Valuing the Warranty Ceiling Clause onNew Mexico Highway 44Using a Binomial Lattice Model
Abstract:
In 1998 the New Mexico State Highway and Transportation Department (NMSHTD) agreed to pay $60 million for a 20-year pavement warranty on their Route 44 project (NM 44, now US 550).The warranty includes a ceiling clause that caps total expenditures at $110 million.As the first long-term highway warranty in the United States, the transaction set a controversial precedent that parties interested in innovative highway contracting, including other state department of transportations (DOTs), the USDOT, sureties, and contractors, view as a test case for evaluating pricing and cost-effectivene.An interim audit report published by the State of\' New Mexico [Abbey (2004).Rep.to the Legislative Finance Committee, State Highway and Transportation Department.Santa Fe.N.M.]provides invaluable fiscal projections and challenges the cost effectivene of the $60 million expenditure.This paper presents an independent analysis of the effectivene of the warranty clauses.Based upon NMSHTD data, the analysis contends that $60 million was a fair cost of the 20-year pavement warranty at the time of acceptance if the expenditure ceiling is not considered.Furthermore.this paper argues that the ceiling on expenditure can be valuable.Using the real options approach, the paper evaluates the warranty ceiling clause on NM 44 and some policy suggestions are discued.
Introduction：
State Departments of Transportation (DOT) turned increasingly proactive when awarding large highway pavement contracts as a result of the United States Federal Highway Administration\'s (FHwA) Special Experimental Projects (SEPs).SEP No.14, implemented in 1990, opened the door for innovative contracting methods including lane rental, cost-plus-time bidding, design.build techniques, and warranty clauses.The warranty clauses hold contractors liable for reparationfor performance failures within a warranty period that typically extends from 5 to 7 years.
Though New Mexico was not among the original eight states that initiated the use of warranties under SEP No.14.they have since evaluated the option of warranty contracting and succe-fully applied it to the New Mexico State Route 44 Project (nowU.S.550),
which traverses 118 mi (190 km) from 1-25 at San Ysidro northwest to Bloomfield, near the Four Corners area.When considering the prospect of infiltrating the northwest corner ofNew Mexico, New Mexico State Highway and TransportationDepartment (NMSHTD) [renamed New Mexico Deparunent of
Transportation (NMDOT) in 2003], determined that the future maintenance and rehabilitation costs of the upgraded 118 mi of roadway would total about $16,000/lane-mi/year over a service life of 20 years (May et al.2003) totaling just over $15I million.Additionally, they determined that the roadbed and surface upgrades would take almost 27 years to complete using normal contracting methods.In an effort to keep the highway in good condition for the long term, NMSHTD purchased a 20-year warranty agreement from MesaPDC who in turn guaranteed the pavement performance during the warranty period.Thc\' NM 44 warranty broke new ground in both length and cost.Itwas the first long-term highway warranty in the United States and.,at $62 million, the most expensive.Since conception, its economics and applicability to other projects has been a subject of debate.Moreover, the two ceiling clauses in the warranty agreement that limit cumulative traffic volume and maintenance expenditures have been neither examined nor evaluated.In this paper we addre the cost effectivene of the warranty clauses in the NM 44 project.
1 Warranty Provisions for NM 44
Two primary participants, NMSHTD and Mesa Project Development Contractor (PDC), a division of Wichita, Kan.-based Koch Performance Roads, Inc., cooperated on the NM 44 project.The NMSHTD laid out design criteria, performance requirements, and oversight procedures, and estimated a life-cycle cost to establish the overall present value of the expected maintenance during the 20-year warranty period.Through team building and open communications, NMSHTD was able to monitor performance without responsibility for performance, while Mesa PDC was able to gain insight into the development and award proce along with the limitations and constraints that had to be addreed.
To carry a long-term warranty agreement, a profeional services contract was introduced.Basic items included delineation of responsibilities and appropriate protocol for repairs, costing, and reimbursement.The final price on the warranty was comprised of $60 million for a 2pavement warranty and, $2 million for a 10-year structures warranty to cover bridges, drainage, erosion, etc.for a total of $62 million in warranty liability.Mesa
PDC also agreed to a 3.5% inflationary risk on future maintenance costs.Based on these numbers, the warranty pricing was $6,400/lane mi/year, a 60% reduction as compared to the initial evaluation ( Mav et al.2003).Additionally, the warranty duration was limited by three ceiling clauses: (1) 20 years of service life: (2) 4,000,000 equivalent single axle loads (ESALs); and (3) $114 million in total expenditures, of which $1 l0 million is the ceiling for the pavement warranty and $4 million is the ceiling for the structure warranty.Thus, in return for $62 million.Mesa PDC agreed to provide up to $114 million in repairs over a period of 20 years or 4 million ESALs.To ensure the fiscal liability was met.the warranty was also backed by a performance bond.
The parties established what constitutes warranted pavement defects based on objective criteria such as smoothne, rutting, transverse crack spacing, crack width, potholes, depreions.bleeding, raveling,and delaminations.Because the warranty provider shoulders the risks aociated with performance, they have a strong incentive to aure quality in the design, composition, and construction of the pavement.The parties also developed plans to monitor performance and perform both preventative and routine maintenance to ensure the highway’s health.
2 Discounted Cash Flow Analysis
In a recent interim report of the NM 44 warranty audit, the state of New Mexico challenged the cost effectivene of the $62 million warranty (Abbey 2004).This interim report and its predeceor (Abbey 1999) provide invaluable cost projections on the NM 44 project and the aociated warranty.Using these data we conducted our own cost analysis based on the information available to the NMSHTD when they made the warranty decision in 1998.So for this analysis,all warrafity benefits and costs incurred during the construction and warranty period were discounted back to the decision time in 1998, and all costs ,and payments were aumed to fall at the end of the year.Additionally, we considered only the pavement warranty which is valued at $60 million and explains 96.8% of the total warranty cost.Ignoring the structures warranty, which is valued at only $2 million, reduces ambiguity without any significant impact on the results.Farthermore.Abbey (2004) estimates that the structures warranty will expire before the end of the 10-year warranty period, while the pavement warranty probably will remain in effect for the entire 20-year term.
3 Discuion and Policy Suggestions
Due to the ceiling clause, the price of the warranty provisions in the NM 44 project
does not reflect the real cost to the NMSHTD.The ceiling clause, valued at 4.8 million/year 1998 dollar as calculated, represents additional revenue to Mesa besides the $62 million warranty payment from NMSHTD.By declaring the ceiling clause, Mesa PDC in fact eliminates unfavorable risk while keeping profitable uncertainty.What Mesa gains is what NMSHTD loses since this is a zero-sum game.The actual cost for the warranty provision in the NM 44 project goes up to 57.3 million/year 1998 dollar.The hurdle rate of a viable warranty provision falls to 4% (Fig.6).Considering that the NMSHTD had to borrow at a higher interest rate to finance the NM 44 project .the warranty provision is not justified because of the high cost of the ceiling clause.
It is suggested that the state highway agencies carefully evaluate the ceiling clauses when requiring warranty services in selling infrastructure projects.A twofold analysis needs to be conducted so a better decision can be made.First, one must realize that the ceiling clause may be costly.The model developed in this paper is a handy approach to evaluate the ceiling clause value.Second state agencies should better determine a favorable ceiling when including ceiling clauses in the warranty.A sensitivity analysis indicates that the value of the ceiling clause is elastic to the determined ceiling.A 10% increase of the ceiling in the NM 44 warranty provisions would reduce the option price of the ceiling clause by 30%.Therefore, careful selection for a ceiling can significantly reduce the impact of the ceiling clause.
The ceiling clause, in eence, is a call option that provides flexibility to switch a decision after more information is available through locking in risks while leaving the favorable uncertainties open.The real option concept provides powerful tools not only for contractors, but also state agencies ceiling clauses or other trigger points in uncertain cash flows.One potential application of the real option concept in warranty contracting is to delay the warranty decision until the end of construction when more performance information is available (Cui et al.2004).Then future maintenance savings could be estimated more accurately, and a better decision can be made on whether to purchase a warranty.
Acknowledgments：
The writers gratefully acknowledge the support for this research provided by the University Transportation Center for Alabama(UTCA) and the Alabama Contractors\' Fees Fund.
Reforance：
1)Warranty Provisions for NM 44Qingbin Cui1; Philip Johnson2; Aaron Quick3; and Makarand Hastak
2)Journal of Construction Engineering and Management,January 2008,Volume 134.Number 1, 10--17
