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Issue 43

Strategic flexibility during uncertainty

Paul Alexandru Tofan
Project Manager @ISDC
MANAGEMENT

Given the economic and business volatility, uncertainty of outcomes and the high risk of investments, is it possible that the huge upside potential of uncertainty is left on the table? In these conditions, how can we value that potential and overcome the difficulty of presenting a compelling business case based solely on traditional standard methods that rely heavily on information available at the moment of the appraisal (e.g. ROI, NPV)?

Static standards

Uncertainty is a central fact of IT world. This uncertainty arises from many sources -the immaturity, complexity and unpredictable nature of technologies themselves; increasing integration of technologies within and across organizations; increasing emphasis on IT to support innovative products and customer facing services with hard-to-predict market appeal. Despite that reality, static valuation techniques discourage investments done under uncertainty as they only account for information considered at the moment of the appraisal.

Faced with small projected cash-flows or big discount rates decision makers feel the market pressure to make investments and compensate the unpalatable NPV analysis by appealing to arguments like "strategic importance" or "table stakes". They are asked to make an all-or-nothing decision with the information available at the time when they would prefer to exercise their decision making flexibility and decide on the go. An appropriate metaphor can be found in poker: assuming the ante is 1$, and you can bet between $1 and $10 for every open card, can you tell how much would you place on the final bet even before the first card has been dealt?

Introducing Options Thinking

Options thinking is a mechanism whose specific purpose is to enable delaying decisions up to the point where you are better informed about them. It borrows heavily from financial world, just like Net-Present-Value (NPV) and Discounted-Cash-Flow (DCF), and is based on the options pricing theory and real options analysis (ROA) technique.

Real options analysis is most valuable when there is high uncertainty within the underlying asset value, management has high flexibility to change the course of the project, and is willing to pay to setup and exercise options to contain the risk given by the uncertainty. It comes handy when the static valuation methods are not sufficient to justify the decision because the NPV value has a small positive value or even a small close to zero negative value. It must be said that if a project has a very negative NPV, trying to justify its existence by using real options is not a good use of options thinking.

ROA complements the traditional tools by offering means to the capture upside potential of uncertainty and management flexibility to respond to it.

 

A real option is a right - not an obligation - to take an action (e.g. defer, growth, abandon) on an underlying non-financial asset at a predetermined cost or before a predetermined date. The date when the option expires or matures is called expiration date. The option cost is the price paid to acquire or create the option, keep it alive and clear the uncertainty.

The value of the option is given by the flexibility to decide whether to exercise the option depending on future conditions. This flexibility means that the option holders can participate in the upside of the investment (in case results are good) but limit their losses to the cost of acquiring the option (in case results are bad). Since uncertainty increases the potential upside outcomes but not the downside (which is capped at zero), greater uncertainty increases value of flexibility and thus the overall value of the option.

Suppose a firm is tasked with a large project to implement a state of the art trading system. The firm chooses to proceed with a prototype implementation and proceed with the full project if the prototype turns successfully. The cost of the prototype is similar to the cost of purchasing a buy option on the full project.

Managers can influence the value creation process by adopting a systematic approach that focuses on appropriately shifting project elements from "must do" to "may do" and structuring the last as growth options.

Being effective in options thinking requires:

Option types:

How to value options

There are numerous ways to calculate the value of the options, one of the most frequent being the Black-Scholes concept.

A simple explanation can be given by taking the scenario of an option (right to decide) that supposedly expires in 1 year from now. Let`s assume you have already determined the range of possible outcomes and there are 3 results: return of nothing (A), return of 26$ (B), return of $100 (C). We assess what is the probability for each outcome to occur and we multiply it with the expected result. By summing up the values for each scenario we arrive to the future value of the option (in 1 year time) - $33.

Assuming an interest rate of 10%, which means that for $100 in the bank you will get back in 1 year time $110, you can work out the value that you would need to put in the bank today to get $33 in 1 year. Doing the calculation you arrive at today`s option value of $30.

The outcome of the option valuation is as good as the accuracy of the probability calculation and assumes a risk neutral stance, making no distinction between guaranteed income and risky income.

Managing options

While having a numerical value per option is desirable, the essential value of the new way of thinking is managing the project in a way that allows for the value created through the options building process to be extracted. This means that for the chosen option, at a given date in time (not later than expiration date), we will compare the revised estimated value of proceeding further with revised estimated cost and proceed if this value exceeds cost.

In reality it seems that some types of options are perceived as more favorable than others, even though in principle they should be equal. The growth and switch options are mostly used while abandon is valued least. One possible explanation may be that managers perceive the positive options easier to exercise in practice then then negative ones.

When approaching a high risk / high reward project:

Applicability

Real options analysis is not applicable when there is no flexibility, everything is a must do. Similarly, where there is little uncertainty or the consequences of that uncertainty can be ignored, then static valuation methods are sufficient.

Complex, strategic or highly innovative projects that tend to have higher uncertainty and time frames, magnify the value of options thinking and make it a powerful tool for project management - it won`t be easy but it can make a difference.

Conference

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