by adjusting discounting rates is
one policy. Another policy is to include the risk premiums within
the valuation formula, that is, calculate the certainty equivalent
value of each risk separately and use fixed discounting rates.
These two policies are in fact identical according to investment
theory. Little and Mirrlees 共1994兲 showed how the Capital Asset
Pricing Model 共CAPM兲 can be applied to public investments and
their risk valuation. Instead of calculating asset betas 共␤兲 indicat-
ing the asset’s risk in relation to overall market risk, they derived
a kind of project risk measure for public projects, indicating the
project’s social profits in relation to national income. Their anal-
ogy with CAPM is straightforward.
The original CAPM assumes the form 共Copeland and Weston
1988, p. 204兲
E 共 R̃ 兲 ⫽R f ⫹ 关 E 共 R̃ m 兲 ⫺R f 兴 ␤
where ␤ is
cov共 R̃,R̃ m 兲
␤⫽
␴m2
where E(R̃)⫽expected uncertain return on project, investment or
asset; the tilde 共⬃兲 denotes the uncertainty of the parameter; R f
⫽risk-free return, for example, return on state bonds; E(R̃ m )
⫽expected, uncertain return on market portfolio, that is, a diver-
sified investment in the stock market; and ␤⫽risk measure of the
project, asset, or investment against the market portfolio invest-
ment, that is, the covariance between project return and market
return divided by the variance of market return.
If ␤⬎1, the project is riskier than the market portfolio invest-
ment, and the required return on it should be more than R m . If
␤⬍1, the required return, that is, the discounting rate, should be
less than R m . In any case, the return should not be lower than the
risk-free rate R f . The risk is measured simply by how volatile the
asset is in relation to the market. This model, used routinely in
capital markets, shows how the risk adjustment of discounting
rates may be done.
Little and Mirrlees 共1994兲 simply replaced the market return
with national income growth. Thus, they measured what is the
risk of a project in relation to overall economic development, that
is, national income, which often is operationalized as gross do-
mestic product 共GDP兲. Although their theoretical approach was
more refined than shown below, the idea remains essentially the
same. The CAPM modification may now be written as
cov共 R̃ p ,R̃ GDP兲
E 共 R̃ p 兲 ⫽R s ⫹ 关 E 共 R̃ GDP兲 ⫺R s 兴
␴ GDP
2 lem. They took the case of a mine and treated it as an option.
⫽R s ⫹ 关 E 共 R̃ GDP兲 ⫺R s 兴 ␤ s
where E(R̃ p )⫽the expected, uncertain social return on the
project; R s ⫽the minimum allowed social return on the projects;
J. Transp. Eng. 2002.128:276-286.
E(R̃ GDP)⫽the expected, uncertain growth of national income,
GDP; and ␤ s ⫽the 共social兲 risk of the project compared to the
national income growth.
This simplified model implies that the project is worth carry-
ing out provided that when using its risk adjusted discounting rate
R p , the calculus produces a positive net present value. In other
words, when doing the actual project appraisal, the social dis-
counting rate may be adjusted according to Eq. 共3兲 and then be
used as normal in the cost-benefit calculus.
Some points here need further discussion. Although the social
return on a project is conceptually clear 共i.e., the net present value
of discounted costs and benefits兲, the minimum allowed social
return is not. In CAPM, the reference minimum rate was obtained
from state bonds, or similar, which can be considered as risk-free
investments. For public investments, this reference rate is not
available, at least not directly. One solution is to use the decided
discounting rate, which in Finland for transport infrastructure in-
vestments has been 6% 共annual basis兲. Thus, it is a matter of
agreement, as proposed by Arrow and Lind 共1994兲. The fact that
annual GDP growth might be less than 6% poses no problem. The
important issue here is that the project should contribute to eco-
nomic growth and welfare. However, if ␤ is large and R GDP is
lower than R s , this could even lead to a negative discounting rate,
at least in theory. 共The rates discussed here are in nominal terms.
If nominal rates are used, then also the cost and benefit compo-
nents must be in nominal terms, as they are in standard cost-
(1)
benefit calculus.兲
Another problem is the time risk or risk of forecasting error.
CAPM and the related models usually assume historical betas,
that is, the risks are measured as ex post. Then, the risks are
(2)
applied as such ex ante. This is one of the major risks in long-
term, strategic investments: the longer the time horizon, the
greater the risk of forecasting error.
Using Finnish historical data, Leviäkangas and Lähesmaa
共1999, appendix A兲 calculated the time risk adjusted discounting
rates for ITS investments. The results implied that the discounting
rates for ITS investments should be 1 to 2% units lower for ITS
than that used normally for infrastructure investments. This
means that ITS investments become ‘‘more easily’’ profitable than
conventional investments.
Case of Real Options
The first presentation of the options theory was made by Black
and Scholes 共1973兲 in their classic article. Typically, an option is
regarded as a right to sell or buy a security 共or any other asset兲 for
a predetermined price. The owner of the option also has the free-
dom not to exercise his or her right to buy or sell, depending on
the market situation. A practical guide to the options approach is
given by Dixit and Pindyck 共1995兲. They provide numerous el-
ementary examples of situations where the options approach is
applicable. Ingersoll and Ross 共1992兲 showed that even the sim-
plest of projects has an option value, that is, it competes with
itself postponed. Thus all projects are subject to the postponement
alternative, which creates a real option with a calculable value.
Brennan and Schwartz 共1993兲 showed how the options approach
may be applied to the natural resource investment valuation prob-
Trigeorgis 共1993兲 identifies the value of options in a situation
(3) where there exist numerous real options, and furthermore, where
these options interact with each other. Trigeorgis 共1993兲 also
shows that the value of flexibility manifests familiar option prop-
erties.
JOURNAL OF TRANSPORTATION ENGINEERING / MAY/JUNE 2002 / 283
 Table 4. Summary of Results when Applying Option Theory 共Leviäkangas and Lähesmaa 1999, p. 28兲
Investment cost
Type of investment 共millions of euros兲
ITS 共VMS, VSL兲 0.50
Capital 共2-level intersection兲 15.13
Sercu and Uppal 共1994兲 applied the options approach in an
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international capital budgeting case. They showed in their article
that irreversible international capital investments include real op-
tions that affect the investment decision at hand. The traditional
net present value 共NPV兲 rule ignores these options. In their par-
ticular case, the NPV method underestimated the true value of
investment. It therefore seems obvious that the option theory can
be applied to almost any investment decision, regardless of the
nature of the investment. Kemna puts it as follows: ‘‘The value of
flexibility associated with investment projects can be derived
from the value of real options, because options are the perfect tool
to value the impact of future decisions on uncertain cash flows.
For example, these real options can be found in several stages of
investment projects, like the option to postpone an investment, to
maintain the scale and life of the project, to shut-down tempo-
rarily or to abandon the project.’’ 共Kemma 1987兲
It must be emphasized that option values are in reality not
direct benefits for the investor, but rather possibilities to adopt a
flexible investment behavior. Often the option value is referred to
as the value of flexibility.
Here, a real world case project is used to demonstrate how the
option theory may be applied to road ITS investments. Our option
calculation is elementary and lacks theoretical sophistication. Fur-
thermore, it should be regarded as an experimental demonstration
because the application of option theory in this field surely needs
more research. However, it shows the idea, which hopefully can
be refined by other researchers in the future. The calculus and
more detailed information on the case project appear in the work
by Leviäkangas and Lähesmaa 共1999, appendix B兲. It is shown
that two different and independent approaches produce positive
option values for ITS investments when compared to traditional
capital investments. The investment alternatives are as follows:
1. A new two-level intersection for two main roads crossing;
this investment alternative serves for 20 years at least.
2. An ITS investment of variable message signs 共VMS兲 and
variable speed limit 共VSL兲 signs; the signs warn of a dan-
gerous crossing and alert drivers that other vehicles may be
approaching the crossing area; the speed limits change ac-
cording to the traffic flow density so that vehicles can
smoothly join the main direction flow, and the risk of cross-
ing accidents is reduced. This alternative serves for 10 years,
and should then be renewed or replaced by the first invest-
ment alternative.
Two alternative option valuation methods are used. The first,
the Black-Scholes model, takes the form
c⫽SN 共 d 1 兲 ⫺Xe ⫺R f T N 共 d 2 兲
where
ln共 S/X 兲 ⫹R f T 1 1999, p. 28 –30兲.
d 1⫽ ⫹ ␴ 冑T, d 2 ⫽d 1 ⫺␴ 冑T
␴ 冑T 2
where c⫽value of the option; S⫽current price of the underlying
asset; in this case, the two-level intersection building investment
284 / JOURNAL OF TRANSPORTATION ENGINEERING / MAY/JUNE 2002
J. Transp. Eng. 2002.128:276-286.
Benefit cost ratio Black-Scholes Benefit cost ratio
without option benefit option value with option value
0.67 3.1 6.87
共10-year period兲 million euros
1.00 — —
共20-year period兲
cost 共15.13 million euros兲; X⫽exercise price of the option; in this
case, the investment cost of building the intersection later, that is,
21.85 million euros, assuming that it will be more expensive to
carry out the work later; ␴⫽standard deviation of the returns of
the underlying asset; in this case, the standard deviation of the
social return on the project 共0.1兲; T⫽the time to maturity of the
option; in this case, the 10-year period gained by investing in ITS;
R f ⫽risk-free interest rate; that is, the minimum required social
rate of return 共6%兲; N(d)⫽cumulative probability for a normally
distributed unit variable z at point d; and e⫽Neper’s number
⫽2.718282.
Secondly, in order to confirm results of option calculus, the
authors also used the state preference model to determine how
well-off the investor 共i.e., the road authority兲 would be when
choosing different investment strategies. The probabilities used in
this model were taken from real historical data on Finnish road
traffic volumes for 1981–1997 共Leviäkangas and Lähesmaa 1999,
appendix B兲. The results of this verifying method confirmed that
there truly exists an option value for the ITS alternative, which is
substantial with regard to ITS investment.
The results are summarized in Table 4. As observed, the option
values are significant compared with the cost of ITS investment.
The Black-Scholes option valuation method yielded to an option
value of 3.1 million euros 共the state preference approach showed
a value of 1.3 million euros; also Monte Carlo simulation may be
used to study option values兲. These figures are of paramount sig-
nificance when considering an ITS investment of 0.50 million
euros. Therefore, if ITS 共or upgrading兲 alternatives are suspected
to include any option elements, they can be surprisingly high in
monetary/benefit terms. Traditional BCA disregards these ben-
efits.
Budgetary Aspects
The traditional engineering measures of capacity expansion and
safety improvement are heavy and expensive. ITS should be re-
garded more as a strategy than an operational measure to avoid
heavy construction operations in new traffic infrastructure. Taking
ITS and telematics as a strategic approach on the aggregate level,
it is possible to ease the financial burden of governmental bud-
gets. If only a portion of larger scale investments can be post-
poned or even avoided by implementing telematics systems, a
significant fiscal impact on the budget is achieved.
The following example reflects the situation in one of the re-
gional units of Finnra 共Finnra 1998兲. The purpose is to illustrate
how ITS can be used as an optional investment strategy, not to
diminish the importance of traditional engineering measures,
which are of course always needed 共Leviäkangas and Lähesmaa
The total investment plan for 1997–2005 yielded to 284.1 mil-
lion euros, of which 256.9 million euros were for new projects to
be initiated. It was assumed by the authors that out of the 11
investment projects there were two projects that could be replaced
 Table 5. Risks and Prospective Tools for Risk Accounting
Prospective tool for risk
Risk⇒impact accounting
Sunken cost⇒ Option theory
unrecoverable investment
Technological⇒unrealized benefits, Multicriteria analysis
operating costs, operating errors
Strategic/forecasting error⇒ Option theory and risk-adjusted
unrealized benefits discounting rate
Fig. 8. Alternative investment programs for the Finnra’s southeast- Environmental risk⇒higher sunken
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ern region
entirely by ITS, and the other two could be postponed by 8 years.
After these adjustments, the total investment plan yielded to 126.8
million euros and new projects to 99.6 million euros, which is
roughly 60% less for the investment plan period compared to the
original plan. However, it is important to realize that investment
pressures will increase in the future if ITS investments prove
inadequate in the long-run. The difference between the example
investment programs in one of Finnra’s regions is shown in Fig.
8. The original program shows darker 共back area兲, and the ITS
emphasizing program shows pale 共front area兲 共Leviäkangas and
Lähesmaa 1999, p. 30兲.
Conclusion
On the basis of theoretical discussion and evidence from case
analyses, it is possible to make the following statements on alter-
native methods of comparing the profitability of ITS and physical
infrastructure investments.
First Statement. ITS and infrastructure investments differ in so
many respects that the traditional BCA developed for the latter
type of investments is an insufficient tool for producing sound
decision-making rules for investment selection.
Second Statement. Multicriteria analysis produces different in-
vestment selection rules than BCA adopted in a straightforward
manner. Furthermore, MCA captures better the decision-makers’
and experts’ preferences and goal settings, although these items
cannot be measured with a single yardstick.
Third Statement. Some of the differences are manageable by ad-
justing the benefit-cost calculus. For example, the different time
risk profiles of ITS and infrastucture investments can be taken
into account by adjusting discounting rates.
Fourth Statement. Some of the ITS investment benefits can be
captured by using option valuation techniques. The items valued
by option tools can be regarded as ‘‘financial flexibility ’’ or
‘‘postponing uncertain, risky and heavy investments 共until we are
sure we really need them兲.’’ It is most interesting that this option
was implicitly recognized by Finnish road authorities when they
favored ITS alternatives when using multicriteria analysis 共AHP
in that particular case兲 despite the fact that traditional BCA
strongly favored traditional engineering solutions.
Fifth Statement. Many aspects nevertheless remain without clear
valuation rules where ITS investments are concerned. For ex-
ample, one can list items such as budget impacts, improved ser-
Multicriteria analysis
cost, bad image, time delays
Uncertainty of impacts on drivers and Multicriteria analysis
eironment⇒unrealized benefits
User acceptance⇒ Multicriteria analysis
consumer dissatisfaction
vice, and driver comfort. However, even these can be evaluated in
monetary terms provided that adequate research is carried out.
We have presented some tools that deal fully or partly with the
above problems resulting from the different nature of invest-
ments. From the risk management point of view, Table 2 can be
reviewed, and different tools may be adopted for risk accounting
共see Table 5兲.
Option theory and risk adjustment of discounting rates are
prospective methods for some risks while others have to be dealt
with using other tools, namely multicriteria analysis 共or similar
evaluation tools兲. Multicriteria analysis, of course, allows the in-
clusion of several alternative tools for aggregate level evaluation,
each tool contributing to certain risk management aspects.
These evaluation methods can be used within the project as-
sessment framework in the transport sector to highlight different
aspects of the profitability and efficiency of transport investments.
None of the methods themselves can reflect all the aspects in
decision making, but by using a suitable set of different methods
depending on the decision situation and by comparing the results,
a wider and more realistic picture of investments can be obtained.
However, these tools need to be developed further so that they
can be applied in standard practice and in management systems.
Notation
The following symbols are used in this paper:
c ⫽ value of option;
E( ) ⫽ expectation operator;
e ⫽ Neper’s number⫽2.718282;
N(d) ⫽ cumulative probability for normally distributed
unit variable at point d;
R ⫽ interest rate, return or discounting rate;
S ⫽ current price of underlying asset;
T ⫽ time to maturity of option;
X ⫽ exercise price of option;
␤ ⫽ risk of project compared to systematic risk;
␴ ⫽ standard deviation; and
⬃ ⫽ uncertainty operator.
Subscript
f ⫽ identifier for risk-free;
GDP ⫽ identifier for gross domestic product, i.e., national
income;
m ⫽ identifier for market; and
s ⫽ identifier for social or socioeconomic.

JOURNAL OF TRANSPORTATION ENGINEERING / MAY/JUNE 2002 / 285

J. Transp. Eng. 2002.128:276-286.

 Acknowledgments
The writers wish to thank the anonymous reviewers of the paper
for useful comments. The Ministry of Transport and Communica-
tions Finland and Dr. Harri Kallberg provided us the opportunity
to carry out this research. The writers thank both for this oppor-
tunity. The ideas, conclusions, and recommendations of this paper
represent only those of the writers.
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