Real options to evaluate technology projects
Capital budgeting methods such as Net Present Value (NPV) and Internal Rate of Return (IRR) are used in most organizations to determine whether to invest in a project or not. Fixed expected cash flows that are estimated much before the project is initiated are assumed in these methods. Any project of decent size and complexity will have some risks are opportunities associated with it. Based on these risks and opportunities, management tends to take decisions that alter the expected cash flows of the project. For example, management can decide to abandon the project mid-way, expand or contract the project thus deviating from the cash flows estimated during the project assessment.
Traditional capital budgeting methods do not account for the management flexibility to alter the cash flows during the project. They rely on fixed expected cash flows determined before the project initiation thereby undermining the value of the projects. It is important to determine and assign a value to management’s flexibility during the project lifetime and consider it in the capital budgeting decisions. This can be done using a technique called Real Options.
Real options are used to determine the value of unknown scenarios based on the probability of their occurrence and is typically applied to assess the value of R&D investment projects and distressed firms that have huge debt. I see an opportunity for the application of real options to technology projects as well.
Traditional Capital Budgeting Methods
Net Present Value (NPV) is calculated as the present value of expected net cash flows discounted at the opportunity cost over the project’s lifetime. The project is considered worth investing only if the NPV is positive.
Internal Rate of Return (IRR) is derived by equating the present value of expected net cash flows discounted at opportunity cost to zero. In other words, internal rate of return is a discount rate that makes the NPV of the project equal to zero. A project is considered worth investing only if the internal rate of return is greater than the hurdle rate, which is the rate of return expected by the management.
One of the limitations of NPV and IRR methods is that they do not capture the options embedded in an investment; i.e., they do not value the management’s flexibility during the course of the project to abandon, defer, expand or contract the project based on the new information acquired. These traditional capital budgeting methods tend to undermine the value of the projects by assuming that the cash flows of the project will be fixed as estimated at the outset.
Real Options Overview
The concept of real options is borrowed from the theory of financial options. Financial options are applied on financial instruments such as stocks and bonds while real options are applied to physical or real assets. For a detailed overview of financial options, refer to Investopedia.
Real options are typically used in assessing distressed firms with huge debt and firms that have significant uncertainty; e.g., a biotech firm with single drug pending FDA approval or an oil and gas exploration firm with potential oil reserves.
Traditional capital budgeting methods assume a single outcome, while real options consider multiple decision paths during the course of the project, where management has the flexibility to make optimal decisions along the way when new information becomes available and uncertainty is resolved. In real options, management has the right but not obligated (i.e., option) to make different updated decisions as time passes. These decisions in the mid-course affect the expected cash flows of the project.
Options or flexibility available to the management during the course of a project must be valued and added to the value of the asset. Real options allows the management to put a value to these options.
Types of Real Options
The most common types of real options are the following:
- Option to expand is the option to expand the business operations during the project lifetime thereby increasing the expected cash flows. In this scenario, one investment allows us the management to take advantage of other opportunities in the future.
- Option to abandon is the option to cease a project at some point during the course of the project, if the cash flows are not as expected thereby decreasing the expected cash flows and project tenure.
- Option to delay is the option of deferring the business decision to the future thereby delaying the investment and the expected cash flows.
- Option to switch is the option to shut down a project at some point in the future if the conditions are unfavorable and resume it when the conditions are favorable.
Real Option Pricing Model
The value of real options embedded in projects can be estimated with the tools used to value financial options. Most of the data required to value financial options is readily available but that is not the case with the real options; i.e., most inputs to value real options is an estimate and needs to be derived.
There are two types of financial options — call and put. A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell a stock. Read more about financial options at Investopedia.
Some real options such as option to expand behave similar to call option while others such as option to abandon behave as a put option.
One of the methods used to determine the value of a financial option is Black-Scholes pricing model. Because of same underlying concept behind real options and financial options, the pricing model used for financial options can be used to value real options as well.
Black Scholes Call (C) and put (P) option prices are calculated using the following formulas:
Application in technology projects
The concept of real options can be applied to technology projects to evaluate whether to invest in them or not. Management should look for the following criteria to determine whether real options method can be used to value a technology project.
- There is some level of uncertainty involved in the project; i.e., value of the project might change significantly in unpredictable ways.
- New information will emerge or an event will occur within a finite period during the course of the project, which will resolve the uncertainty. Based on this, management will be able to make some decisions affecting the cash flows.
- Project can be seen as a multi-step process or phases. For example, certain investment is made initially post which management can determine whether to abandon, delay, expand, or switch the project.
- Exclusivity to execute the project is preferred though not mandatory to apply real options.
Real option can be applied to the following scenario: An IT service provider evaluating a fixed price project to build a software product with not-so well defined requirements for a client whose viability or existence depends on the success of this product. If the product is successful and well received, there will be an opportunity for the IT firm to win more business from the client. If the project fails, the project may not be profitable for the IT firm. Such a project should be structured by the IT firm’s management into multiple phases — each phase providing an opportunity to make some decisions to abandon, expand, contract the project altering the cash flows. Real options method can be utilized to assess the value of the option management has at the end of each phase, and add to the net present value to determine the total estimated value of the project.
I will work through an example and illustrate the application of real options to a project in another article.
