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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.

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.
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

- 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.

—John Schuyler, December 1998

Copyright © 1998 by John R. Schuyler. All rights reserved. Permission to copy with reproduction of this notice.