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

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