Valuation of an IT project using the real options analysis

Abstract

Under traditional analysis of the capital budgeting, it is assumed that management cannot react to deviation from the expected scenario of cash flows. In the real world, however, the expected scenario will likely not be realized when new information arrives and uncertainty in the marketplace gets resolved. Uncertainty and risk can be influenced through “managerial flexibility”, which becomes a central instrument for value creation. The real options framework takes this managerial flexibility into account. It is distinguished from its response to uncertainty. It is not appropriate to use the traditional tools when valuing the rapid developing IT projects, which have more uncertainties than other industries. We evaluate an IT project by using the real options analysis. When we perform net present value calculation, the project has a negative net present value, and it would be rejected without flexibility. However, as applying the real options analysis to that project, we identify the various types of real options of the project. The real options analysis value is much higher than the net present value that fails to value these flexibilities. We come to know that the extra value of flexibility makes the project worthwhile.