Hybrid real options valuation of risky product development projects

Abstract

Managers and designers of technological systems face a common difficulty; new projects or products are inherently risky, both technologically and financially, especially given the rate of change in the high technology, deregulated economy. Consequently, they need solid methods for valuing prospective investments, so that they can justify their development strategies. Their fundamental problem is compounded by two methodological difficulties: (a) traditional net present value (discounted cash flow) evaluations are inadequate for many risky projects, and (b) the available methods for valuing these projects are limited and often impractical. This paper identifies practical solutions to this problem. Conceptually, it is crucial to focus on dynamic strategies of development, rather than on specific projects or products. Planners need to understand that they are consciously managing risk, and will do so most effectively by developing options they can exploit or abandon depending on future events. Methodologically, it is useful to combine the best of the alternative approaches to valuing risky projects, to achieve a practical and effective means of valuation. Hybrid real options valuation combines the best features of decision and options analysis. The paper describes this new approach and illustrates it with an application to a portfolio of technological developments of a major automobile company. The example demonstrates the effectiveness of the new method. Real options valuation has the further advantage that it rightfully increases the assessed value of risky projects, once we see them as options that can be abandoned in the context of a long-term development strategy. This increase is greatest for projects that are particularly risky or expensive to implement over time.