Prepared by
Alexander Soetjipto
This is a paper about how Real Option Valuation (ROV) can capture the value of flexibility in Information Technology (IT) project. This paper will consist of six parts. The background, what the ROI, NVP, and ROV are, what is wrong with the ROI and NPV methods, how is ROV better than the conventional methods, integrated approach and the conclusion.
IT project includes all matters concerned with the furtherance of computer science and technology and with the design, development, installation, and implementation of information systems and applications [San Diego State University].
Background
In the article posted by Dr. Vicky Sauter on her website entitled “The IT Interaction Model: An Overview”, the authors mention that the effects of an information system for an organization emerge over time as the result of the interaction of the system with the organization. These effects include performance effects, consequences for people (the organization's personnel), and future flexibility. At its early implementation, the information systems might provide their benefit through a direct reduction in costs through simplifying the organization's value chain.
The expenditures needed for IT projects have always provided a challenge for IT executives trying to present conventional, financially-based returns. The difficulty lies in trying to capture the strategic benefits of an IT investment that is often a combination of competitive advantage, organizational volatility and new strategic direction, mixed with cutting-edge technology and uncertain market conditions. The key to valuing these IT investments is in understanding this diversity. Different types of IT project generate different types of returns.
Although growing numbers of business and information systems executive believe that investment in IT help boost firm performance, issues of risk and uncertainty due to technical, organizational and environmental factors continue to frustrate efforts to produce meaningful cost-benefit analyses [Tallon et al., 2000]. The main concern associated with IT investment is the difficulty to adequately measure the costs and benefits associated with any specific IT project.
The conventional valuation methods, such as Return On Investment (ROI) and Net Present Value (NPV), estimate cost and benefit using a number of established techniques that yield a dollar value. However, many of the benefits generated by IT project are intangible. Using conventional valuation method will result in an underestimation of the intangible benefits associated with an information system project. Therefore, using a strict dollar value measurement will not be suitable for a good valuation in IT project.
One valuation methodology which takes into account the value of flexibility of IT project in the analysis process is ROV. ROV allows an IT executive to determine a dollar value for an event that is to occur in the future.
Real options theory recognizes that the ability to delay, suspend and abandon a project is valuable when the value of the project is uncertain. In evaluating IT investments that exhibit high growth potential and high uncertainty, while traditional decision rules such as internal rate of return (IRR) or net present value (NPV) are often inadequate [McGrath, 1997], real options analysis seems to be a better tool [Lucas, 1999].
Researchers in Information Systems
have begun to realize that real options theory provides useful insights into
investments in information technology [Clemons, 1991; Dos Santos, 1991;Kumar,
1996]. Option pricing models have been used to evaluate real world IT projects
[Benaroch and Kauffman, 1999; Panayi and Trigerogis, 1998; Taudes et al., 2000].
For example, Benaroch and Kauffman [1999] use a Black-Scholes approximation for
an American call option on a dividend-paying stock to evaluate the project of
point-of-sale debit service in an e-banking network..
What are ROI, NVP, and ROV?
Calculating Return-on-Investment (ROI) is a practice of modern management used in the analysis of many business strategies and operations. Perhaps the most popular application of this tool is in the analysis of purchase decisions for investments in capital equipment or technology. ROI is simply a measure of benefit versus cost. Expressed as a percentage, ROI is determined by total net present benefits divided by total net present costs. Benefits and costs are converted into present values since they usually accrue over extended periods of time. The basic rule of thumb is that projects with an ROI of less than 100 percent should not be undertaken
The Net Present Value method (NPV) is a
traditional valuation method used in the analysis of many business strategies
and operations, whereby the following steps are undertaken:
1. Calculation of expected free cash flows
(FCF) (often per year) that result out of the investment
2. Subtract /discount for the cost of capital (an
interest rate to adjust for time and risk)
The intermediate result is called: Present
Value.
3. Subtract the
initial investments
The end
result is called: Net Present Value (NPV)
So Net Present Value is an amount that expresses how much value an
investment will result in. This is done by measuring all cash flows over time
back towards the current point in present time. If the Net Present Value method
results in a positive amount, the project should be
undertaken.
Timothy A. Luehrman in two Harvard Business Review-articles: "Investment Opportunities as Real Options: Getting Started on the Numbers" (July-August 1998) and "Strategy as a Portfolio of Real Options" (September-October 1998) says: "In financial terms, a business strategy is much more like a series of options than a series of static cash flows". Therefore, as a result, in valuations that involve significant future flexibility and uncertainty is involved and/or future cash-flows alone are close to break-even, such as long-term strategic scenarios, flexibility has become a major source of value and option value must be taken into consideration then.
The concept of real options is based upon the fact that management does have the flexibility to alter decisions as further information becomes available. If future conditions are favorable, a project may be expanded to take advantage of these conditions. On the other hand, if the future is unfavorable, a project may be curtailed or even canceled as the conditions warrant. A traditional NPV analysis does not take these factors into account.
To conduct ROV for a project the following
steps are undertaken:
1.
Calculate FCF for each component of the project thus assuming committed
investment decisions.
2.
Execute ROV to identify options that are embedded in the Base FCF. Create Option
Map. Analyze interactions among options.
3. Identify main value drivers (major underlying
uncertainties). Estimate ROV input parameters.
4. Expand ROV to capture additional
opportunities.
5. Execute a
full ROV strategy
What is wrong with the ROI and NPV methods?
In the article posted by Dr. Vicky Sauter on her website entitled “"The Trouble With ROI", the author mentions that many IT executives polled by CIO Insight December 2002 expressed dissatisfaction and frustration with current ROI methods. In general, the panel agreed that separating IT's ROI from the ROI of a business process or project is difficult, while the precision and objectivity ROI promises is an illusion. In addition, ROI lacks a universal definition; company cost structures, economics, and risks are being left out of the ROI equation. Supporting these notions is Stuart Ruben with his article “Don't use ROI in investment decisions”. In his article he wrote that ROI is not useful in investment decisions. He knew this, as he had sat on both sides of the fence. He spent years in an IT services company writing investment proposals, winning capital authorizations, all with beautiful ROIs, but knowing they were commercial nonsense.
In the article written by IBM Institute for Business Value entitled “Calculating value during uncertainty: Getting real with “real options” ”, the author mentions that many executives intuitively know that technology initiatives have some sort of value that NPV fails to capture. Yet, even in today’s difficult environment, executives continue to invest in technology and other initiatives that fail to show a positive NPV.
In short, the following are the problem
with ROI and NPV methods. These methods assume that an IT project has constant
uncertainty; inflexible management; and a reversible investment. In reality, in
an IT project, uncertainty changes over period under consideration; management
has the flexibility to defer, to scale up/down, to abandon, or to switch; and
investment is irreversible.
How is ROV better than the conventional methods?
The following simple purchasing case is one of the easy ways to demonstrate that ROV is better than the conventional methods. The gadget being discussed is PC computer.
Suppose a company is planning to replace the ten IT gadgets in one department, at a cost of $5,000 each. The average revenue the gadget is expected to produce is $1,600, $1,400, and $1,900, respectively, over the three years of its life. But instead of replacing all the gadgets at once, the IT manager tries to better estimate the potential return by first replacing only one. The question of whether to delay or expand an investment is precisely the kind of choice that's not handled well in conventional analysis. Each year, there are two possible outcomes: an increase or a decrease in value, each has 50% probability.
Now say that the CFO has set a rate of return of 10% as the expected return on all investments; any project that can't deliver at that return won't be approved by the executive. The total cash flows on the computer upgrade project are slightly less than its initial cost--$4,900 vs. an initial $5,000 investment. Calculating the 10% rate of return on investments that the CFO is demanding, the discounted cash flow is negative (a deficit of $600 ($100 - $500)). Here, the NVP is negative. The project looks like a non feasible project. Therefore the purchase is dropped.
Using ROI method we will see that the ROI is $4,900/$5,000. This is less than 100%. Therefore, as the rule of thumb says, this purchase will be dropped.
But there's another way to look at this
investment. The manager is not really purchasing an IT gadget for its own
three-year return, but as a trial to see if a complete rollout of new gadgets is
in order. Here's where the application of ROV offers greater insight. Purchasing
the single gadget today gives the CIO the option to purchase the nine machines
12 months from now if the returns look promising in the environment that exists
then. The CIO options are to defer, to scale up/down, to abandon, or to
switch. Therefore, in this
case, the CIO will only invest in one gadget for the first year. The cost of the
gadget, which was $5,000 will become the price that the CIO pays for the option
to either defer, scale
up/down, abandon, or switch. As the result, this gadget
purchasing project is a feasible project. The purchase will be
executed.
Integrated Approach
Before ROV can be used to help value the flexibility provided by an IT project, they must be integrated into a cost benefit model. This section will show where real options fit in to the analysis process.
The costs associated with an IT project fall into a number of categories. These categories include: procurement costs associated with the equipment; start-up costs; project related costs; and ongoing costs. The benefits can also be placed into a number of categories. Some of the benefits provided are concrete such as a reduction in processing errors; strategic advantage; decreased time; improved effectiveness; or reduction in the amount of labor to perform tasks. Other benefits are abstract such as improved asset utilization, improved resource control, improved organizational planning, improved organizational flexibility, more timely information, increased organizational learning, legal requirements attained, enhanced employee goodwill, increased job satisfaction, improved decisionmaking, improved operations, higher client satisfaction, better corporate image, and "flexibility". ROV is a technique that can be used to value this flexibility. Thus, ROV fit directly into the existing analysis models.
The flexibility associated with IT project can be seen from two aspects. First, the flexibility can be associated with the IT project itself. The flexibility to grow can indicate the hardware and software associated with the IT project can be expanded if there is a need of more system. For example, in our simple gadgets purchasing, additional memory and hard disk space can be added to the computers if the future circumstance required. Second, the flexibility to grow can mean that the business can grow because of the IT project. For example, developing an IT project that can allow the business to utilize the previously collected data will give the organization the flexibility to use that information to grow in ways that were not possible without the IT project.
Therefore integrating the various valuation
methods to produce the most suitable valuation for IT project is a project in
itself that will enhance the feasibility of an IT project.
Conclusion
The IT executive has to balance tangible costs with both tangible and intangible benefits in adopting an IT project. In many IT project, the value of these intangible benefits are failed to be recognized in the calculation of the cost and benefit analysis of the project. As the result, the dollar value associated with the project is underestimated. ROV will be an ideal solution for this problem.
Any new valuation method takes time to be
adopted by organizations that are used to doing things a certain way. In
addition, ROV is not an easy method to explain. Nevertheless, because of the
capability of this method in capturing the value of flexibility in IT project,
It must be developed further for IT project valuation.
Reference
Amram, M. and Kulatilaka,
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Bodie, Z. and Merton,
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Ingersoll, J.E. and
Kumar, R.L. (1996) A
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Kumar, R.L. (1999) Understanding DSS Value: An Options Perspective. Omega, The International Journal of Management Science. Vol. 27, 295-304
Taudes, A., Feurstein,
M., and Mild, A. (2000) Options Analysis of
Software Platform Decisions:
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