### Tip of the Week #45                     Tip Index

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## Competitive Bidding: Bid Fraction

Optimizing a competitive bid is an interesting and challenging analysis.  The objective is to maximize expected value, not to win the bid.  Uncertainties in asset value, number of competitors, quality of information, and bidding aggressiveness are among the details incorporated in a Monte Carlo simulation of a competitive bidding situation.

Two rules of thumb can be verified by a simulation model:  You should reduce your bid amount when:

• there is more uncertainty in the value of the asset being sought.
• there are more competitors bidding.

The second rule seems counter-intuitive to many people.  However, it is indeed the case.

### Bid Fraction

Suppose you want to acquire a cash-producing asset, such as a producing petroleum property.  Little or no investment in the property is needed to realize the future cash flow.  Typically buyers of such properties pay 75% of the cash flow present value.  The ratio of the bid/value is the bid fraction at cash auction.  The discount reflects cost of acquisition (lawyers and accountants), an allowance for uncertainty, and a profit margin necessary to induce the buyer to bid.

 The analysis is similar for competitive bidding to develop or construct an asset or bidding to provide a service. In such cases, the variable to optimize is instead bid margin or bid markup.

The bid fraction characterizes the bidding strategy, and the analysis is to determine the optimal value of this decision variable.  A graph of expected monetary value (EMV) vs. bid fraction (or bid amount) shows the optimal value.  The seemingly straightforward bid fraction gets complicated easily.  A client and I have been dealing with issues including:

• The submitted bid includes a cash amount plus a work program (e.g., drilling wells);
• Additional research expenditures will be necessary (e.g., geology and geophysics); and
• Additional capital expenditures will be necessary to realize any value from the asset.

In computing bid fraction:

• Should the numerator (bid amount) include additional required expenditures in the bid package? Additional investments required to realize any value?
• Should the denominator (asset value) be reduced for such additional expenditures?

Thus, a "rule of thumb" bid fraction should not be applied. Bid fraction is similar to \$/barrel for oil in the ground, cashflow multiplier, and similar measures.   These guidelines are useful for reference only.  Instead, I recommend constructing a competitive bid simulation reflecting the situation that you face as best that you understand it. What gets included in the bid fraction numerator and denominator will not matter: you will be optimizing the one or more decision variables (e.g., cash and work commitment). Regardless of how you define bid fraction, the optimal amount will depend upon how it is calculated.  The actual cash offered should be the same.

—John Schuyler, December 1998