Fichman Options Thinking

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Beyond Valuation: 'Options Thinking' in IT Project Management

April 20, 2004

Robert ! "ichman

Department of Operations and Strategic ManagementBoston College, Carroll School of Management

452B Fulton allChestnut ill, MA 024!"#$%0%

&elephone' !("#552#04"(Fa)' !("#552#04$$

*mail' fichman+c-edu

Mark #eil

Department of Computer .nformation S/stems- Mac1 oinson College of Business

3eorgia State niersit/

$5 Broad Street, oom 422Atlanta, 3eorgia $0$0$&elephone' 404#!5(#$%$0

Fa)' 404#!5(#$%42*#mail' m1eil+gsu-edu

$mrit Ti%ana

3oi6ueta Business School*mor/ niersit/

($00 Clifton oad, Atlanta, 3eorgia $0$22&elephone' 404#"2"#!$"%

Fa)' 404#"2"#205$*#mail' ati7ana+us-emor/-edu

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mailto:[email protected]:[email protected]


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I&TRO()TIO&

ncertaint/ is a central fact of life on most large .& capital inestments- From enterprise

applications 8e-g-, *9, CM: to infrastructure technologies 8e-g-, 1no7ledge

management, 7ireless net7or1ing: to .enaled strategic initiaties of eer/ flaor, a

common element is dout aout 7hether the pro;ect 7ill achiee its goals, and if so, 7hat

pa/offs can e e)pected- &his uncertaint/ arises from man/ sourcesD-

3ien the potential for ma;or losses on .& pro;ects, the defensie posture e)hiited /

man/ organi6ations to7ards these efforts should come as no surprise- One manifestation

of this posture is simpl/ do7npla/ing the leel of ris1- Although it has een demonstrated

7ith some regularit/ that ma;or .& initiaties produce disappointing results 50? of the

time or more,( this uncomfortale fact rarel/ ma1es it into the planning processes of

man/ organi6ations- Another manifestation of a defensie posture is penali6ing pro;ects

that hae large ris1s ut also large potential re7ards / emplo/ing an e)cessiel/ high

hurdle rate- A third manifestation is appl/ing a eneer of predictailit/ to .& inestments

/ demanding rigidit/ in pro;ect planning and e)ecution- A final manifestation is the

tendenc/ to treat setac1s on .& pro;ects as arising first from the inade@uacies of the

pro;ect team, rather than eing inherent in the process of underta1ing uncertain entures-

.ronicall/, these defensie maneuers are ;ust as li1el/ to increase an organi6ations

e)posure to unnecessar/ ris1 as to reduce it' do7npla/ing uncertaint/ discourages

igilance to potential prolems= rigid pro;ect plans inite corner#cutting= and a lame#the#

team#first mentalit/ deters forthright communication aout pro;ect status- A etter

approach is to assume a proactie stance that full/ ac1no7ledges and see1s to manage

uncertaint/ on these pro;ects- e eliee that options thin1ing, an emerging inestment

management philosoph/ ased on the theor/ of real options, proides an especiall/

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promising foundation for this sort of proactie stance-

A real option refers to the right to ac@uire some real 7orld asset 7ithout the oligation to

e)ercise that right- heneer an .& pro;ect has fle)iilit/ aout 7hich applications and

functions to implement, and 7hen or ho7 to implement them, real options are present-

&hese options can e @uite aluale, and much of the academic literature on this topic has

focused on deeloping appropriate tools to assist in @uantif/ing option alue- Managers,

ho7eer, do not need to ac@uire option @uantification s1ills to put options thin1ing to

7or1- &he igger 7in comes from using real options concepts to actiel/ create and

e)tract the alue of emedded options that can other7ise e difficult to see-

Our goal in this article is to highlight ho7 practitioners can incorporate options thin1ing

into contemporar/ .& pro;ect ealuation and management- 2 hile 7e 7ill pinpoint some

tools for @uantif/ing option alue, 7e eliee it is more important for managers to learn

to recogni6e 7hat 1inds of options can e emedded in .& inestments= to deelop a

sound intuition aout ho7 options create alue= and to understand ho7 to manage

pro;ects so that option alue that e)ists in theor/ is actuall/ reali6ed in practice- .t is a

certain philosoph/ of pro;ect management


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processes or products- *en so#called standard pac1ages come 7ith a large arra/ of

potential configurations and associated applications- Further increasing the fle)iilit/ of

man/ .& assets


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uncertaint/ aout enefits increases the range of the potential upside outcomes ut not

the do7nside 87hich is capped at 6ero:, greater uncertaint/ increases the alue of

fle)iilit/ and thus the alue of the option-

Although most managers can understand 7h/ increased uncertaint/ e)pands the alue of

a stoc1 option, the same principle applied to .& inestments 7ith emedded options

stri1es man/ as counterintuitie, so 7e offer the follo7ing concrete illustration- Suppose

a firm is faced 7ith a large pro;ect to implement radio fre@uenc/ .D 8F.D: tagging

across its suppl/ chain- &he firm chooses to egin 7ith a smaller pilot initiatie, and

e)pects to proceed 7ith full inestment onl/ if the pilot goes faoral/- &he cost of the

pilot is a1in to the cost of purchasing a call option on the full pro;ect


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ncertaint/ can arise from an un1no7n future 8mar1et uncertaint/: and from inherent

ris1s endemic in particular .& pro;ects 8technical uncertaint/:- &he main re@uirement is

thatsomeof the uncertaint/ e resolale- &he mechanisms for resoling uncertaint/ 7ill

differ for technical ersus mar1et uncertaint/- &he former usuall/ re@uires that managers

do something to resole the uncertaint/, 7hile the latter can often e resoled /

simpl/ 7aiting 8and, of course, pa/ing alert attention to the mar1et:- Iet, the same pro;ect

structuring elements can adance oth goals simultaneousl/- Scheduling a pilot pro;ect or

a small scale initial implementation can proide information that reduces uncertaint/

aout technical feasiilit/, 7hile simultaneousl/ allo7ing for an elapse of time during

7hich some mar1et uncertaint/ 7ill e resoled-

&here is of course no free lunch in the 7orld of traded financial options, ecause the

purchase price of an option at an/ moment reflects the mar1ets current est estimate of

7hat the option is actuall/ 7orth- o7eer in the case of real options, there isnt

necessaril/ a strong relationship et7een 7hat an option costs to ac@uire, and 7hat the

option is actuall/ 7orth, so @uite aluale .& options can often e created relatiel/

ine)pensiel/- &hus, managers that emplo/ options thin1ing stand to gain a considerale

adantage, especiall/ in fast moing, unpredictale enironments 7here real options tend

to e most aluale and plentiful-

"ROMOPTIO&V$,($TIO&TOOPTIO&0T*II&

eal options concepts not onl/ allo7 an organi6ation to more accuratel/ assessuncertain

.& inestments, ut perhaps more importantl/, can guide managers in ho7 to actiel/

createand extractalue- &his is the heart of options thin1ing- &he 1e/ to understanding

ho7 options create actual alue lies in the distinction et7een 7hat an organi6ation must

doon a pro;ect, ersus 7hat it may do- For those things an organi6ation must do, there is

8/ definition: no fle)iilit/, and so traditional anal/tic tools 8such as E9G and O.: that

place no economic alue on fle)iilit/ are appropriate- o7eer, for those things a firm

may do, alue is created / actiel/ structuring those elements as an option-

&his suggests managers can enhance alue creation 7ith t7o general strategies 8a:

shifting pro;ect elements that are part of the aseline implementation from must do to

may do status= and 8: performing a s/stematic search for opportunities e/ond the

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aseline implementation that represent additional may doelements- .n options terms, the

first sort are referred to as operating options, in that the/ relate to the operational aspects

of a pro;ect- &he latter sort are referred to as growth options, in that the/ refer to the

opportunit/ to gro7 the pro;ects scope through follo7#on inestments e/ond 7hat 7as

initiall/ anticipated- Figure 2 illustrates the difference et7een a traditional pro;ect and

one drien / options thin1ing-

- Insert Figure 2 about here -

*ffectie options thin1ing re@uires that managers do three things 7ell' 8(: recognizeand

enhance opportunities to create options 7ith .&, 82: valuethese options 8in some 7a/:,

and 8$: managepro;ects to full/ e)tract this alue- e address each of these tas1s in the

follo7ing sections- First 7e proide si) e)amples of options thin1ing in practice that

illustrate ho7 some organi6ations hae recogni6ed, alued and managed pro;ects

according to the logic of real options- &hen 7e proide some more detail on the latter t7o

tas1s, aluing and managing real options-

0I.-.$MP,-0O"R-$,OPTIO&0I&PR$)TI)-

*medded .& options can ta1e man/ forms, including the options to' 8(: stage

inestments, 82: to abandoninestment, 8$: deferinitiation of inestment, 84: to create

growth opportunities ased on an initial inestment, 85: to change the scale of

inestment, and 8!: toswitchassets created / the inestment to another use%8See &ale

(:- 3aining an appreciation for these option t/pes and ho7 each adds alue 7ill ma1e

them easier to recogni6e in practice- .n addition, all ar/ some7hat in terms of the

conditions under 7hich the/ proide the most alue, and the different pitfalls and

challenges associated 7ith managing them-

.t is 7orth noting that the same pro;ect can emed more than one t/pe of option, and it is

not al7a/s completel/ clear ho7 a particular option should e classified- o7eer, our

goal is to proide e)amples that gie the richest illustration of ho7 to manage options in

practice, rather than ones that can e most neatl/ classified- .n three instances the

pro;ects 7e identified inoled a formal O9M- e also found three e)amples that 7ere

managed as real options, een though options 7ere not formall/ considered as part of the

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;ustification- &hese latter e)amples are included to sho7 that firms can emplo/ guide#

lines that are consistent 7ith options thin1ing 7ithout haing to adopt a sophisticated

aluation methodolog/-

-1ample 2: The Options to 0tage and to $bandon 3 )arlson *ospitality

.n practice, most large .& pro;ects are diided into stages for the purpose of resource

planning and setting milestones for pro;ect trac1ing- o7eer, the mere e)istence of

stages in a pro;ect does not / itself create emedded stage options- &o create alue using

stage options re@uires an actie management approach 7here e)ecution of each stage is

made contingent on a reassessment of the costs and enefits of completing that stage at

the time the stage is reached- B/ then team memers 7ill e more e)perienced in the

pro;ect domain from haing completed prior stages and so etter information 7ill e)ist at

aout the actual costs and enefits of completing the stage- .n addition, usiness

re@uirements or opportunities often change in 7a/s that increase or decrease the

importance of 7hat a gien stage deliers, and so the team 7ill e etter ale to

recogni6e and aoid inesting in stages that no longer hae a 7orth7hile pa/off- .n

summar/, stage options create alue / proiding the chance to alter or terminate a

pro;ect efore each ne7 stage of funding, ased on updated information aout costs and

enefits-

.n practice, stage options often oerlap 7ith other options, such as aandon, change scale,

and strategic gro7th- .n cases 7here completion of each stage does not produce a useale

s/stem, ut is merel/ a necessar/ condition to proceed to the ne)t stage, this is a form of

the aandon option 8stage#aandon:-J Stage#aandon options can e created /

deeloping thro7 a7a/ protot/pes or follo7ing the traditional 7aterfall SDKC 8i-e-,

anal/sis, design, construction, implementation: ut 7ith a formal goLno#go decision for

each phase, such as in the spiral model of deelopment-(0Conersel/, 7hen earl/ stages

produce a useale, ut smaller scale s/stem that can suse@uentl/ e scaled up, or to

7hich additional functions can e added, the oerlap is 7ith the option to change scale

8stage#scale: and gro7th options 8stage#gro7th:- &he latter sort of staging options are

naturall/ preferale, as the/ produce a useale asset at the end of each stage


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are not al7a/s feasile, and een a stage#aandon option can create considerale alue in

the right circumstances-

Carlson ospitalit/ orld7ides recent implementation of a ne7 Customer eseration

S/stem(( 8CS: illustrates ho7 a pro;ect can e reconceptuali6ed to create emedded

stage-growth and stage-abandon options- &he pro;ect 7as initiall/ pitched as a H(5

million all#at#once inestment- hen that proposal 7as soundl/ re;ected, the .S team

reconceptuali6ed the pro;ect as a set of nine separatel/ implementale chun1s, each of

7hich had to produce a direct usiness enefit- &hough no formal O9M 7as used, it 7as

clear that management understood ho7 staging can create alue through increased

fle)iilit/' [the IS team] managed to get funding for the first chun! and soon they

started rolling out the new "#Salong the way! they would insert one chun and ditch

another as needed to get the biggest paybac! while staying open to suggestions-

Furthermore, .& managers structured each stage to e implemented graduall/, so that at

an/ point the roll#out of a gien stage could e reersed, thus creating additional stage#

aandon options-

&his e)ample illustrates a 1e/ tactic for increasing the alue produced / emedded stage

options, 7hich is to ensure that each stage actuall/ produces an identifiale enefit

e/ond simpl/ enaling suse@uent stages- Other7ise it is difficult to deelop an estimateof net enefits of performing that stage in isolation- &his suggests that a pro;ect e

diided into incremental units of functionalit/, each of 7hich can e implemented

separatel/ een if no further increments are implemented-(2A second useful tactic is to

schedule stages 7ith the most uncertaint/ as late as possile in the oerall pro;ect

lifec/cle, since the alue of an option increases the longer the option can e held- &his

tactic 7ill e een more aluale if pro;ect managers segregate functions 7ith the most

uncertaint/ from functions 7ith the least uncertaint/- &his can e done / comining the

most uncertain functions together into the same stages, or een etter, / isolating

uncertain functions into their o7n stages- &his sort of modulari6ation of pro;ect effort

87hich creates fle)iilit/ in theprocess: is different from modulari6ation of the functions

in the deliered s/stem 87hich creates fle)iilit/ in the result:, although it seems li1el/

that pursuing either one 7ill ma1e it easier to achiee the other-

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Potential Pit4alls o4 0tage5ro%th and $bandon Options! Eot all pro;ects can e

diided up to create emedded stage options- Sometimes a firm must ma1e a inding

commitment to a pro;ect as a 7hole, such as 7hen a pro;ect is so large that e)ternal funds

must e raised, or 7hen co#inestment from other parties are re@uired- Or, the pa/offs

from inestment ma/ depend on 7hether a self#reinforcing adoption process reaches

critical mass, meaning that a potential inestor must, in essence, pla/ to 7in or not pla/ at

all-($.n such all#or#nothing inestment situations, aluale options ma/ still e)ist in the

form of the option to defer 8as descried in the ne)t section:-

*en 7hen a pro;ect could e staged in principle, managers ma/ hae difficult/ crafting

stages that conform to the aoe criteria- Another pitfall is that sta1eholders ma/ prefer

all#at#once funding to otain ma)imum control oer a pro;ects fate, and to hae more

time to get a trouled pro;ect ac1 on trac1 efore facing the ne)t round of ;ustification-

.n practice, it can e difficult to distinguish the ordinar/ setac1s that occur on almost

most implementations(4 from those that indicate emedded options should not e

e)ercised


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unanticipated, resistance from nited Airlines 7hich sought to loc1 the cit/s e)it plan-("

Furthermore, the perceied 7aste of ta)pa/er mone/ generated considerale criticism for

the cit/ goernment- 3ranted, a firm that e)plicitl/ conceptuali6es a pro;ect as carr/ing

an aandon option and ;ustifies the pro;ect on that asis should find it easier to e)ercise

an option to terminate compared to a firm that unexpectedlyfinds itself @uestioning the

alue of proceeding


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A retrospectie options#ased anal/sis of the Ian1ee case / t7o .& researchers

determined that the optimal time for Ian1ee to defer inestment 7as three /ears- &his

three /ear deferral option 7as estimated 8using the Blac1 Scholes O9M: to e 7orth

appro)imatel/ H(50,000- &his compares 7ith an estimated E9G for initiating the pro;ect

immediatel/ in (J%" of minus H%0,000- .nterestingl/, Ian1ee did, in fact, defer entr/ for

three /ears, 7hich gies an e)ample of managing an inestment in 7a/s that 7ere

consistent 7ith options thin1ing 7ithout adopting a formal O9M-

Possible Pit4alls o4 e4erral Options!&here are t7o main pitfalls associated 7ith this

option- &he first is the potential for erosion of pro;ect enefits 7ith time- &his ma/ occur

7hen first moer adantages e)ist and there is a danger of preemption / another firm, or

7hen it can e e)pected that other firms 7ill @uic1l/ follo7 8thus shortening the 7indo7

of competitie adantage:- .n fact, as 7ill e discussed later in the section on aluation,

the possiilit/ of alue eroding 7ith time runs counter to the standard O9M assumption

that longer deferral periods increase the alue of options- &he second pitfall stems from

the fact that a firm must often gain direct e)perience 7ith an innoatie technolog/ in

order to e in a position to resole uncertaint/ aout its potential uses and enefits-

Organi6ations that ma1e a hait of deferring inestments ma/ therefore suffer a general

loss of innoatie capailities and ma/ lose the ailit/ to appreciate ne7 technologies,

and thus ma/ find themseles loc1ed out of not onl/ the current opportunit/, ut future

opportunities as 7ell-(J

-1ample 9: Options that Pro7ide ro%th Opportunities 3 $ -uropean $utomaker

An emedded growth option e)ists 7hen an initial aseline inestment opens the

opportunit/ to pursue a ariet/ of potential add#on pro;ects- nli1e the other options

descried so far, 7hich produce alue mainl/ / limiting the e)tent of potential losses in

the eent of unfaorale circumstances, gro7th options add alue / increasing potential

gains in the eent of faorale circumstances- As firms increasingl/ rel/ on .& to e

innoatie, the/ step into a terrain 7here it is much more difficult to pin do7n 7hat a

s/stem should do- Because the .S units 1no7ledge of the application domain of a noel

s/stem is li1el/ to e emr/onic at the outset, oth the gro7th and s7itch options matter

more 7hen firms see1 to Ntilt the pla/ing fieldN using .&-20

((


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A case stud/ of an *9 implementation pro;ect / a *uropean auto ma1er proides a

7ell#deeloped e)ample of ho7 to alue .& gro7th options in practice-2( &he ase

pro;ect, 7hich inoled upgrading from SA9s L2 s/stem to L$, 7as e)pected to cost

H(-%5 million and to produce aout H(-45 million in operational saings, leading to

negatie E9G of aout H400,000- &he ase implementation / itself 7as not cost

;ustified, ut managers reali6ed that the greater roustness and fle)iilit/ of the L$

s/stem 7ould enale seeral potential follo7#on pro;ects that 7ould other7ise hae een

infeasile, including introduction of *D.#ased purchasing and inoicing, 7or1flo7

applications for sales, engineering document handling, and 7e#ased ecommerce- &he

E9G of these additional applications 7as estimated to e H(50,000


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8(: the ase pro;ect has an unclear pa/off ta1en alone, 82: the E9G of the add#on pro;ects

is not enough to gie the pro;ect an oerall positie pa/off, and 8$: there is much

uncertaint/ regarding the net pa/offs of the add#on pro;ects-

Potential Pit4alls o4 ro%th Options! 3ro7th options are most li1el/ to e present on

more innoatie pro;ects and on those that implement a platform for future applications-22

&he main challenge here is the difficult/ of estimating option alues 8due to amiguit/

aout potential future cash flo7s: and uncertaint/ aout the appropriate alue for option

model parameters- &hese challenges are compounded to the e)tent that longer time

hori6ons are inoled, as is often the case 7ith gro7th options-

-1ample 8: The Option to )hange 0cale 3 )ypress )ommunications $uthority

An emedded option to change scalee)ists 7hen the resources allocated to a pro;ect can

e contracted or e)panded in response to future conditions, or 7hen the production

s/stem enaled / a pro;ect can e scaled up or do7n 7ith comparatie ease- .f

une)pected technical arriers are encountered


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should conditions 7arrant 7as estimated to e 2-55 million, resulting in an oerall

aluation for the .S deelopment of 0-%5 million, enough to ;ustif/ proceeding 7ith the

pro;ect-

Possible Pit4alls o4 0cale Options! &he pitfalls associated 7ith scale options depend on

7hether the option is to scale up or do7n- &he option to scale up can add to pro;ect costs,

and some organi6ations ma/ resist adding such costs in return for an uncertain future

pa/off- Conersel/, in the case of scale do7n options, there ma/ e resistance


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compared to the (% months needed for a from#scratch deelopment- &he rapid modifi#

cations 7ere possile ecause of' 8(: the e)plicit depiction of usiness rules and other

design elements in the CAS* template 8rather than haing this uried in program code:=

82: the ease of generating operational protot/pes, 7hich facilitated re@uirements anal/sis

and communication 7ith end users= and 8$: the ease of modif/ing a design model and

regenerating program code compared to modif/ing the program code itself-

Potential Pit4alls o4 0%itch use Options!&he main potential pitfall of this option is that

it can add e)tra time and e)pense to the initial deelopment pro;ect- Some researchers

hae estimated that ma1ing program modules genericall/ reusale


17/34

second stage could easil/ hae een anticipated and included from the start- o7eer, /

segregating this functionalit/ into a separate stage, managers created an emedded stage

option- .f the card had flopped, the e)pense of this e)tra functionalit/ 7ould hae een

aoided-

After the second stage 7as completed Staruc1s managers reali6ed that the card could do

much more than simpl/ speed chec1 out' it could e enhanced to sere as a platform for a

customer lo/alt/ program- As a third stage, the card 7as enhanced to support lo/alt/

points redeemale at Staruc1s ased on purchase olume, entr/ in occasional

s7eepsta1es, and email notification of in#store promotions and ne7 products- Since this

add#on pro;ect created a ne7 asset 8e-g-, a lo/alt/ program: rather than changing the

alue of an e)isting asset 8as 7ith online registration for the initial pre#paid card:, it

represented a gro7th option rather than a scale#up option- B/ implementing this program,

Staruc1s not onl/ increased lo/alt/, ut perhaps ;ust as importantl/, created a dataase

of customer ehaior- Eo7 the/ can tell, for e)ample, that card holders isit a Staruc1s

cafP (" times a month, on aerage-

Most recentl/, Staruc1s has ta1en a fourth step that illustrates an emedded s7itch use

option similar to the &A FFB case- &he/ hae collaorated 7ith Gisa SA and Ban1

One to introduce a co#randed card that comines the functionalit/ of the enhancedStaruc1s prepaidLlo/alt/ card 7ith standard Gisa credit card functionalit/- Since all of

the prior functionalit/ of the pre#paid card 8programming of cash registers, online

registration: could e reused to support the ne7 dual use card, this can e seen as a

s7itch use option-

.t is 7orth emphasi6ing that there is no eidence that Staruc1s managers had planned

from the start to consider an/ specific potential enhancements= rather their intent 7as

simpl/ to 1eep their options open / using an incremental commitment approach-

o7eer, this sort of alert incrementalism is a central principle of options thin1ing- One

thing managers apparentl/ did not do 7as to identif/ at the start 7hat enhancements

might e 7orth pursuing later, and to estimate a alue for each enhancement using an

O9M- As it happened, Staruc1s managers 7ere confident that at least the initial step 7as

7orth pursuing and so putting a alue on options 7as not necessar/- o7eer, if things

(!


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had een different and the initial step 7as less clearl/ ;ustified, then estimating the option

alue of potential enhancements could hae een crucial in ;ustif/ing the initial pro;ect,

as 7as the case in the *9 and net7or1 e)pansion e)amples descried earlier- &hus, it is

important that managers interested in real options e ac@uainted 7ith approaches to

estimating option alue, a topic 7e consider ne)t-

V$,(I&R-$,OPTIO&0

B/ increasing the ratio of 7hat may bedone to 7hat must bedone, and structuring 7hat

may bedone as an option, managers create alue een if the/ do not go the e)tra step of

@uantif/ing 7hat this alue is- o7eer, managers that do deelop option alue

@uantification s1ills 7ill stand to ma1e etter decisions on those occasions 7here option

alue is crucial to ;ustif/ing a pro;ect that does not appear to pa/ off from a traditional

E9G standpoint- As prior e)amples sho7, the @uantified alue of a real option is not

al7a/s intuitiel/ oious and can change a decision on a 7orth7hile pro;ect from a no#

go to a go- Also, estimating option alue can help 7ith more tactical decisions, for

e)ample, 7hether to uild in fle)iilit/ to support either of t7o standards that are

currentl/ attling it out in the mar1et place, rather than placing a et on onl/ one

standard-

&he most commonl/ used tools for aluing real options are the Blac1#Scholes and the

Binomial O9Ms- Some of the .& e)amples alread/ mentioned used the Blac1#Scholes,

and the associated articles each proide e)cellent discussions of ho7 to appl/ this model

in practice- &he Binomial model2"has less stringent assumptions than the Blac1#Scholes

and is li1el/ to receie increasing attention from options researchers- .n a recent article,

Copeland and &ufano note Qthe $inomial model] captures the contingencies of real

options and addresses nearly all of the more commonly voiced criticisms of using option

theory to manage those contingencies-2% .n addition, some ne7er O9M ariants hae

een deeloped that are een more fle)ile than the Binomial model-2J

&he use of O9Ms on .& inestments is su;ect to seeral challenges, starting 7ith

concerns aout transparenc/- &he Blac1#Scholes model in particular is ased on a

comple), fie#parameter formula can seem li1e a lac1#o) to an/one lac1ing a solid

grasp of calculus- Other complaints hae een raised aout the asence of a traded

("


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mar1et for .& assets, 7hich leads to difficult/ in estimating options parameters and

concerns that anal/sts ma/ fudge these parameters= the asence of a fi)ed time /

7hich an .& option must e e)ercised= and the fact that the alue of an .& initiatie ma/

erode 7ith time due to loss of potential for competitie adantage- $0 e eliee that

counter arguments and remedies e)ist 8see Sidear ( Options Galuation Challenges:

that ma1e the use of O9Ms, 7hile not perfect, still generall/ superior to traditional E9G

approaches that place no @uantified alue on fle)iilit/ at all-$( Eeertheless, adopting

formal O9Ms toda/ 7ill re@uire that senior management e open to considering leading

edge aluation techni@ues, and een then, a considerale education effort 7ill e

re@uired- o7eer, these hurdles should e lo7ered as more managers get e)posed to

the use of O9Ms in usiness schools and at leading firms such as Merc1, $2 e7lett#

9ac1ard, $$and .ntel-$4 After all, it too1 man/ /ears for the E9G approach to ma1e the

leap from te)too1 to standard organi6ational practice, and real options hae onl/

recentl/ ecome a fi)ture in finance and M.S te)too1s-

-- Put sidebar about here --

AK&*EA&.G*S&OFOMAKO9MS

.f it is e)pected that senior managers 7ill 8for 7hateer reason: resist the use of formal

O9Ms, then decision trees or een @ualitatie option aluation approaches proide iale

alternaties- Decision trees, unli1e O9Ms, are highl/ transparent- .n the *9 e)ample

aoe the framing of proposed inestments in the form of a decision tree is 7hat

ultimatel/ coninced management, rather than the O9M estimates per se- &he main

limitations of decision trees are first, that the comple)it/ of a tree can increase rapidl/ as

more alternaties scenarios are incorporated, and second, that there is no straightfor7ard

7a/ to determine 7hat the correct ris1 ad;usted discount rate for the 7hole tree should

e-$5Iet, decision trees can e e)pected to come closer to correctl/ aluing a pro;ect that

has important emedded options than conentional approaches that place the alue of

fle)iilit/ at e)actl/ 6ero-

e also thin1 that managers can gain considerale enefit from using structured ut

@ualitatie approaches that help them to thin1 aout option alue more intuitiel/- $!

o7eer, if managers are to rel/ on intuition the/ must e on guard against s/stematic

(%


20/34

iases- .n a separate research stud/, 7e found some interesting indications of ias in ho7

managers ie7ed different 1inds of options 8see Sidear 2 .s Options &hin1ing eal:-

&he follo7ing attriutes increase the importance of using real options concepts 7hen

estimating a pro;ects alue'

*medded options clearl/ e)ist due to high uncertaint/ in comination 7ith

fle)iilit/ in the s/stems delier/ process andLor in the deliered s/stem itself-89reious sections hae proided e)amples to assist managers in recogni6ing7hen this is the case-:

&he pro;ect is going to e ealuated @uantitatiel/ / the numers- 3ien that

managers are going through the effort of estimating cash flo7s, the incrementaleffort of emplo/ing O9Ms is, surprisingl/, not that great, although there is, ofcourse, a learning cure associated 7ith gaining competenc/ in the applications ofsuch models-

&raditional @uantitatie anal/sis produces a result that leaes the alue of thepro;ect 7ith a negatie E9G


21/34

thin1ing- Iet creating an organi6ation, a process and culture that ensures that options

contracts 7ill e honored ma/ present some organi6ations 7ith special challenges- A fe7

e)amples illustrate the point-

One of the easiest 7a/s to create option alue on a pro;ect is simpl/ to defer non#

essential features to a separate stage, as Staruc1s did 7ith the pre#paid card- &his

amounts to changing a fi)ed commitment into a call option- 3etting sta1eholders to gie

candid opinions aout 7hich features are essential and non#essential re@uires trust that

options contracts on non#essential items 7ill e honored- Also, sta1eholders must

understand that honoring the contract does not mean the feature 7ill definitely e

addressed later- ather, it means at some future date the pro;ect team and the re@uestor

7ill ;ointl/ determine 7hether the option is 7orth e)ercising according to a predefined

set of criteria-

As a second illustration, consider an organi6ation that has proceeded 7ith a no7 or

neer inestment opportunit/ o7ing to the alue associated 7ith an aandon option-

&his amounts to 7riting a put contract on the pro;ect- o7eer, as preiousl/ argued,

these sorts of put options can e difficult to honor ecause of the negatie signal pro;ect

termination ma/ send aout the pro;ect teams ailities- .ndeed, man/ of the @ualities 7e

see1 to instill in pro;ect team memers 8positie thin1ing, personal responsiilit/ foroutcomes: can 7or1 against pro;ect termination-

&hus, firms that use real options as part of the pro;ect ;ustification process must put

managerial guidelines in place that allo7 sound options contracts to e created and

honored in practice- e offer ten such guidelines in the Sidear $ 3uidelines for

Bringing Options &hin1ing into 9ro;ect Management-

-- Put side bar about here --

0*O(,/O($OPT=

As ;ust discussed, options thin1ing re@uires ma;or changes to pro;ect management and

complimentar/ changes to organi6ational culture- So managers need to assess the

prealence of real options and their readiness to underta1e the challenges of options

thin1ing efore ta1ing the lead as an earl/ adopter-

20


22/34

$ssessing the Pre7alence o4 Real Options- &he enefits from adoption of real options

depend on ho7 prealent real options are in /our firm- &he follo7ing sorts of @uestions

gie insights on this point'

Does .& pla/ a strategic or merel/ a supporting role in /our

usiness 3ro7th options are especiall/ common in organi6ations7here technolog/ pla/s a strategic role-

Does /our firm operate in a fast moing enironment 7ith a high

rate of innoation in areas dependent on .&, or does it operate in amore stale enironment Fast moing enironments tend to haemore uncertaint/ regarding the alue of .& inestments, 7hich, inturn, increases the alue of associated emedded options of all1inds-

Does /our firm often underta1e er/ large and comple) pro;ects,

or are most pro;ects smaller and straightfor7ard Karge, comple)

pro;ects 7ill usuall/ hae a 7ider ariet/ of operating options- Does /our firm often underta1e discretionar/ or leading#edge .&

pro;ects, or does it tend to 7ait until something ecomes acompetitie necessit/ Discretionar/ and leading#edge pro;ectstend to hae high leels of uncertaint/ and fle)iilit/, 7hilepro;ects that hae ecome a competitie necessit/ hae less ofeither-

$ssess Organi>ational Readiness!3ien that /our firm operates in an enironment

7here real options aound, the other main consideration is 7hether /ou are read/, in

terms of s1ills and culture, to properl/ alue and manage real options- egarding s1ills, a

1e/ issue is 7hether an organi6ation alread/ performs sophisticated @uantitatie

ealuations of .& inestment pro;ects that inole the estimation of future cash flo7s- .f

so, then the incremental effort to estimate the alue of real options 7ill e more

manageale- Furthermore, 1e/ decision ma1ers 7ill alread/ e ac@uainted 7ith man/

fundamental financial concepts that underlie oth traditional E9G sorts of anal/ses and

real options, and thus should e more ale to appreciate real options estimates-

hile there are alternaties to formal O9Ms for organi6ations that lac1 the necessar/

s1ills, there is no sustitute for cultural readiness- &o emplo/ options thin1ing re@uires

fran1 discussions of uncertaint/ and ris1 on .& pro;ects- .f, on the other hand, the er/

admission that a pro;ect might not pa/ off or could e terminated altogether constitutes its

death 1nell


23/34

options contracts in practice' Can managers imagine sustantiall/ curtailing or

terminating pro;ects that 7ere defined upfront to include an emedded stage or aandon

option and still sa/ to eer/one inoled ;o 7ell done .s there a sufficient leel of

trust among sta1eholders to institute staged funding and aggressie deferral of uncertain

or discretionar/ items to later pro;ect stage &hese sorts of @uestions reeal 7hether real

options are feasile from a cultural standpoint-

)O&),(0IO&0

&he goal of this article has een to proide a detailed managerial introduction to options

thin1ing on .& inestment pro;ects- &o7ards this end 7e hae argued the follo7ing si)

essential points'

8(: eal options can e a po7erful tool for aluing the strategic and operationalfle)iilit/ associated 7ith uncertain .& inestments- o7eer, real options are not;ust a ne7 methodolog/ for aluing .& inestments


24/34

inestments 7ill al7a/s e difficult- Eeertheless, options thin1ing proides a promising

philosoph/ to promote the longstanding goals of doing the right pro;ects and doing

pro;ects right- B/ recogni6ing the alue of real options, managers adance the first goal-

B/ honoring options contracts and allo7ing appropriate e)it, managers adance the

second goal- B/ structuring pro;ects to promote fle)iilit/, managers adance oth goals-

As .& ecomes inseparal/ intert7ined 7ith innoation in suppl/ chains, mar1eting,

operations, and ne7 product deelopment, .& inestments ecome increasingl/ difficult

to properl/ assess and manage using conentional tools- Firms see1ing to innoate using

.& tread an unpaed path- Options thin1ing help managers naigate the considerale

uncertainties and e)ploit the fleeting 7indo7s of opportunit/ that present themseles

along this path-

2$


25/34

"igure 2a' *stimated Galue 7ith no Option "igure 2b' *stimated Galue 7ith an *medded

Call

"igure 6' &raditional 9ro;ect Management s- Options &hin1ing

24

.02

.02

.09

.18 .20 .17

.10

.08.07

.05.04

Expected NPV = $1.1m

ProbabilityThe proposed project costs $10m toimplemet! "d h"s poteti"l p"#osr"%i% rom $0 to 20m! res&lti% ithe pro'"'ilit# distri'&tio o etp"#os 'elo(. ) discrete "pproxim"*tio o the expected NPV is c"lc&l"ted'# m&ltipl#i% the pro'"'ilit# o thetr&e p"#o "lli% (ithi oe o the 10pro'"'ilit# '"rs! times the "+er"%ep"#o or the '"r! i.e.!.02,-*9 / .09,-*7.04,-/9= * $1.1m

.10

.08.07

.05 .04

)pproxim"te optio +"l&e = $1.4

Probability

Thee s#stem is str&ct&red "s " ollo(*o project to 'e completed l"ter -e.%.!"ter " pilot project. it is "ss&medm""%ers (ill o( the tr&e p"#o "tthis l"ter time! the the e%"ti+e etp"#o re%io (ill 'e "+oided. Thisle"ds to " re+ised estim"ted p"#o o .10,-1 / .08-3/ .04-9 = $1.4 m.

This is ol# " "pproxim"tio o the+"l&e th"t (o&ld 'e estim"ted '# "orm"l P.

*$9m *7m *5m *3m *1m /1m /3m /5m /7m /$9m /1m /3m /5m /7m /$9m

S u b s y s t e m C

S u b s y s te m B

P r o j e c t w i t h o u t o p t i o n s t h i n k i n g

S u b s y s t e m A

S u b s y s t e m B

S u b s y s t e m C

B u ilds o n

Y e a r 1 Y e a r 3Y e a r 2

Y e a r 1

Y e a r 2

Y e a r 3

P r o je c t d e c o m p o s e d i n t o

s u b p r o j e c t s t o m a ! i m i " e o p t i o n # a l u e

N o O p t io n s

O p t i o n s - d r i v e n m a n a g e m e n t

$ u t u r e

p r o j e c t s

$ u t u r e

p r o j e c t s

$ u t u r e

p r o j e c t s

% & u s t d o % % & u s t d o % % & a y d o % % & a y d o %

S u b s y s t e m '

% & a y d o %

S u b s y s t e m A

% & a y d o %


26/34

0ummary Table: 0i1 Types o4 Real Options

Option e4inition *o% Value is )reated Pit4alls

0tage A pro;ect can e diided intodistinct stages 7here pursuit

of each stage is contingenton a reassessment of costsand enefits at the time thepreceding stage iscompleted

As each stage is completed theamiguities aout the net

pa/offs from suse@uent stagesare resoled= onl/ stages 7ithpositie pa/offs are pursued

Managers ma/ prefer all#at#oncefunding to otain ma)imum

control oer a pro;ects fate orto generate full a prioricommitment to the pro;ect

$bandon A pro;ect can e terminatedmidstream and remainingpro;ect resources relatiel/easil/ redeplo/ed

As a pro;ect unfolds actual costsand enefits ecome more clear,and losses can e curtailed /terminating the pro;ect

9ro;ects tend to ta1e on a life oftheir o7n and are difficult toterminate

Aandoning pro;ects can carr/intangile costs related tocrediilit/ and morale

esources cant al7a/s eproductiel/ redeplo/ed

e4er A decision on 7hether toinest can e deferred forsome period 7ithoutimperiling the potentialenefits

&he firm aoids inesting in 7hatis destined to e a losingproposition

Chances are increased of ma1ingthe right choice on a crucialpro;ect decision

Strategic enefits often erode7ith time

Direct e)perience 7ith atechnolog/ is often re@uired toresole uncertaint/

0trategic

ro%th

An initial aseline inestmentopens the door to pursue aariet/ of potential follo7#on opportunities

Oer time, the relatie alue offollo7#on inestments ecomesmore apparent and onl/ inest#ments 7ith positie pa/ offs arepursued

3ro7th options can e difficultto alue due to higheramiguit/ and the longer timeframes often inoled

)hange

0cale

esources allocated to a

pro;ect can e contracted ore)panded, or the operationals/stem enaled / a pro;ectcan e scaled up or do7nmore easil/

&he organi6ation can increase the

scale of a pro;ectLs/stem 8andthus the range of potentialenefits: if circumstances arefaorale= or can reduce thescale 8and thus potential losses:if circumstances are unfaorale

Building in the option to scale

up or do7n can add to pro;ectcosts

As 7ith the aandon option,scaling do7n a pro;ect cancarr/ intangile costs relatedto crediilit/ and morale

0%itch An .& asset deeloped for onepurpose can e redeplo/edto sere another purpose8s7itch use:

A 1e/ foundation technolog/supporting a pro;ect can e

s7apped out for another8s7itch inputs:

Oer time, the relatie alue ofalternatie uses ecome moreapparent and onl/ uses 7ithpositie pa/offs are pursued

.f a chosen foundation technolog/proes less roust than a rial

technolog/, the organi6ation cans7itch to the rial technolog/

.f licensed technologies areinoled there ma/ e legalrestrictions on the ailit/ tos7itch use

Creating this option usuall/inoles ma1ing the s/stem

more generic, t/picall/ atadded e)pense

25


27/34

0idebar 2: Real Options Valuation )hallenges

)hallenge )ounter $rgument?Remedy

Asence of a traded mar1et for .& assetsma1es it difficult to estimate the e)pectedalue of a pro;ect 8one 1e/ option modelparameter:

Managers must estimate the future e)pected cash flo7s ofa pro;ect een under the E9G approach, and optionsaluation is no more sensitie than E9G aluation tomis#estimates of pro;ect cash flo7s

Asence of a traded mar1et for .& assetsma1es it difficult to estimate the olatilit/8uncertaint/: of the alue of a pro;ect8another 1e/ option model parameter: andma/ raise concerns that anal/sts mightfudge this parameter

Anal/sts can identif/ traded securities that are perceiedto hae a similar ris1 profile and use the eta aluesfor these securities to estimate olatilit/ of pro;ectalue

Anal/sts can do a sensitiit/ anal/sis to determine7hether a pro;ect is ;ustified under different sets ofassumed leels of olatilit/

Anal/sts can use conseratie alues for uncertaint/ until

the/ hae gained more e)perience

Asence of a fi)ed time / 7hich an optionsmust e e)ercised ma1es it less li1el/ thatpro;ects 7ill e appropriatel/ terminated

*scalation of commitment is a common prolem een onpro;ects not conceied as options= in fact, options, /e)plicitl/ recogni6ing things might not go as planned,can support a more disciplined approach to theprolem of terminating trouled pro;ects

Managers can adopt ne7 pro;ect management guidelines8such as e)plicit e)it points: that counter the naturalresistance to pro;ect termination

Kac1 of transparenc/ associated 7ithO9Ms, especiall/ the Blac1#Scholes

hen transparenc/ is important, anal/sts can use theinomial O9M or een more transparent approaches,such as a decision trees

&he alue of an .& initiatie ma/ erode 7ithtime due to loss of potential forcompetitie adantage, ut optionsformulas place a higher alue on longertimes to e)pir/

hen erosion of competitie adantage is an issue,anal/sts can estimate the e)pected alue of a pro;ectseparatel/ for multiple candidate e)piration dates

2!


28/34

0ide Bar 6: Is Options Thinking Real=

&o inestigate 7hether an/ iases might e)ist in the intuitie aluation of real options, 7e recentl/undertoo1 a field stud/ to e)amine ho7 the presence or asence of different 1inds of options affectedmanagers 7illingness to continue a trouled pro;ect- $% Managers in (2$ firms 7ere each as1ed to assessseeral h/pothetical situations, each consisting of a ase inestment pro;ect comined 7ith a differentcomination of emedded options 8e-g-, stage, aandon, scale, s7itch, strategic gro7th: descried incommonsense terms- For each pro;ect the/ 7ere as1ed to indicate the li1elihood that the pro;ect had apositie pa/off loo1ing for7ard and 7hether it should e continued- Some of our findings indicated thatmanagers intuitiel/ ie7 real options in 7a/s consistent 7ith options theor/- For e)ample, the/ didrecogni6e that emedded options added alue, and that the presence of multiple options increased thatalue-

.nterestingl/, 7e also found that .& managers tended to loo1 more faoral/ on some 1inds of options thanothers, despite the fact that, in principle, no one t/pe of option is necessaril/ more or less aluale than an/other- Specificall/ 7e found gro7th options and s7itch use options 7ere the most highl/ alued, 7hileaandon options and stage options 8presented in the form of stage#aandon: 7ere alued least-

&hese results suggest that options representing positie opportunities to increase the potential upside of apro;ect if things go 7ell 8i-e-, options that are li1e adding an additional call option to an e)isting ase

inestment: are more highl/ alued than options that proide opportunities to contain the most e)tremedo7nside losses if things do not go 7ell 8i-e-, options that are li1e adding a put option to an e)isting aseinestment:- Further research is re@uired to estalish e)actl/ 7h/ this ias e)ists, ut one plausilee)planation is that managers anticipate that positie options 8calls: associated 7ith pro;ect success 7ille easier to e)ercise in practice, 7hile negatie options 8puts: 7ill proe more difficult to e)ercise-

One managerial implication of these results is that until organi6ations are ale to oercome culturall/#emedded iases, it ma/ e 7orth7hile to change ho7 options are structured and portra/ed so that the/ cane interpreted as positie opportunities 8i-e-, call options: rather than as hedging against negatie outcomes8i-e-, put options:- ere are three e)amples of such tactics'

Tactic 2' .nstead of undling uncertain features as part of the initial ase pro;ect 7ith the understandingthe/ ma/ e ta1en out if things do not go 7ell 87hich is li1e adding a put option:, managers can shift these

uncertain features to a second stage pro;ect 87hich is li1e adding a call option:-

Tactic 6' .nstead of immediatel/ underta1ing an uncertain pro;ect 7ith the understanding that it ma/ eaandoned later 87hich is li1e adding a put option: managers ma/ choose to defer initiation of the pro;ect87hich is li1e adding a call:-

Tactic 9' .nstead of using traditional staged funding 87hich emeds a stage#aandon option that ehaesli1e a put: managers can see1 to stage a pro;ect so that each completed segment produces the potential forusiness alue as 7ith the Carlson e)ample 87hich produces a stage#gro7th option that ehaes li1e a call:-

2"


29/34

0ide Bar 9: uidelines 4or Bringing Options Thinking into Project Management

(- Place a 7alue on 4le1ibility in some systematic %ay! &his can range from using a formalO9M, to decision trees, to a s/stematic ut @ualitatie anal/sis of option alue-

2- Be %illing to initiate high5risk?high5re%ard projects %hen the risks can be contained%ith options! &hese pro;ects hae the most option alue, and are most li1el/ to e 7rongl/ re;ected

using the E9G rule-$- ,ook 4or %ays to shi4t the balance 4rom must doto may doproject elements!&his includes

deferring non#critical items for later implementation stages, and e)plicitl/ identif/ing futureapplications and enhancements at the time the initial aseline pro;ect is considered-

4- $t the outset o4 project< e1plicitly identi4y the 4actors that create uncertainty!.dentif/uncertain factors that determine 7hether may doitems 7ill e more or less attractie- Deelop a set ofe)plicit statements aout ho7 faorale and unfaorale shifts in these factors should affect7illingness to continue- 9ut procedures in place to actiel/ trac1 uncertain factors as the/ eole oerthe course of the pro;ect-

5- Be aggressi7e in the use o4 incremental project 4unding and staging!or1 especiall/ hardto structure implementation so that each stage creates alue een if no further stages are funded-

!- Be %illing to in7est in design practices that create gro%th options by promoting 4uture4le1ibility o4 deli7ered applications- &his includes ma1ing s/stems more generic, multi#purpose,interoperale and scalale-

"- Be generous in the use o4 implementation tactics that create operating options!&heseinclude simulations, protot/pes, pilot pro;ects, and incremental roll#outs- se incremental roll#outs tophase introduction of different functionalities to the same population of users or to phase the samefunctionalit/ to different sets of users-

%- Build5in e1plicit options checkpoints! &hese are analogous to options e)piration dates, andshould e located at points 7here a pro;ect can e most gracefull/ redirected or terminated 8e-g-, at theend of each stage: if uncertaint/ has een resoled in an unfaorale 7a/- At each chec1point thecurrent status of uncertain factors and the pro;ect more generall/ should e re#ealuated and matchedagainst e)pectations- Decision rule triggers for terminating a pro;ect should e articulated at theoutset of the pro;ect to help guard against pro;ect managers falling asleep at the s7itch-$J

J- &ominate an @e1it championA to counter balance the regular project champion!An e)it

champion is a 7ell#respected, senior person 7hose ;o it is to 1no7 7hen the time has come to pull theplug on a pro;ect, and to adocate for doing so 7hen and if that time is reached-40 A natural additionalresponsiilit/ for an e)it champion in the conte)t of real options 7ould e to trac1 e)ercise decisionperformance 8i-e-, are pro;ects continued or terminated as appropriate:- &his does not mean ;udgingresults of these difficult decisions 7ith 20#20 hindsight- ather, it means ;udging the @ualit/ of theanal/ses used to support e)ercise decisions at each chec1 point, and 7hether e)plicit e)ercise decisions7ere in fact made, rather than the pro;ect simpl/ continuing along / default-

(0- )reate incenti7es 4or proper options e1ercise! After procedures are in place to trac1e)ercise performance, organi6ations must then re7ard good performance 7ith some comination ofcompensation, increased responsiilit/ and pulic recognition-4(Additionall/, the organi6ation mustclearl/ signal that pulling the plug on a failing pro;ect does not necessaril/ carr/ the connotation ofadmitting failure-

2%


30/34

-ndnotes

2J


31/34

1 - Failure rates of 50? and aoe hae een osered for adanced manufacturing technolog/8See Ma;chr6a1, A-%he &uman Side of 'actory (utomation osse/#Bass, San Francisco, (J%%-:,usiness process re#engineering 8see Bashein, B--, Mar1us, M-K-, and ile/, 9- N9reconditions forB9 Success,NInformation Systems )anagement 8(('Spring: (JJ4, pp "#($-: and customerrelationship management s/stem implementation 8see ig/, D-R-, eichheld, F-F-, and Schefter,9- NAoid the four perils of CM,N&arvard $usiness #evie7 8%0'2: 2002, pp (0(#(0"-:-

2 - .n deeloping our ideas 7e hae een particularl/ influenced /' Benaroch, M- NManaging.nformation &echnolog/ .nestment is1' A eal Options 9erspectie,N*ournal of )anagementInformation Systems 8(J'2: 2002, pp 4$#%4= Benaroch, M-, and Rauffman, -- Nustif/ingelectronic an1ing net7or1 e)pansion using real options anal/sis,N)IS +uarterl/ 824'2: (JJJ, pp(J"#22!= Copeland, &-*-, and Reenan, 9-&- No7 much is fle)iilit/ 7orthN)c,insey+uarterl/'2: (JJ%, pp $%#4J= Mc3rath, -3- NA eal Options Kogic for .nitiating &echnolog/9ositioning .nestments,N(cademy of )anagement #evie7 822'4: (JJ", pp J"4#JJ!= &audes, A-,Feurstein, M-, and Mild, A- NOptions anal/sis of soft7are platform decisions' A case stud/,N)IS+uarterl/ 824'2: 2000, pp 22"#244-

3 - &hom1e and einersen proide a detailed discussion of tactics for promoting fle)iilit/ in thene7 product deelopment 8E9D: process- Much of this discussion is applicale to the conte)t of.& s/stems deelopment- See' &hom1e, S-, and einertsen, D- NAgile product deelopment'Managing deelopment fle)iilit/ in uncertain enironments,N "alifornia )anagement #eview84('(: (JJ%, pp %#$0-

4 - &he follo7ing proide useful introductions to real options models' Amram, M-, and Rulatila1a,E-#eal ptions. )anaging Strategic Investment in an /ncertain 0orld BS 9ress, Boston, (JJJ,p- 24!= Di)it, A-, and 9ind/c1, -Investment /nder /ncertaint/ 9rinceton niersit/ 9ress,9rinceton, E, (JJ4= Kuehrman, &-A- N.nestment opportunities as real options' 3etting started onthe numers,N&arvard $usiness #evie7 8"!'4: (JJ%, pp 5(#!0= &rigeorgis, K- 8ed-:#eal optionsand business strategy1 (pplications to decision maing- is1 Boo1s, (JJJ-

5 - &he application of real#options to >D is descried in' Angelis, D-.- NCapturing the Option

Galue of >D,N#esearch %echnology )anagement 84$'4: 2000, pp $(#$4= Mc3rath, -3- NA ealOptions Kogic for .nitiating &echnolog/ 9ositioning .nestments,N(cademy of )anagement#evie7 822'4: (JJ", pp J"4#JJ!= 9erlit6, M- Neal options aluation' &he ne7 frontier in >Dpro;ect ealuationN# 2 3 )anagement 82J'$: (JJJ, pp 255#2!J-

6 - &he application of real#options to .& is illustrated in Amram, M-, Rulantila1a, E-, andenderson, C-- N&a1ing an Option on .&,N"I )agazine 8(2'(": (JJJ, pp 4!#52= Benaroch, M-,and Rauffman, -- Nustif/ing electronic an1ing net7or1 e)pansion using real options anal/sis,N )IS +uarterl/ 824'2: (JJJ, pp (J"#22!= Dos Santos, B-K- Nustif/ing .nestments in Ee7.nformation &echnologies,N*ournal of )anagement Information Systems 8"'4: (JJ(, pp "(#%J=Fichman, -3- Neal Options and .& 9latform Adoption' .mplications for &heor/ and 9ractice,Nconditionall/ accepted atInformation Systems #esearch, 2004= Ramil, A-, enderson, -C-, andMohsen6adeh, - NStrategic Management of .nformation &echnolog/' An Options 9erspectie,N in'Strategic Information %echnology )anagement. 4erspectives on rganizational 5rowth and"ompetitive (dvantage, -D- Ban1er, -- Rauffman and M-A- Mahmood 8eds-:, .dea 3roup9ulishing, Middleton, 9A, (JJ$= Reil, M-, and Flatto, - N.nformation s/stems pro;ect escalation'A reinterpretation ased on options theor/,N(ccounting! )anagement 2 Information %echnolog/8J: (JJJ, pp ((5#($J= Rim, I--, and Sanders, 3-K- NStrategic actions in information technolog/inestment ased on real option theor/,N3ecision Support Systems 8$$'(:, MAI 2002, pp (#((=Rumar, -K- NManaging ris1s in .& pro;ects' an options perspectie,NInformation 2 )anagement840'(:, OC& 2002, pp !$#"4= &audes, A-, Feurstein, M-, and Mild, A- NOptions anal/sis of soft7are


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platform decisions' A case stud/,N)IS +uarterl/ 824'2: 2000, pp 22"#244-

7 - Konger holding periods are more aluale ecause the estimate of a pro;ects alue 7ill haehad a longer time to shift up or do7n due to ne7 information-

8 - For a discussion of these si) options t/pes, see &rigeorgis, K- Neal options and interactions7ith financial fle)iilit/,N'inancial )anagement 822'$: (JJ$, pp 202#224-

9

- Benaroch, M- NManaging .nformation &echnolog/ .nestment is1' A eal Options9erspectie,N*ournal of )anagement Information Systems 8(J'2: 2002, pp 4$#%4-

10 - Boehm, B-- NA Spiral Model of Soft7are Deelopment and *nhancement,NI666 "omputer82('5: (J%%, pp !(#"2-

11 - Scalet, S-D- NStage Managers,N in'"I )agazine, 2000-

12 - Fichman, -3-, and Moses, S-A- NAn incremental process for soft7are implementation,NSloan)anagement #evie7 840'2: (JJJ, pp $J#52-

13 - Shapiro, C-, and Garian, --Information #ules. ( Strategic 5uide to the 7etwor 6conom/arard Business School 9ress, Boston, (JJ%-

14

- Che7, B--, Keonard#Barton, D-, and Bohn, -*- NBeating Murph/s Ka7,NSloan )anagement#evie7 8$2'$: (JJ(, pp 5#(!-

15 - Reil, M-, Mann, -, and Arun, - Nh/ soft7are pro;ects escalate' An empirical anal/sis andtest of four theoretical models,N)IS +uarterl/ 824'4: 2000, pp !$(#!!4-

16 - Adner, -, and Keinthal, D-A- Nhat is not a real option' Considering oundaries for theapplication of real options to usiness strateg/,N(cademy of )anagement #evie7 82J'(: 2004, pp"4#%5= Fin1, - Nealit/ chec1 for real options,N"' )agazine 8("'J: 200(= &each, *- Nill ealOptions &a1e ootN"'O 8(J'J: 200$, pp "$#"5-

17 - Montealegre, -, and Reil, M- NDe#escalating .nformation &echnolog/ 9ro;ects' Kessons fromthe Dener .nternational Airport,N)IS +uarterl/ 824'$: 2000, pp 4("#44%-

18 - Benaroch, M-, and Rauffman, -- Nustif/ing electronic an1ing net7or1 e)pansion using realoptions anal/sis,N .id-'2: (JJJ, pp (J"#22!-

19 - Schilling, M-A- N&echnological Koc1out' An .ntegratie Model of the *conomic and StrategicFactors Driing &echnolog/ Success and Failure,N(cademy of )anagement #evie7 82$'2: (JJ%,pp 2!"#2%4-

20 - 9rahalad, C-R-, and Rrishnan, M-S- N&he d/namic s/nchroni6ation of strateg/ and informationtechnolog/,N )I% Sloan )anagement #evie7 84$'4:, SM 2002, pp 24#$(-

21 - &audes, A-, Feurstein, M-, and Mild, A- NOptions anal/sis of soft7are platform decisions' A casestud/,N)IS +uarterl/ 824'2: 2000, pp 22"#244-

22 - &audes, A- NSoft7are gro7th options,N*ournal of )anagement Information Systems 8(5'(:(JJ%, pp (!5#(%5-

23 - 9ana/i, S-, and &rigeorgis, K- NMulti#stage real options' &he cases of information technolog/infrastructure and international an1 e)pansion,N+uarterly #eview of 6conomics and 'inance 8$%:(JJ%, pp !"5#!J2-

24 - ofman, -D-, and oc1art, -F- NApplication &emplates' Faster, Better, and Cheaper S/stems,NSloan )anagement #evie7 8$5'(: (JJ4, pp 4J#!0-


33/34

25 - Fichman, -3-, and Remerer, C-F- N.ncentie Compatiilit/ and S/stematic Soft7are euse,N*ournal of Systems and Software 85": 200(, pp 45#!0-

26 - o7e, - NAt Staruc1s, the Future .s in 9lastic,N$usiness 810 84'": 200$, pp 5!, !$-

27 - &he uenstein inomial model allo7s non#constant ariance in e)pected pa/offs, and theadditie form of the model forms also allo7s e)pected pa/offs to e normall/ distriuted 7ith thepotential for non#negatie alues- &he latter form of fle)iilit/ is important since it allo7s for thepossiilit/ that an .& s/stem 7ill actuall/ decrease the performance of the firm- For furthere)planations, see' Copeland, &-, and Anti1aro, G-#eal ptions. ( 4ractitioner9s 5uide &e)ere,Ee7 Ior1, 200(, p- $"2-

28 - Copeland, &-, and &ufano, 9- NA real#7orld 7a/ to manage real options,N&arvard $usiness#evie7 8%2'$: 2004, pp J0#JJ-

29 - Sch7art6 and o6a/a#3orosti6a hae deeloped an O9M that e)plicitl/ models uncertaint/ inthe cost of follo7#on pro;ects, and allo7s an additional form of uncertaint/, 7hich is the possiilit/of catastrophic eent during deelopment Sch7art6, *-S-, and o6a/a#3orosti6a, C- NGaluation of.nformation &echnolog/ .nestments as eal Options,N T!#00, CKA, Kos Angeles, p- $"-- .naddition, Monte Carlo simulation methods can e used that permit a great deal of fle)iilit/ in

modeling options 8see' Amram, M-, and Rulatila1a, E-#eal ptions. )anaging StrategicInvestment in an /ncertain 0orld BS 9ress, Boston, (JJJ, p- 24!-:-

30 - For more discussion of challenges to the use of O9Ms in practice, see Fin1, - Nealit/ chec1for real options,N"' )agazine 8("'J: 200(= &each, *- Nill eal Options &a1e ootN"'O8(J'J: 200$, pp "$#"5-

31 For more details on counter#arguments and remedies to O9M challenges, see Benaroch, M-, andRauffman, -- NA case for using real options pricing anal/sis to ealuate information technolog/pro;ect inestments,NInformation Systems #esearch 8(0'(: (JJJ, pp "0#%!= Copeland, &-, and&ufano, 9- NA real#7orld 7a/ to manage real options,N&arvard $usiness #evie7 8%2'$: 2004, ppJ0#JJ-

32 - Eichols, E-A-, and Ke7ent, - NScientific Management at Merc1 # an .nterie7 7ith CFO ud/Ke7ent,N&arvard $usiness #evie7 8"2'(: (JJ4, pp %%#JJ-

33 - Bu)aum, 9- N&apping .nto eal Options,N"omputerworld 8$!'2: 2002, pp 2%#2J-

34 - &each, *- Nill eal Options &a1e ootN"'O 8(J'J: 200$, pp "$#"5-

35 - See the follo7ing for discussions of the limitations of decision trees Benaroch, M- NManaging.nformation &echnolog/ .nestment is1' A eal Options 9erspectie,N*ournal of )anagementInformation Systems 8(J'2: 2002, pp 4$#%4= Copeland, &-*-, and Reenan, 9-&- No7 much isfle)iilit/ 7orthN)c,insey +uarterl/'2: (JJ%, pp $%#4J-

36 - .n e)ample of a @ualitatie approach to aluating real options in the conte)t of >D is proided

in Mc3rath, -3-, and MacMillian, .-C- NAssessing technolog/ pro;ects using real optionsreasoning,N#esearch %echnology )anagement 84$'4: 2000, pp $5#4J-

37 - seful adice on managing real options is also proided in' Amram, M-, and Rulatila1a, E-#eal ptions. )anaging Strategic Investment in an /ncertain 0orld BS 9ress, Boston, (JJJ, p-24!= Copeland, &-, and Anti1aro, G-#eal ptions. ( 4ractitioner9s 5uide &e)ere, Ee7 Ior1,200(, p- $"2= Copeland, &-, and &ufano, 9- NA real#7orld 7a/ to manage real options,N&arvard$usiness #evie7 8%2'$: 2004, pp J0#JJ= amilton, -F- NManaging eal Options,N in'0harton on)anaging 6merging %echnologies, 3-S- Da/, 9--- Schoema1er and -*- 3unther 8eds-:, ohn


34/34

ile/ > Sons, Ee7 Ior1, 2000-

38 - &i7ana, A-, Reil, M-, and Fichman, -3- NSoft7are 9ro;ect *scalation' An *medded OptionsModel-N

39 - For a fuller discussion of triggers and other tactics to encourage appropriate e)ercise of realoptions, see Copeland, &-, and &ufano, 9- NA real#7orld 7a/ to manage real options,N&arvard$usiness #evie7 8%2'$: 2004, pp J0#JJ-

40 - For a discussion of e)it champions and other tactics for terminating pro;ects see o/er, .- Nh/ad pro;ects are so hard to 1ill,N .id- 8%('2:, F*B 200$, pp 4%#5!-

41 - Copeland, &-, and &ufano, 9- NA real#7orld 7a/ to manage real options,N&arvard $usiness#evie7 8%2'$: 2004, pp J0#JJ-

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