In today’s fast-paced digital environment, companies, from start-ups to scale-ups to large enterprises, must continually balance the demands of digital transformation. This includes introducing new products, services, and technologies that can accelerate growth and improve efficiency. However, given limited resources and businesses (and an increased need to delivery on mandatory regulatory requirements) businesses must assess and prioritise these projects carefully to maximise their strategic and economic value.
While project costs (such as initial investment, COGS, and operating expenses) can typically be predicted with a higher degree of accuracy, the real uncertainty, lies in the investment case assumptions that need to be made about customer adoption and the revenue realisation that will follow.
These adoption curves and revenue projections often carry significant risk, especially when launching new products in dynamic markets.
Traditional financial evaluation methods like Net Present Value (NPV) can be useful, but they do not fully account for the strategic flexibility required to adapt to unforeseen circumstances, a need that becomes especially clear in environments marked by rapid technological shifts, regulatory changes, and evolving customer preferences.
This is where Real Options Theory provides an insightful and interesting addition to typical project investment portfolio planning.
By considering the optionality of decisions, real options theory offers a more dynamic approach to decision-making, helping companies assess not just the immediate viability of a project but also the value of having the flexibility to modify or abandon the project as more information becomes available.
In this article, we’ll explore how real options theory can be applied to evaluate new project ideas, initiatives and investments and how it can influence investment decisions when considering the inherent uncertainty in future revenue generation.
Let's start with a refresh on NPV Evaluation of Typical Proposed New Project Investments (across the portfolio).
Net Present Value (NPV, a well-established financial metric used to evaluate investment opportunities; and without going into specific details of the mathematical formula, includes the key elements of:
the net cash flow (revenue minus costs) over time
the discount rate,
the number of time periods (usually years),
the initial investment.
The NPV calculation helps assess the immediate profitability of a project, but it has limitations:
Uncertainty in future cash flows: NPV assumes that future cash flows can be predicted with a reasonable level of certainty. However, revenue projections, particularly for new products where customer adoption rates are uncertain, can vary significantly from expectations.
Lack of flexibility: NPV doesn't account for the optionality inherent in future decisions, such as the ability to delay, expand, or abandon a project based on new information.
Real Options Theory: Enhancing Strategic Flexibility
Real options theory provides a framework for incorporating strategic flexibility into investment decisions. It allows businesses to evaluate projects based not only on immediate costs and revenues but also on the value of having the right (but not the obligation) to make certain decisions in the future, such as:
Delaying a project to wait for more information about customer adoption or market conditions.
Expanding a project if initial results prove favourable.
Abandoning the project if it does not meet performance expectations.
Switching strategies or products based on market shifts.
By considering these options, companies gain a clearer picture of the long-term value of a project, particularly in uncertain environments where new information can dramatically change the course of action.
The Black-Scholes Model for Valuing Real Options
One of the most widely used models for valuing financial options is the Black-Scholes model. It can also be applied to real options, where the flexibility to make future decisions adds value to the project. For this formula, whether you are mathematically interested and oriented, spent some time with these in financial services of just curious to learn more, let’s break it down.
By calculating the real options value of a project, companies can better understand the strategic value of their investment, beyond just the static NPV.
Example: Evaluating New Payment Product / Platform Project Options
Let’s consider an enterprise company evaluating three potential options for investing in new payments products. The company has a $1.5 million budget for each project, but the future net cash flows (i.e., revenue minus COGS and operating costs) will vary depending on customer adoption and market conditions. In each scenario, we will calculate the NPV based on projected cash flows and then assess the impact of adding the real options value.
Option 1: New Payment Platform with Progressive Legacy System Windup
Initial investment: $1.5 million.
Net Cash Flow Impact (per year for 5 years): Revenue: $1 million. COGS and Operating Costs: $600,000. Net Cash Flow Impact: $400,000 per year.
Option 2: Full Legacy Replacement with a New Integrated Platform
Initial investment: $1.5 million.
Net Cash Flow Impact (per year for 5 years): Revenue: $1.2 million. COGS and Operating Costs: $500,000. Net Cash Flow Impact: $700,000 per year.
Option 3: Parallel Operation of Legacy and New Systems
Initial investment: $1.5 million.
Net Cash Flow Impact (per year for 5 years): Revenue: $1.3 million. COGS and Operating Costs: $700,000. Net Cash Flow Impact: $600,000 per year.
Step 1: NPV for Each Option
Using a discount rate of 10%, we calculate the NPV for each option:
Option 1: The NPV is $16,000.
Option 2: The NPV is $1,153,000.
Option 3: The NPV is $774,000.
At this point, Option 2 appears the most profitable, followed by Option 3, with Option 1 offering only a modest return.
Step 2: Valuing Flexibility Using Real Options
Now, let’s consider the value of flexibility by applying real options theory. Assume the following assumptions for all options:
Volatility (σ\sigma) of 25% in future cash flow estimates.
Time to Decision (TT) is within 3 years.
Risk-free rate (rfr) is 5%.
We use the Black-Scholes formula to calculate the value of flexibility in each project option. Based on these assumptions, the calculated value of the real options for each project option is:
Option 1: $350,000 value for flexibility (e.g., the option to delay or expand).
Option 2: $500,000 value for flexibility (e.g., the ability to scale or pivot).
Option 3: $400,000 value for flexibility (e.g., the option to switch strategies based on performance).
Final Value Consideration
Now, let’s add the real options value to the NPV for each option:
Option 1: NPV = $16,000 + $350,000 = $366,000
Option 2: NPV = $1,153,000 + $500,000 = $1,653,000
Option 3: NPV = $774,000 + $400,000 = $1,174,000
This approach reveals that when real options are factored in, the decision-making process becomes more strategic. While Option 2 remains the most profitable, Option 1 gains additional value from the flexibility to adapt to future changes.
These were simply example scenarios and of course your own company project investments portfolio will have it's own nuances. As we also like to say, all financial models will likely be wrong but most are very useful and insightful, even if for just the debate and discussion on the inputs and assumptions that are going into them.
These formulaic structures enable organisations and teams to get very specific on which aspect of say the NPV + Options Value variables is there most agreement or disagreement on.
Like all Financial Forecasting; Real Options Theory is a Great NPV addition, but Limitations Must Also Be Acknowledged
Real options theory is a valuable tool for evaluating investments under uncertainty, but its application to company strategy and project evaluation comes with several limitations. These challenges are particularly evident when dealing with strategic opportunities and complex organisational dynamics:
Impossibility of Pre-specifying Outcomes: Unlike financial options, strategic options cannot always be clearly defined at the outset, as new opportunities may emerge during the process.
Path-Dependent Processes: Flexible markets and technical agendas mean strategic initiatives are often better understood as ongoing learning journeys rather than discrete options.
Blurred Investment Stages: Strategic investments often evolve, making it difficult to clearly define discrete stages or decisions.
Failure Doesn’t Prove Inability: Negative outcomes (e.g., technology failures) do not conclusively show that a project can’t succeed, complicating the decision to abandon or continue.
Difficulties in Defining Abandonment: The criteria for abandoning a project are often unclear, making it harder to realise the flexibility promised by real options.
Organisational Challenges: Different organisational levels (managers vs. executives) often have conflicting views on when to abandon or continue, leading to misalignment.
Psychological Biases: Biases like sunk cost fallacy and escalation of commitment can prevent timely abandonment of failing projects.
Lack of Rigid Boundaries: Strategic initiatives with flexible scope make it difficult to apply clear real options frameworks.
Challenges with Option Duration: The lack of clear expiration dates for many strategic options makes timing decisions harder and increases the risk of overvaluation.
Conclusion: Real Options Theory and Ongoing Project Investment Portfolio Evaluation
In today’s rapidly evolving business environment, projects investment evaluation (and confidences on returns) is a fluid state and no longer simply an output of the Annual Company Strategy Planning Day. Quarterly or at least every 6-monthly project portfolio reviews provide enterprises with the opportunity to reassess investments based on new insights, evolving market conditions, and improved confidence in future net cash flows.
By incorporating real options theory into these reviews, companies can not only adjust their revenue projections but also more accurately assess the level of volatility, confidence, and certainty surrounding future cash flows.
This means that as market conditions stabilize or as customer adoption patterns become clearer, businesses can fine-tune their investment decisions, including the decision to expand, delay, or even abandon a project.
Through the lens of real options, the assessment shifts from static assumptions to a more dynamic and flexible view of the future. If confidence in projected cash flows increases or if uncertainty (volatility) decreases, the potential value of a project can be recalculated with greater precision. This ongoing assessment enables enterprises to make more informed decisions, ensuring that investments align with the most strategic and economically beneficial initiatives at any given time.
That said, such ongoing evaluations also raise the broader question of organisational flexibility and agility. In order to benefit from the dynamic nature of real options, companies must be able to pivot quickly in response to new information or changing conditions.
The ability to adjust project priorities, timelines, resources and even business models in the face of uncertainty requires a level of organisational agility that goes beyond just financial analysis; a discussion that deserves its own exploration.
Nonetheless, we trust the above has provided some further ideas on potential inputs into your future (and current in progress) key initiatives investment conversations and some useful tools, prompts and evaluation frameworks for better informed decisions and actions.
For those further interested in the above concepts and practical applications, Harvard Business Review published a number of articles also on this topic through the 1990s and 2000s, so it is not a new idea however I was prompted to bring it up again in view some current work and practicalities of looking at potential investments in an ongoing volatile and hard to protect forward investment horizon. We would be happy to discuss more of our thoughts on this as you work through your own company prioritisation of projects. Do reach out and let's chat at www.artipi.com.au.
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