Real options theory

Acronym
N/A

Alternate name(s)
N/A

Main dependent construct(s)/factor(s)
Option value

Main independent construct(s)/factor(s)
Cash flow, adjusted risk factors (risk adjusting probabilities), uncertainty, volatility

Concise description of theory
An financial 'option' is a right, but not an obligation, to make an investment decision. A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments.

Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project. Traditional methods (e.g. net present value) fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change. The real options method represents the new state-of-the-art technique for the valuation and management of strategic investments. There are five types of real options: Waiting-to-Invest option, Growth option, Flexibility option, Exit option and Learning option.

Adapted from: Ulrich Hommel (www.real-options.de)

Diagram/schematic of theory
The Black and Scholes Model:



An example of how real options can show different valuations of an investment over time:



Originating author(s)
Fischer Black and Myron Scholes conducted pioneering work on options pricing

Seminal articles
Amram, M. and Kulatilaka, N. (1999). Real Options. Harvard Business School Press.

Black, Fischer and Myron Scholes, "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, 81:3, 1973, pp. 637-654.

Bookstaber, Richard M. Option Pricing and Strategies in Investing, 1981, Addison-Wesley Publishing Company.

Luehrman, T., “Strategy as a Portfolio of Real Options,” Harvard Business Review, 76 (5), 1998, pp. 89-99.

Myers, S.C. (1977) Determinants of Corporate Borrowing. Journal of Financial Economics, vol 5, 147-175.

Originating area
Economics

Level of analysis
Decision

IS articles that use the theory
Amram, M., N. Kulatilaka and C.J. Henderson, “Taking an Option on IT,” CIO Magazine, 12 (17), 1999, pp. 46-52.

Benaroch, M. and R.J. Kauffman, “A Case for Using Real Options Pricing Analysis to Evaluate Information Technology Project Investments,” Information Systems Research, 10 (1), 1999, pp. 70-86.

Benaroch, M. and R.J. Kauffman, “Justifying Electronic Network Expansion Using Real Option Analysis,” Management Information Systems Quarterly, 24 (2), 2000, pp. 197-225.

John A. Campbell, Real options analysis of the timing of IS investment decisions, Information and Management, v.39 n.5, p.337-344, March 2002

Dai, Q., R.J. Kauffman and S.T. March, “Analyzing Investments in Object-oriented Middleware: An Options Perspective,” working paper, Carlson School of Management, University of Minnesota, 2000.

Dos Santos, B.L., “Justifying Investment in New Information Technologies,” Journal of Management Information Systems, 7 (4), 1991, pp. 71-89.

Grenadier, S. & Weiss, A. (1997). Investment in technological innovations: An option pricing approach. Journal of Financial Economics, 44(3), 397-416.

Arnd Huchzermeier, Christoph H. Loch, Project Management Under Risk: Using the Real Options Approach to Evaluate Flexibility in R&D, Management Science, v.47 n.1, p.85-101, January 2001

Kambil, A., C.J. Henderson and H. Mohsenzadeh, “Strategic Management of Information Technology Investments,” in Strategic Information Technology Management: Perspectives on Organizational Growth and Competitive Advantage, R.D. Banker, R.J. Kauffman and M.A. Mahmood (editors), Idea Group Publishing, 1993.

Kim, Y. & Sanders, G. (2002). Strategic actions in information technology investment based on real option theory. Decision Support Systems, 33(1), 1-11.

Kumar, R., “A Note on Project Risk and Option Values of Investments in Information Technologies,” Journal of Management Information Systems, 13 (1), 1996, pp. 187-193.

Li, X. (2001). Optimal Timing for Brokerage to Go Wireless--A Real Options Approach. Unpublished PhD Dissertation, The University of Mississippi.

Li, X. & Johnson, J. (2002). Evaluate IT investment opportunities using real options theory. Information Resource Management Journal, 15(3), 32-47.

Lucas, H.C., Information Technology and the Productivity Paradox: Assessing the Value of Investing in IT, Oxford University Press, 1999.

McGrath, R., “A Real Options Logic for Initiating Technology Positioning Investments,” Academy of Management Review, 22 (4), 1997, pp. 974-996.

Nalin Kulatilaka, Enrico C. Perotti, Strategic Growth Options, Management Science, v.44 n.8, p.1021-1031, August 1998

Panayi, S. and L. Trigeorgis, “Multi-stage Real Options: The Cases of Information Technology Infrastructure and International Bank Expansion,” The Quarterly Review of Economics and Finance, 38, 1998, pp. 675-692.

Raghunathan, M. & Madey, G.R. (1999). A firm level framework for planning electronic commerce information system infrastructure. International Journal of Electronic Commerce, 4(1), 121-145.

Schwartz, E.S. and C. Zozaya-Gorostiza, “Valuation of Information Technology Investments as Real Options,” 6-00 Finance Working Paper, University of California, Los Angeles, 2000.

Taudes, A., “Software Growth Options,” Journal of Management Information Systems, 15 (1), 1998, pp. 165-185.

Taudes, A., M. Feurstein and A. Mild, “Options Analysis of Software Platform Decisions: A Case Study,” Management Information Systems Quarterly, 24 (2), 2000, pp. 227-243.

Elizabeth Olmsted Teisberg, An option valuation analysis of investment choices by a regulated firm, Management Science, v.40 n.4, p.535-548, April 1994

Zhu, K., “Evaluating Information Technology Investment: Cash Flows or Growth Options,” Paper presented to Workshop on Information Systems Economics, 1999.

Links from this theory to other theories
Options pricing theory, Arbitrage pricing theory

Original Contributor(s)
Mike Wade Please feel free to make modifications to this site. In order to do so, you must register. Return to Theories Used in IS Research