Decision Support for IT Investment Projects - A Real Option Analysis Approach Based on Relaxed Assumptions

Managerial flexibilities have to be taken into account in ex-ante decision-making on IT investment projects (ITIPs). In many papers of the IS literature, standard financial option pricing models are used to value such managerial flexibilities. Based on a review of the related literature, the paper critically discusses the assumptions of the most frequently used financial option pricing model, namely the Black–Scholes model, arguing for relaxed assumptions that better represent the characteristics of ITIPs. The authors find that existing real option analysis approaches featured in the IS, Finance, and Economics literature are unable to consider more than two of our relaxed assumptions. Consequently, they present their own approach in form of a simulation model for the valuation of real options in ITIPs which offers a better representation of the characteristics of ITIPs by taking the discounted cash-flows and the runtime to be uncertain as well as the market to be incomplete. Based on these modifications of the Black–Scholes model’s assumptions, it is found that the resulting option value contains idiosyncratic risk that has to be taken into account in ITIP decision making. For the realistic case of risk averse decision makers, the consideration of idiosyncratic risk usually leads to a lower risk-adjusted option value, compared to one calculated by means of the Black–Scholes model. This confirms the perception of managers who feel that financial option pricing models frequently overvalue ITIPs and hence may induce flawed investment decisions

Taxation under Uncertainty – Problems of Dynamic Programming and Contingent Claims Analysis in Real Option Theory

This article deals with the integration of taxes into real option-based investment models under risk neutrality and risk averison. It compares the possible approaches dynamic programming and contingent claims analysis to analyze their effects on the optimal investment rules before and after taxes. It can be shown that despite their different assumptions, dynamic programming and contingent claims analysis yield identical investment thresholds under risk neutrality. In contrast, under risk aversion, there are severe problems in determining an adequate risk-adjusted discount rate. The application of contingent claims analysis is restricted to cases with a dividend rate unaffected by risk. Therefore, only dynamic programming permits an explicit investment threshold without taxation. After taxes, both approaches fail to reach general solutions. Nevertheless, using a sufficient condition, it is possible to derive neutral tax systems under risk aversion as is demonstrated by using dynamic programming.

Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development

We examine the extent to which uncertainty delays investment and the effect of competition on this relationship using a sample of 1,214 condominium developments in Vancouver, Canada built from 1979-1998. We find that increases in both idiosyncratic and systematic risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the return volatility reduces the probability of investment by 13 percent, equivalent to a 9 percent decline in real prices. Increases in the number of potential competitors located near a project negate the negative relationship between idiosyncratic risk and development. These results support models in which competition erodes option values and provide clear evidence for the real options framework over alternatives such as simple risk aversion.

An analysis of spending behaviour under liquidity constraints with an application to financial hedging

Imperial Users onl

A Theory of the Reform of Bureaucratic Institutions

By bureaucratic institutions or bureaucracy, we mean the rules and regulations that are implemented by government agencies. Burdensome bureaucratic institutions are leading obstacles to economic development and therefore the target of economic reform of many countries in today's world. In this paper, we provide a theoretical framework to analyze the reform of bureaucratic institutions. The analysis shows the key to the reform is to properly incentivize the incumbent generation of bureaucrats, whose cooperation is needed to reform the bureaucracy. However, a simple buy out strategy of reform may not always work. Under certain conditions, a delegation strategy that grants incumbent bureaucrats the decision rights to initiate and to reap the benefit of reform can be successful.

A review of subsidy and carbon price approaches to greenhouse gas emission reduction

The Climate Institute requested SKM MMA and Centre of Policy Studies (CoPS) to undertake an assessment of alternative policy options to achieve a given carbon emission target in Australia. The focus of the study was to compare outcomes under a suite of subsidy based policies to the outcomes under an emission trading scheme. The outcomes of the study are presented in this report.There are several market based approaches that could be used to achieve a carbon emission target. Which approach is more or less effective in achieving the target will depend on any restriction placed on the measure, the ability of each approach to manage the uncertainties on the cost and future scale of abating carbon emissions, the long term behavioural signals provided and the relative impacts on the broader economy.In principle, a subsidy scheme, such as the proposed Emission Reduction Fund (ERF), could achieve the same level of abatement at a similar cost to an emission trading scheme provided the sectoral coverage was the same and the eligible abatement options were the same. Any difference in effectiveness and cost may be due to other factors such as a limit on the budget available to be spent through the subsidy scheme and differences in sectoral coverage. Whether projects receiving funding under the subsidy scheme will proceed or go under either before they are built or after a few years of operation, as has happened under other subsidy scheme, is also important to the effectiveness of the scheme.SKM MMA used a marginal abatement cost approach to assess the options chosen under the subsidy fund. The approach was used to assess a range of emissions abatement opportunities in a range of sectors covering energy, transport, agriculture and land use change, industrial processes, fugitive emissions, and waste. The approach involved the assessment of the cost and potential emission abatement of the eligible options. The assumption was that the lowest cost combination of options is selected under the fund to meet the abatement cap up to any budget or other declared constraints. Only options that are additional (i.e. would not have proceeded in absence of the fund or carbon abatement incentive) were considered.The estimated level of abatement by options and their cost are input into CoPS’s Monash Multi Regional Forecasting Model (MMRF)to determine broader economic impacts.This report outlines the assumptions and method used and discusses the result of the modelling. Limitations and uncertainties in the approach are also outlined. The focus of the analysis was on potential impacts – there is no discussion on which approach is more efficient

Towards a Well-Founded Valuation of Managerial Fleibilities in IT Investment Projects - A Multidisciplinary Literature Review

In the IS literature standard financial option pricing models are predominantly used to value real options embedded in uncertain IT projects. Based on a multidisciplinary literature review, we discuss the assumptions implicit in the prevalent Black-Scholes model and argue for relaxed assumptions that better represent characteristics of uncertain IT projects. This is followed by a discussion of real option approaches from the fields of IS, Finance, and Economics in respect of their compliance with these relaxed assumptions. Findings are: (I) by relaxing the assumptions, the option value and project selection decisions are liable to change; (II) several approaches from Finance and Economics literature better comply with our relaxed assumptions compared to existing approaches in IS literature; (III) no existing real option approach complies with all relaxed assumptions. Adapting and enhancing approaches of other disciplines could be a push towards a well-founded valuation of real options embedded in IT projects