Beyond Valuation:

OPTIONS THINKING IN
IT PROJECT MANAGEMENT

Robert G. Fichman
Mark Keil
Amrit Tiwana

ncertainty is a fact of life for most large IT capital investments.

From enterprise applications to infrastructure technologies to ITenabled strategic initiatives of every flavor, a common element is
doubt about the project will achieve its goals. This uncertainty
arises from many sourcesthe immaturity, complexity, and unpredictable evolution of the technologies themselves; the increasing integration of technologies
within and across organizations; and the increasing emphasis on using IT to support customer-facing processes and innovative products with hard-to-predict
market appeal.
Given the potential for major losses on IT projects, the defensive posture
exhibited by many organizations towards these efforts should come as no surprise. One manifestation of this posture is simply downplaying the level of risk.
Although major IT initiatives produce disappointing results 50% of the time or
more,1 this uncomfortable fact rarely makes it into the planning processes of
many organizations. Another manifestation of a defensive posture is penalizing
projects that have large risks but also large potential rewards by employing an
excessively high hurdle rate. A third manifestation is applying a veneer of predictability to IT investments by demanding rigidity in project planning and execution. A final manifestation is the tendency to treat setbacks on IT projects as
arising first from the inadequacies of the project team, rather than being inherent in the process of undertaking uncertain ventures.
Ironically, these defensive maneuvers are just as likely to increase an
organizations exposure to unnecessary risk as to reduce it: downplaying uncertainty discourages vigilance to potential problems; rigid project plans invite
corner-cutting; and a blame-the-team-first mentality deters forthright communication about project status. A better approach is to assume a proactive stance
that fully acknowledges and seeks to manage uncertainty on these projects.

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Beyond Valuation: Options Thinking in IT Project Management

Options thinking, an emerging investment management philosophy based on

the theory of real options, provides an especially promising foundation for this
sort of proactive stance.
A real option refers to the right to acquire some real world asset without
the obligation to exercise that right. Whenever an IT project has flexibility about
which applications and functions to implement, and when or how to implement
them, real options are present. These options can be quite valuable, and much of
the academic literature on this topic has focused on developing appropriate tools
to assist in quantifying option value. Managers, however, do not need to acquire
arcane option quantification skills to put options thinking to work. The bigger
win comes from using real options concepts to actively create and extract the
value of embedded options that can otherwise be difficult to see.
In this article we describe how practitioners can incorporate options
thinking into contemporary IT project evaluation and management.2 This
requires that managers to learn to recognize what kinds of options can be
embedded in IT investments; to develop a sound intuition about how options
create value; and to understand how to manage projects so that option value
that exists in theory is actually realized in practice. It is a certain philosophy of
project managementmore so than precise quantificationthat is the essence
of options thinking.

How Flexibility Creates Option Value

on Uncertain IT Investments
No other technology supports managerial flexibility quite like IT. One
aspect of this flexibility is that modern IT systems are themselves highly malleable. While many kinds of assets (traditional equipment, manufacturing plants,
real estate) have a relatively fixed set of potential uses, most forms of IT can be
applied to a variety of business processes or products. Further increasing the
flexibility of many IT assetsat least those
embedded in softwareis they can be
Robert G. Fichman is an Associate Professor in
replicated at low cost, modified if necessary, the Boston College Wallace E. Carroll School of
Management. <fichman@bc.edu>
and then shared or sold. The level of flexiMark Keil is the Board of Advisors Professor of
bility associated with any given IT system
Computer Information Systems (CIS) in the J.
is not pre-ordained. Organizations can
Mack Robinson College of Business at Georgia
enhance flexibility by making systems
State University. <mkeil@gsu.edu>
more generic, multi-purpose, interoperable, Amrit Tiwana is an Assistant Professor in Emory
and scalable.
Universitys Goizueta Business School in Atlanta.
<atiwana@bus.emory.edu>
A second dimension of flexibility on
IT investments concerns the processes by
which IT systems are delivered. IT is particularly well suited to the use of simulations, prototypes, pilots, and various forms of staged implementationall
of which generate a wide variety of opportunities for incremental project
commitment.3

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The two pillars of IT project uncertainty and managerial flexibility make

real options especially pervasive on IT investment projects. What exactly are real
options, and why does uncertainty together with flexibility enhance their value?
Real options are similar to financial-trading options such as calls and puts, and
they can be valued similarly using options pricing models (OPMs), such as the
Black-Scholes and the Binomial. OPMs were originally developed to assist in the
valuation of tangible assets,4 but have increasingly been applied to more intangible sorts of investments, such as those related to R&D and information
technology.5
Just as a call (or put) option confers the right but not the obligation to
buy (or sell) a given stock at some future date, a real option provides the right
but not the obligation to acquire or dispose of some real world asset in the
future. In both cases, the value of the option comes from the flexibility to decide
whether to exercise the option depending on future conditions. Option holders
can participate in the upside of the investment, but limit their losses to the cost
of acquiring the option. Since uncertainty about benefits increases the range of
the potential upside outcomes but not the downside (which is capped at zero),
greater uncertainty increases the value of flexibility and thus the value of the
option.
Although most managers can understand why increased uncertainty
expands the value of a stock option, the same principle applied to IT investments
with embedded options strikes many as counterintuitive, so we offer the following concrete illustration. Suppose a firm is faced with a large project to implement radio frequency ID (RFID) tagging across its supply chain. The firm
chooses to begin with a smaller pilot initiative and expects to proceed with full
investment only if the pilot goes favorably. The cost of the pilot is akin to the
cost of purchasing a call option on the full projectan option that will only be
exercised if information gained during the pilot indicates that the payoff for the
larger project will likely be positive. These sorts of options can change a project
that has a negative expected payoff according to conventional tools (i.e., NPV);
to one that has a significant positive value. Figure 1 illustrates the difference
in the payoffs for a hypothetical $10 million RFID investment project with
no embedded options (e.g., proceeding immediately with full implementation)
versus one with an embedded call (e.g., starting with a pilot project that reveals
payoffs ). Traditional tools do not take into account this sort of managerial flexibility, but rather assume equal exposure to both potential losses and gains (as
shown in Figure 1a).
Because options acknowledge managerial flexibility to act in ways that
avoid potential losses while preserving potential gains, a project with an embedded option is more valuable than one without (as illustrated in Figure 1b). The
extent of this extra value depends on the degree of uncertainty and corresponding variability in potential future gains or losses and on how long the option can
be held.6
Uncertainty can arise from inherent risks endemic in particular IT projects
(technical uncertainty) and from an unknown future (market uncertainty). The

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FIGURE 1A. Estimated Value with No Option

Probability

.09

.18

.20

The proposed project costs $10m to implement,

and has potential payoffs ranging from $0 to 20m,
resulting in the probability distribution of net payoffs
below. A discrete approximation of the expected
NPV is calculated by multiplying the probability of
the true payoff falling within one of the 10 probability
bars, times the average payoff for the bar, i.e.,
.02*(9) + .09*(7) .04*(+9)= $1.1m
.17

.02

.10

$9m 7m 5m 3m 1m

.08

.07

.05

.04

+1m +3m +5m +7m +$9m

Expected NPV = $1.1m

FIGURE 1B. Estimated Value with an Embedded Call

Probability

The system is structured as a follow-on project to

be completed later (e.g., after a pilot project). If it is
assumed managers will know the true payoff at this
later time, then the negative net payoff region will be
avoided.This leads to a revised estimated payoff of
.10*(1) + .08(3)+ .04(9) = $1.4 m.This is only an
approximation of the value that would be estimated
by a formal OPM.

.10

.08

.07

.05

.04

+1m +3m +5m +7m +$9m

Approximate Option Value = $1.4

Note:The two figures above are reprinted by permission, Fichman, R.G.,Real Options and IT Platform Adoption: Implications for
Theory and Practice, Information Systems Research, 15/2 (2004): 132-154. Copyright 2004, the Institute for Operations
Reseazrch and the Management Sciences, 7240 Parkway Drive, Suite 310, Hanover, MD 21076 USA.

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main requirement is that some of the uncertainty be resolvable. The mechanisms

for resolving uncertainty will differ for technical versus market uncertainty.
The former usually requires that managers do something to resolve the uncertainty, while the latter can often be resolved by simply waiting (and, of course,
staying alert to the market).
There is, of course, no free lunch in the world of traded financial options,
because the purchase price of an option at any moment reflects the markets
current best estimate of what the option is actually worth. However, in the case
of real options, there isnt necessarily a strong correlation between what an
option costs to acquire and what the option is actually worth, so quite valuable
IT options can often be created relatively inexpensively. Thus, managers that
employ options thinking stand to gain a considerable advantage, especially in
fast-moving, unpredictable environments where real options tend to be most
valuable and plentiful.

From Option Valuation to Options Thinking

Real options concepts not only allow an organization to more accurately
assess uncertain IT investments, but perhaps more importantly, can guide managers in how to actively create and extract value. This is the heart of options
thinking. The key to understanding how options create actual value lies in the
distinction between what an organization must do on a project, versus what it
may do. For those things an organization must do, there is (by definition) no flexibility, and so traditional analytic tools (such as NPV and ROI) that place no economic value on flexibility are appropriate. However, for those things a firm may
do, value is created by actively structuring those elements as an option.
This suggests managers can enhance value creation with two general
strategies:
shifting project elements that are part of the baseline implementation
from must do to may do status; and
performing a systematic search for opportunities beyond the baseline
implementation that represent additional may do elements.
In options terms, the first sort are referred to as operating options, in that they
relate to the operational aspects of a project. The latter sort are referred to as
growth options, in that they refer to the opportunity to grow the projects scope
through follow-on investments beyond what was initially anticipated. Figure 2
illustrates the difference between a traditional project and one driven by options
thinking.
Effective options thinking requires that managers do three things well:
recognize and enhance opportunities to create options with IT; value these options
(in some way); and manage projects to fully extract this value.

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FIGURE 2. Traditional Project Management vs. Options Thinking

Six Examples of Real Options in Practice

Embedded IT options can take many forms, including the options to: stage
investment, abandon investment, defer initiation of investment, create growth
opportunities based on an initial investment, change the scale of investment, and
switch assets created by the investment to another use (see Table 1).7

Example 1: The Options to Stage and to Abandon

Carlson Hospitality
In practice, most large IT projects are divided into stages for the purpose
of resource planning and setting milestones for project tracking. However, the
mere existence of stages in a project does not by itself create embedded stage
options. To create value using stage options requires an active management
approach where execution of each stage is made contingent on a reassessment
of the costs and benefits of completing that stage at the time the stage is reached.
In addition, business requirements or opportunities often change in ways that
increase or decrease the importance of what a given stage delivers, and so the
team will be better able to recognize and avoid investing in stages that no longer
have a worthwhile payoff. In summary, stage options create value by providing
the opportunity to alter or terminate a project before each new stage of funding,
based on updated information about costs and benefits.
In practice, stage options often overlap with other options, such as abandon, change scale, and strategic growth. In cases where completion of each stage
does not produce a useable system, but is merely a necessary condition to proceed to the next stage, this is a form of the abandon option (stage-abandon).8
Stage-abandon options can be created by developing throw away prototypes

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TABLE 1. Six Types of Real Options

Option

Definition

How Value is Created

Pitfalls

Stage

A project can be divided into

distinct stages where pursuit
of each stage is contingent
on a reassessment of costs
and benefits at the time the
preceding stage is completed.

As each stage is completed

the ambiguities about the
net payoffs from subsequent
stages are resolved; only
stages with positive payoffs
are pursued.

Managers may prefer allat-once funding to obtain

maximum control over a
projects fate or to generate
full a priori commitment to
the project.

Abandon

A project can be terminated

midstream and remaining
project resources relatively
easily redeployed.

As a project unfolds actual

costs and benefits become
more clear, and losses can be
curtailed by terminating the
project.

Projects tend to take on a life

of their own and are difficult
to terminate.
Abandoning projects can
carry intangible costs related
to credibility and morale.
Resources cant always be
productively redeployed.

Defer

A decision on whether to
invest can be deferred for
some period without
imperiling the potential
benefits.

The firm avoids investing

in what is destined to be
a losing proposition.

Strategic
Growth

An initial baseline investment

opens the door to pursue a
variety of potential follow-on
opportunities.

Over time, the relative value

of follow-on investments
becomes more apparent and
only investments with positive
pay offs are pursued.

Growth options can be

difficult to value due to
higher ambiguity and the
longer time frames often
involved.

Change
Scale

Resources allocated to a
project can be contracted or
expanded, or the operational
system enabled by a project
can be scaled up or down
more easily.

The organization can increase

the scale of a project/system
(and thus the range of potential benefits) if circumstances
are favorable; or can reduce
the scale (and thus potential
losses) if circumstances are
unfavorable.

Building in the option to scale

up or down can add to
project costs.

An IT asset developed
for one purpose can be
redeployed to serve another
purpose (switch use).

Over time, the relative value

of alternative uses becomes
more apparent and only uses
with positive payoffs are
pursued.

If licensed technologies are

involved there may be legal
restrictions on the ability to
switch use.

Switch

A key foundation technology

supporting a project can be
swapped out for another
(switch inputs).

80

Chances are increased of

making the right choice on
a crucial project decision.

If a chosen foundation
technology proves less robust
than a rival technology, the
organization can switch to
the rival technology.

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Strategic benefits often erode

with time.
Direct experience with a
technology is often required
to resolve uncertainty.

As with the abandon option,

scaling down a project can
carry intangible costs related
to credibility and morale.

Creating this option usually

involves making the system
more generic, typically at
added expense.

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or following the traditional waterfall SDLC (i.e., analysis, design, construction,

implementation) but with a formal go/no-go decision for each phase, such as in
the spiral model of development.9 Conversely, when early stages produce a useable, but smaller-scale system that can subsequently be scaled up, or to which
additional functions can be added, the overlap is with the option to change scale
(stage-scale) and growth options (stage-growth). The latter sort of staging
options are naturally preferable, as they produce a useable asset at the end of
each stage.
Carlson Hospitality Worldwides recent implementation of a new Customer Reservation System (CRS)10 illustrates how a project can be reconceptualized to create embedded stage-growth and stage-abandon options. The project was
initially pitched as a $15 million all-at-once investment. When that proposal was
soundly rejected, the IS team reconceptualized the project as a set of nine separately implementable chunks, each of which had to produce a direct business
benefit. Though no formal OPM was used, it was clear that management understood how staging can create value through increased flexibility: [the IS team]
managed to get funding for the first chunk, and soon they started rolling out the
new CRSalong the way, they would insert one chunk and ditch another as
needed to get the biggest payback, while staying open to suggestions. Furthermore, IT managers structured each stage to be implemented gradually, so that at
any point the roll-out of a given stage could be reversed, thus creating additional
stage-abandon options.
This example illustrates a key tactic for increasing the value produced by
embedded stage options, which is to ensure that each stage actually produces an
identifiable benefit beyond simply enabling subsequent stages. Otherwise it is
difficult to develop an estimate of net benefits of performing that stage in isolation. This suggests that a project be divided into incremental units of functionality, each of which can be implemented separately even if no further increments
are implemented.11 A second useful tactic is to schedule stages with the most
uncertainty as late as possible in the overall project lifecycle, since the value of
an option increases the longer the option can be held. This tactic will be even
more valuable if project managers segregate functions with the most uncertainty
from functions with the least uncertainty. This can be done by combining the
most uncertain functions together into the same stages or, even better, by isolating uncertain functions into their own stages.

Potential Pitfalls of Stage-Growth and Stage-Abandon Options

Not all projects can be divided up to create embedded stage options.
Sometimes a firm must make a binding commitment to a project as a whole,
such as when external funds must be raised or when co-investment from other
parties is required. The payoffs from investment may depend on whether a
self-reinforcing adoption process reaches critical mass, meaning that a potential
investor must, in essence, play to win or not play at all.12 In such all-or-nothing
investment situations, valuable options may still exist in the form of the option
to defer.

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Even when a project could be staged in principle, managers may find it

hard to craft stages that conform to the above criteria. Another pitfall is that
stakeholders may prefer all-at-once funding to obtain maximum control over
a projects fate and to have more time to get a troubled project back on track
before facing the next round of justification. In practice, it can be difficult to
distinguish the ordinary setbacks that occur on most implementations13 from
those that indicate embedded options should not be exercisedthus raising the
possibility of premature cancellation of valuable may do project elements. A
final pitfall of stage-growth options is they may require temporary interfaces and
reworking previously implemented functions. Some organizations may resist the
idea of incurring these certain expenses to enable uncertain benefits later.
The main pitfall associated with abandonment, a second kind of option
on the Carlson CRS project, is that many projects take on a life of their own and
can be difficult to terminate, as illustrated in the large literature on escalation of
commitment.14 In fact, some observers see this as perhaps the central challenge
associated with options thinking.15 People involved in a project can become personally vested in seeing the project succeed, thus terminating projects can carry
intangible costs related to morale. Also, those involved may suffer a loss of credibility, owing to ambiguity about whether project failure was due to project team
deficiencies or factors beyond their control.

Example 2: The Option to Defer InvestmentYankee 24

An option to defer exists when a decision on whether or how to invest
can be delayed for some period without imperiling the potential benefits. When
uncertainty is high but can be resolved over time, deferral options can be surprisingly valuable. A good example of an embedded deferral option was Yankee
24s implementation of a network infrastructure to support point of sale (POS)
debit cards for New England merchants.16
Yankee first began considering the POS network investment in 1987
when considerable uncertainty existed in four key areas:
How fast would retailers adopt POS debit cards as a payment option?
Would Massachusetts, which represented 50% of the New England market, revise banking regulations that currently discouraged POS debit
adoption among smaller businesses?
Would consumers in New England take up POS debit cards at the same
rate as other markets?
Would a competing network signal an intent to enter the POS debit
arena?
Yankee understood, correctly, that by simply waiting, much of the uncertainty
about payoffs could be resolved. For example, they could observe debit card
adoption rates in other more mature markets and lobby the Massachusetts government for favorable legislation. Meanwhile, the upside opportunity was not in
serious peril for at least three years, because this was how long Yankee thought
the most likely competitor would need to establish the necessary infrastructure.

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Yankee, by contrast, could move much more quickly because it had most of the
necessary infrastructure already in place.
A retrospective options-based analysis of the Yankee case by two IT
researchers determined that the optimal time for Yankee to defer investment
was three years. This three-year deferral option was estimated (using the Black
Scholes OPM) to be worth approximately $150,000. This compares with an estimated NPV for initiating the project immediately in 1987 of minus $80,000.
Interestingly, Yankee did, in fact, defer entry for three years, which gives an
example of managing an investment in ways that were consistent with options
thinking without adopting a formal OPM.

Possible Pitfalls of Deferral Options

There are two main pitfalls associated with this option. The first is the
potential for erosion of project benefits with time. This may occur when first
mover advantages exist and there is a danger of preemption by another firm or
when it can be expected that other firms will quickly follow. In fact, the possibility of value eroding with time runs counter to the standard OPM assumption
that longer deferral periods increase the value of options. The second pitfall
stems from the fact that a firm must often gain direct experience with an innovative technology in order to be in a position to resolve uncertainty about its
potential uses and benefits. Organizations that make a habit of deferring investments may therefore suffer a general loss of innovative capabilities and may lose
the ability to appreciate new technologies, and thus they may find themselves
locked out of not only the current opportunity, but future opportunities as
well.17

Example 3: Options that Provide Growth Opportunities

A European Automaker
An embedded growth option exists when an initial baseline investment
opens the opportunity to pursue a variety of potential add-on projects. Unlike
the other options described so far, which produce value mainly by limiting the
extent of potential losses, growth options add value by increasing potential
gains.
A case study of an ERP implementation project by a European auto
maker provides a well-developed example of how to value IT growth options
in practice.18 The base project, which involved upgrading from SAPs R/2 system
to R/3, was expected to cost $1.85 million and to produce about $1.45 million
in operational savings, leading to a negative NPV of about $400,000. The base
implementation by itself was not cost justified, but managers realized that the
greater robustness and flexibility of the R/3 system would enable several potential follow-on projects that would otherwise have been infeasible, including
introduction of EDI-based purchasing and invoicing, workflow applications for
sales, engineering document handling, and web-based e-commerce. The NPV of
these additional applications was estimated to be $150,000still not enough.

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Thus, had the project team simply expanded the bounds of the initial must
do project to include these elements, the project would have remained unjustified, with a negative NPV of $250,000. However, the project team recognized
that the add-on projects should be treated as may do elements that would only
be pursued in favorable circumstances, and to value them accordingly using an
OPM. The resulting Black-Scholes estimate for the add-on projects was $650,000
enough to make the overall project worth undertakingand based on this
expanded estimate of value managers did proceed with the implementation.
In this case, the value of having the flexibility to say no to one or all of
the add-on projects if the base implementation went poorly or other unfavorable
events transpired (e.g., an adverse change in business environment) was over
$500,000. (To put this amount in perspective, the add-on projects were expected
to cost $2.2 million to implement and maintain.)
IT platform implementations, by their very nature, will tend to have
a variety of embedded growth opportunities. Managers will gain the most by
attempting to identify and value these opportunities as embedded options when:
the base project has an unclear payoff taken alone; the NPV of the add-on projects is not enough to give the project an overall positive payoff; and there is
much uncertainty regarding the net payoffs of the add-on projects.

Potential Pitfalls of Growth Options

Growth options are most likely to be present on more-innovative projects
and on those that implement a platform for future applications.19 The main challenge here is the difficulty of estimating option values (due to ambiguity about
potential future cash flows) and uncertainty about the appropriate value for
option model parameters. These challenges are compounded to the extent that
longer time horizons are involved, as is often the case with growth options.

Example 4: The Option to Change Scale

Cypress Communications Authority
An embedded option to change scale exists when the resources allocated
to a project can be contracted or expanded in response to future conditions, or
when the production system enabled by a project can be scaled up or down with
comparative ease. If unexpected technical barriers are encounteredor a change
in business conditions reduces the value of the intended systema project with
an embedded scale-down option can be reduced in scope, and some project
resources can be reassigned. Thus the scale-down option may be viewed as a
milder form of an abandon option. Conversely, a project structured to increase
the scope of the resulting system in the event of favorable future conditions has
a scale-up option that is similar to a growth option.
An initiative by the Cypress Communications Authority (CYTA) to enable
a major network expansion provides a case of an IT investment that created a
valuable scale-up option.20 In 1992, CYTA anticipated that Cypresss eventual
entry into the European Union would warrant a significant expansion of its
telecommunication network. Yet, they determined that this expansion would

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only be feasible if a complementary investment was made in upgrading the

information system used to support the daily operations of the authority. The
upgrade would produce some immediate benefits (e.g., improved network utilization, productivity improvement, and overtime reduction) even if the future
network expansion was not pursued, but the expected value of these immediate
benefits was negative 1.7 million. However, the value of the option to expand
the telecommunication network in the future, should conditions warrant, was
estimated to be 2.55 million, resulting in an overall valuation for the IS development of 0.85 million, enough to justify proceeding with the project.

Possible Pitfalls of Scale Options

The pitfalls associated with scale options depend on whether the option
is to scale up or down. The option to scale up can add to project costs, and some
organizations may resist adding such costs in return for an uncertain future payoff. Conversely, in the case of scale-down options, there may be resistance
albeit less severeto exercising the option in practice similar to that for the
abandon option.

Example 5: The Option to Switch UseTWA

An embedded option to switch use exists when an IT asset developed for
one purpose can be redeployed to serve another purpose. Software is more malleable than physical assets and has a very low cost of reproduction. This means
that software applications can be more easily repurposed without necessarily
having to discontinue use of the system from its original application.
Trans World Airlines (TWA) development of a computer-aided software
engineering (CASE) template for their Frequent Flyer Benefits (FFB) shows
how to create a switch-use option.21 A CASE template is a detailed design model
that automatically generates part or all the program code required to implement
the target system.
The FFB system was originally developed for TWAs own use, however,
the CASE template facilitated subsequent sale of the system to Canadian Air.
While any software system can, in principle, be sold to another firm, the likelihood of another firm being interested and what they will payand thus the
value of the embedded switch-use optiondepends on how easy the system is
to understand and modify. In this case, the use of a template allowed Canadian
Air to produce a customized system in eight months, as compared to the 18
months needed for a from-scratch development. The rapid modifications were
possible because of: the explicit depiction of business rules in the CASE template
(rather than having this buried in program code); the ease of generating operational prototypes, and the ease of modifying a design model and regenerating
program code compared to modifying the program code itself.

Potential Pitfalls of Switch-Use Options

The main potential pitfall of this option is that it can add extra time and
expense to the initial development project. Some researchers have estimated

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that making program modules generically reusablewhich may be seen as the

ultimate in creating switch-use optionscan cost several times as much as creating single-use modules.22 In some cases, the cost of creating a switch-use option
could exceed the value it produces.

Example 6: Stage, Growth, and Switch-Use Options

Starbucks Coffee Company
Starbucks recent introduction of their pre-paid card was a project that
had embedded stage, growth, and switch-use options.23 Though a formal options
valuation methodology wasnt used, the approach to managing the project provides an excellent example of options thinking in practice.
The original intent for the Starbucks card was simply to speed checkout
in a business where cash transactions dominate. Managers were unsure about
demand for such a card, and so they consciously chose a bare-bones approach
to the initial implementation rather than a more ambitious rollout. The card
used a simple, stand-alone magnetic stripe design, which meant the only infrastructure upgrade needed was some reprogramming of cash registers to read the
cards. Later, after demand for the card was clear, Starbucks went the additional
step of providing online registration of the cards, which allowed users to replace
lost cards, reload cards with more money, and view transaction histories. This
second stage could easily have been anticipated and included from the start.
However, by segregating this functionality into a separate stage, managers created an embedded stage option. If the card had flopped, the expense of this extra
functionality would have been avoided.
After the second stage was completed Starbucks managers realized that
the card could do much more than simply speed check out, so a third stage, the
card was enhanced to support loyalty points redeemable at Starbucks based on
purchase volume, entry in occasional sweepstakes, and e-mail notification of instore promotions and new products. Since this add-on project created a new
asset (e.g., a loyalty program) rather than changing the value of an existing asset
(as with online registration for the initial pre-paid card), it represented a growth
option rather than a scale-up option.
Most recently, Starbucks has taken a fourth step that illustrates an
embedded switch-use option similar to the TWA FFB case. They have collaborated with Visa USA and Bank One to introduce a co-branded card that combines the functionality of the enhanced Starbucks prepaid/loyalty card with
standard Visa credit card functionality. Since all of the prior functionality of
the pre-paid card (programming of cash registers, online registration) could be
reused to support the new dual use card, this can be seen as a switch-use option.
It is worth emphasizing that there is no evidence that Starbucks managers
had planned from the start to consider all of these potential enhancements or to
place a value on them using an OPM; rather, their intent was simply to keep
their options open by using an incremental commitment approach. However,
this sort of alert incrementalism is a central principle of options thinking. As it
happened, Starbucks managers were confident that at least the initial step was

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worth pursuing and so putting a value on options was not necessary. However,
if things had been different, then estimating the option value of potential
enhancements could have been crucial in justifying the initial project, as was
the case in the ERP and network expansion examples described earlier. Thus,
it is important that managers interested in real options be acquainted with
approaches to estimating option value.

Valuing Real Options

As prior examples show, the quantified value of a real option is not
always intuitively obvious and can change a decision on a worthwhile project
from a no-go to a go. Also, estimating option value can help with more tactical
decisions, for example, whether to incorporate flexibility to support either of
two standards that are currently battling it out in the market place, rather than
placing a bet on only one standard.
The most commonly used tools for valuing real options are the BlackScholes and the Binomial OPMs. The Binomial model24 has less stringent
assumptions than the Black-Scholes and is likely to receive increasing attention
from options researchers. Copeland and Tufano note that[the Binomial model]
captures the contingencies of real options and addresses nearly all of the more
commonly voiced criticisms of using option theory to manage those contingencies.25 In addition, some newer OPM variants have been developed that are
even more flexible than the Binomial model.26
The use of OPMs on IT investments is subject to several challenges, starting with concerns about transparency.27 However, counterarguments and
remedies exist (see Sidebar 1: Options Valuation Challenges) that make the
use of OPMs, while not perfect, still generally superior to traditional NPV
approaches, which place no quantified value on flexibility at all.28 Nevertheless,
adopting formal OPMs today will require that senior management be open to
considering leading-edge valuation techniques; and, even then, a considerable
education effort will be required. However, these hurdles should be lowered as
more managers get exposed to the use of OPMs in business schools and at leading firms such as Merck, Hewlett-Packard, and Intel.29

Alternatives to Formal OPMs

If it is expected that senior managers will (for whatever reason) resist
the use of formal OPMs, then decision trees or even qualitative option-valuation
approaches provide viable alternatives. Decision trees, unlike OPMs, are highly
transparent. In the ERP example above, the framing of proposed investments in
the form of a decision tree is what ultimately convinced management, rather
than the OPM estimates per se. The main limitations of decision trees are: first,
that the complexity of a tree can increase rapidly as more alternative scenarios
are incorporated; and second, that there is no straightforward way to determine
what the correct risk adjusted discount rate for the whole tree should be.30 Yet,

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SIDEBAR 1. Real Options Valuation Challenges

Challenge

Counter Argument/Remedy

Absence of a traded market for IT

assets makes it difficult to estimate the
expected value of a project (one key
option model parameter).

Managers must estimate the future expected cash

flows of a project even under the NPV approach,
and options valuation is no more sensitive than
NPV valuation to mis-estimates of project cash
flows.

Absence of a traded market for IT

assets makes it difficult to estimate the
volatility (uncertainty) of the value of a
project (another key option model
parameter) and may raise concerns
that analysts might fudge this
parameter.

Analysts can identify traded securities that are perceived to have a similar risk profile and use the beta
values for these securities to estimate volatility of
project value.
Analysts can do a sensitivity analysis to determine
whether a project is justified under different sets of
assumed levels of volatility.
Analysts can use conservative values for uncertainty
until they have gained more experience.

Absence of a fixed time by which

options must be exercised makes it less
likely that projects will be appropriately
terminated.

Escalation of commitment is a common problem

even on projects not conceived as options; in fact,
options, by explicitly recognizing things might not
go as planned, can support a more disciplined
approach to the problem of terminating troubled
projects.
Managers can adopt new project management
guidelines (such as explicit exit points) that counter
the natural resistance to project termination.

Lack of transparency associated with

OPMs, especially the Black-Scholes.

When transparency is important, analysts can use

the binomial OPM or even more transparent
approaches, such as a decision trees.

The value of an IT initiative may erode

with time due to loss of potential for
competitive advantage, but options
formulas place a higher value on longer
times to expiry.

When erosion of competitive advantage is an issue,

analysts can estimate the expected value of a project separately for multiple candidate expiration
dates.

decision trees come closer to correctly valuing a project than conventional

approaches that place the value of flexibility at exactly zero.
Managers can gain considerable benefit from using structured but qualitative approaches that help them to think about option value more intuitively.31

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However, if managers are to rely on intuition, they must be on guard against

systematic biases. In a separate research study, we found some interesting indications of bias in how managers viewed different kinds of options (see Sidebar 2:
Is Options Thinking Real?).
The following attributes increase the importance of using real options
concepts when estimating a projects value:
Embedded options clearly exist due to high uncertainty in combination
with flexibility in the systems delivery process and/or in the delivered
system itself.
The project is going to be evaluated quantitatively by the numbers.
Given that managers are going through the effort of estimating cash
flows, the incremental effort of employing OPMs is, surprisingly, not that
great.
Traditional quantitative analysis produces a result that leaves the value of
the project with a negative NPVbut not so negative that the potential
value of options is overshadowed. It is when options value might well
change the decision on whether to proceed with a project that using an
OPM will be most important.

Managing Real Options

While putting a number on the option value of projects is not a mandatory part of options thinking, it is essential that projects at least be managed in
such a way that the potential value that has been created by building in options
actually gets extracted. To put this another way, projects must be managed so
that options contracts are honored.32
When managers seek to create value by embedding options, they are in
effect writing an options contract. What this contract says is that at some specific
future time they will compare the revised estimated value of proceeding with
further investments against the revised estimated cost, and they will proceed if,
and only if, this value exceeds the costjust as the holders of financial options
only choose to exercise options that are in the money at expiration. Thus, an
options contract is a commitment to employ certain principles in deciding
whether the element will be done, rather than binding commitment to actually
do a project element.
An organization that fails to honor such contracts will not only systematically over-value options, but will also lose credibility and thus the discretion to
write such contracts in the future. Thus, firms that use real options as part of the
project justification process must put managerial guidelines in place that allow
sound options contracts to be created and honored in practice. We offer ten such
guidelines in Sidebar 3: Guidelines for Bringing Options Thinking into Project
Management.

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SIDEBAR 2. Is Options Thinking Real?

To investigate whether any biases might exist in the intuitive valuation of real options, we
recently undertook a field study to examine how the presence or absence of different kinds
of options affected managers willingness to continue a troubled project.a Managers in 123
firms were each asked to assess several hypothetical situations, each consisting of a base
investment project combined with a different combination of embedded options (e.g., stage,
abandon, scale, switch, strategic growth) described in commonsense terms. For each project,
they were asked to indicate the likelihood that the project had a positive payoff looking forward and whether it should be continued. Some of our findings indicated that managers
intuitively view real options in ways consistent with options theory. For example, they did
recognize that embedded options added value and that the presence of multiple options
increased that value.
Interestingly, we also found that IT managers tended to look more favorably on some kinds
of options than others, despite the fact that, in principle, no one type of option is necessarily
more or less valuable than any other. Specifically, we found growth options and switch-use
options were the most highly valued, while abandon options and stage options (presented
in the form of stage-abandon) were valued least.
These results suggest that options representing positive opportunities to increase the potential
upside of a project if things go well (i.e., options that are like adding an additional call option
to an existing base investment) are more highly valued than options that provide opportunities
to contain the most extreme downside losses if things do not go well (i.e., options that are like
adding a put option to an existing base investment). Further research is required to establish
exactly why this bias exists, but one plausible explanation is that managers anticipate that positive options (calls) associated with project success will be easier to exercise in practice, while
negative options (puts) will prove more difficult to exercise.

Should You Adopt?

As noted, options thinking requires major changes to project management and complimentary changes to organizational culture. So managers need
to assess the prevalence of real options and their readiness to undertake the
challenges of options thinking before taking the lead as an early adopter.

Assessing the Prevalence of Real Options

The benefits from adoption of real options depend on how prevalent real
options are in your firm. The following sorts of questions give insights on this
point:
Does IT play a strategic or merely a supporting role in your business?
Growth options are especially common in organizations where technology plays a strategic role.
Does your firm operate in a fast-moving environment with a high rate of
innovation in areas dependent on IT, or does it operate in a more stable

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One managerial implication of these results is that until organizations are able to overcome
culturally embedded biases, it may be worthwhile to change how options are structured and
portrayed so that they can be interpreted as positive opportunities (i.e., call options) rather
than as hedging against negative outcomes (i.e., put options). Here are three examples of such
tactics:
Tactic 1: Instead of bundling uncertain features as part of the initial base project with the
understanding they may be taken out if things do not go well (which is like adding
a put option), managers can shift these uncertain features to a second stage project
(which is like adding a call option).
Tactic 2: Instead of immediately undertaking an uncertain project with the understanding
that it may be abandoned later (which is like adding a put option), managers may
choose to defer initiation of the project (which is like adding a call).
Tactic 3: Instead of using traditional staged funding (which embeds a stage-abandon option
that behaves like a put), managers can seek to stage a project so that each completed segment produces the potential for business value as with the Carlson
example (which produces a stage-growth option that behaves like a call).
a. A.Tiwana, M. Keil, and R.G. Fichman,Can Escalation Be Rational? An Embedded Real-Options Perspective,
Working Paper, 2005.

environment? Fast-moving environments tend to have more uncertainty

regarding the value of IT investments, which, in turn, increases the value
of associated embedded options of all kinds.
Does your firm often undertake very large and complex projects, or are
most projects smaller and straightforward? Large, complex projects will
usually have a wider variety of operating options.
Does your firm often undertake discretionary or leading-edge IT projects,
or does it tend to wait until something becomes a competitive necessity?
Discretionary and leading-edge projects tend to have high levels of uncertainty and flexibility, while projects that have become a competitive
necessity have less of either.

Assess Organizational Readiness

Given that your firm operates in an environment where real options
abound, the other main consideration is whether you are ready, in terms of skills
and culture, to properly value and manage real options. Regarding skills, a key
issue is whether an organization already performs sophisticated quantitative
evaluations of IT investment projects that involve the estimation of future cash
flows. If so, then the incremental effort to estimate the value of real options will
be more manageable.
While there are alternatives to formal OPMs for organizations that lack
the necessary skills, there is no substitute for cultural readiness. To employ

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SIDEBAR 3. Guidelines for Bringing Options Thinking into

Project Management
Place a value on flexibility in some systematic way. This can range from using
a formal OPM, to decision trees, to a systematic but qualitative analysis of option value.
Be willing to initiate high-risk/high-reward projects when the risks can be
contained with options. These projects have the most option value, and are most likely
to be wrongly rejected using the NPV rule.
Look for ways to shift the balance from must do to may do project elements.
This includes deferring non-critical items for later implementation stages and explicitly identifying future applications and enhancements at the time the initial baseline project is
considered.
At the outset of a project, explicitly identify the factors that create uncertainty. Identify uncertain factors that determine whether may do items will be more or less
attractive. Develop a set of explicit statements about how favorable and unfavorable shifts in
these factors should affect willingness to continue. Put procedures in place to actively track
uncertain factors as they evolve over the course of the project.
Be aggressive in the use of incremental project funding and staging. Work especially hard to structure implementation so that each stage creates value even if no further
stages are funded.
Be willing to invest in design practices that create growth options by promoting future flexibility of delivered applications. This includes making systems more
generic, multi-purpose, interoperable, and scalable.
Be generous in the use of implementation tactics that create operating
options. These include simulations, prototypes, pilot projects, and incremental roll-outs.
Use incremental roll-outs to phase introduction of different functionalities to the same
population of users or to phase the same functionality to different sets of users.

options thinking requires frank discussions of uncertainty and risk. If the very
admission that a project might not pay off or could be terminated altogether
constitutes its death knell, then a major cultural change will be required. A
related issue is whether the organization will be able to honor options contracts:
Can managers imagine substantially curtailing or terminating projects that were
defined upfront to include an embedded stage or abandon option and still say
to everyone involved job well done? Is there a sufficient level of trust among
stakeholders to institute staged funding and aggressive deferral of uncertain or
discretionary items to later project stages? These sorts of questions reveal
whether real options are culturally feasible.

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Build-in explicit options checkpoints. These are analogous to options expiration

dates, and should be located at points where a project can be most gracefully redirected
or terminated (e.g., at the end of each stage) if uncertainty has been resolved unfavorably.
At each checkpoint, the current status of uncertain factors and the project more generally
should be re-evaluated and matched against expectations. Decision rule triggers for terminating a project should be articulated at the outset of the project to help guard against
project managers falling asleep at the switch.a
Nominate an exit champion to counter balance the regular project champion. An exit champion is a well-respected, senior person whose job it is to know when
the time has come to pull the plug on a project, and to advocate for doing so when and if
that time is reached.b A natural additional responsibility for an exit champion in the context
of real options would be to track exercise decision performance (i.e., are projects continued
or terminated as appropriate).This does not mean judging results of these difficult decisions
with 20-20 hindsight. Rather, it means judging the quality of the analyses used to support
exercise decisions at each check point, and whether explicit exercise decisions were in fact
made, rather than the project simply continuing along by default.
Create incentives for proper options exercise. After procedures are in place to
track exercise performance, organizations must then reward good performance with some
combination of compensation, increased responsibility, and public recognition.c Additionally,
the organization must clearly signal that pulling the plug on a failing project does not necessarily carry the connotation of admitting failure.
a. For a fuller discussion of triggers and other tactics to encourage appropriate exercise of real options, see
T. Copeland and P.Tufano, A Real-World Way to Manage Real Options, Harvard Business Review, 82/3
(March 2004): 90-99.
b. For a discussion of exit champions and other tactics for terminating projects see I. Royer, Why Bad Projects
Are So Hard to Kill, Harvard Business Review, 81/2 (February 2003): 48-56.
c. Copeland and Tufano, op. cit.

Conclusions
There are six essential points to options thinking on IT investment
projects.
Real options can be a powerful tool for valuing the strategic and operational flexibility associated with uncertain IT investments. However, real
options are not just a new methodology for valuing IT investmentsthey
constitute a new way of thinking about how projects can be structured and
managed.
Promoting flexibility in the systems development process or result creates
a quantifiable value, and this value exists whether or not an organization
actually attempts to quantify it using an options pricing model. Under
conditions of high uncertainty, this value can be surprisingly high.

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Real options exist in a variety of formsstage, defer, abandon, switch,

scale, strategic growththat differ according to the conditions where
they add the most value and in terms of associated pitfalls. Understanding
these different varieties makes it easier to identify, value, and manage
options in practice.
Options thinking requires the adoption of new project management
guidelines that promote flexibility in the development process and delivered result; that allow sources of uncertainty to be explicitly identified
and tracked; and that facilitate appropriate exit on projects where uncertainty has been resolved in an unfavorable way.
Real options are most abundant in firms undertaking IT projects that are
complex, strategic, and/or innovative. These projects tend to have high
uncertainty and longer time frames, both of which magnify option values.
Using real options effectively will require a cultural change in many
organizations. Adopters must be able to hold candid discussions of project
risks and the potential for failure at the outset and they must be willing to
redirect or terminate projects without the fear of stigmatization or
reprisals.
Real options are by no means a panaceaevaluating and managing
uncertain IT investments will always be difficult. Nevertheless, options thinking
provides a promising philosophy to promote the longstanding goals of doing the
right projects and doing projects right. By recognizing the value of real
options, managers advance the first goal. By honoring options contracts and
allowing appropriate exit, managers advance the second goal. By structuring
projects to promote flexibility, managers advance both goals. Firms seeking to
innovate using IT tread an unpaved path. Options thinking helps managers navigate the considerable uncertainties and exploit the fleeting windows of opportunity that present themselves along this path.
Notes
1. Failure rates of 50% and above have been observed for advanced manufacturing technology. See A. Majchrzak, The Human Side of Factory Automation (San Francisco, CA: Jossey-Bass,
1988). For business process re-engineering, see B.J. Bashein, M.L. Markus, and P. Riley,
Preconditions for BPR Success, Information Systems Management, 11 (Spring 1994): 7-13. For
customer relationship management system implementation, see D.K. Rigby, F.F. Reichheld,
and P. Schefter, Avoid the Four Perils of CRM, Harvard Business Review, 80/2 (February
2002): 101-107.
2. In developing our ideas, we have been particularly influenced by M. Benaroch, Managing
Information Technology Investment Risk: A Real Options Perspective, Journal of Management Information Systems, 19/2 (2002): 43-84; M. Benaroch and R.J. Kauffman, Justifying
Electronic Banking Network Expansion Using Real Options Analysis, MIS Quarterly, 24/2
June 2000): 197-226; T.E. Copeland and P.T. Keenan, How Much Is Flexibility Worth?
McKinsey Quarterly, 2 (1998): 38-49; R.G. McGrath, A Real Options Logic for Initiating
Technology Positioning Investments, Academy of Management Review, 22/4 (1997): 974-996;
A. Taudes, M. Feurstein, and A. Mild, Options Analysis of Software Platform Decisions: A
Case Study, MIS Quarterly, 24/2 (2000): 227-244.
3. Thomke and Reinertsen provide a detailed discussion of tactics for promoting flexibility in
the new product development (NPD) process. Much of this discussion is applicable to the

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4.

5.

6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

16.
17.

18.
19.
20.

context of IT systems development. See S. Thomke and D. Reinertsen, Agile Product Development: Managing Development Flexibility in Uncertain Environments, California Management Review, 41/1 (Fall 1998): 8-30.
The following provide useful introductions to real options models: M. Amran and N. Kulatilaka, Real Options: Managing Strategic Investment in an Uncertain World (Boston, MA: Harvard
Business School Press, 1999), p. 246; A. Dixit and R. Pindyck, Investment Under Uncertainty
(Princeton, NJ: Princeton University Press, 1994); T.A. Luehrman, Investment Opportunities as Real Options: Getting Started on the Numbers, Harvard Business Review, 76/4
(July/August 1998): 51-60; L. Trigeorgis, Real Options and Interactions with Financial
Flexibility, Financial Management, 22/3 (1993): 202-224; L. Trigeorgis, ed., Real Options and
Business Strategy: Applications to Decision Making (London: Risk Books, 1999).
The application of real-options to R&D is described in: D.I. Angelis, Capturing the Option
Value of R&D, Research Technology Management, 43/4 (2000): 31-34; R.G. McGrath, A Real
Options Logic for Initiating Technology Positioning Investments, Academy of Management
Review, 22/4 (1997): 974-996; M. Perlitz, Real Options Valuation: The New Frontier in R&D
Project Evaluation? R&D Management, 29/3 (1999): 255-269. The application of real options
to IT is illustrated in M. Amran, N. Kulatilaka, and C.J. Henderson, Taking an Option on
IT, CIO Magazine, 12/17 (1999): 46-52; Benaroch and Kauffman (1999), op. cit.; B.L. Dos
Santos, Justifying Investments in New Information Technologies, Journal of Management
Information Systems, 7/4 (1991): 71-89; R.G. Fichman, Real Options and IT Platform
Adoption: Implications for Theory and Practice, Information Systems Research, 15/2 (2004):
132-154; A. Kambil, J.C. Henderson, and H. Mohsenzadeh, Strategic Management of Information Technology: An Options Perspective, in R.D. Banker, R.J. Kauffman, and M.A.
Mahmood, eds., Strategic Information Technology Management: Perspectives on Organizational
Growth and Competitive Advantage (Middleton, PA: Idea Group Publishing, 1993); M. Keil and
J. Flatto, Information Systems Project Escalation: A Reinterpretation Based on Options
Theory, Accounting, Management & Information Technology, 9 (1999): 115-139; Y.J. Kim and
G.L. Sanders, Strategic Actions in Information Technology Investment Based on Real
Option Theory, Decision Support Systems, 33/1 (May 2002): 1-11; R.L. Kumar, Managing
Risks in IT Projects: An Options Perspective, Information & Management, 40/1 (October
2002): 63-74; Taudes, Feurstein, and Mild, op. cit.
Longer holding periods are more valuable because the estimate of a projects value will have
had a longer time to shift up or down due to new information.
For a discussion of these six options types, see Trigeorgis (1993), op. cit.
Benaroch, op. cit.
B.W. Boehm, A Spiral Model of Software Development and Enhancement, IEEE Computer,
21/5 (1988): 61-72.
S.D. Scalet, Stage Managers, CIO Magazine (2000).
R.G. Fichman and S.A. Moses, An Incremental Process for Software Implementation, Sloan
Management Review, 40/2 (1999): 39-52.
C. Shapiro and H.R. Varian, Information Rules: A Strategic Guide to the Network Economy
(Boston, MA: Harvard Business School Press, 1998).
B.W. Chew, D. Leonard-Barton, and R.E. Bohn, Beating Murphys Law, Sloan Management
Review, 32/3 (1991): 5-16.
M. Keil, J. Mann, and A. Rai, Why Software Projects Escalate: An Empirical Analysis and
Test of Four Theoretical Models, MIS Quarterly, 24/4 (2000): 631-664.
R. Adner and D.A. Levinthal, What Is Not a Real Option: Considering Boundaries for the
Application of Real Options to Business Strategy, Academy of Management Review, 29/1
(2004): 74-85; R. Fink, Reality Check for Real Options, CFO Magazine, 17/9 (2001); E.
Teach, Will Real Options Take Root? CFO, 19/9 (2003): 73-75.
Benaroch and Kauffman, op. cit.
M.A. Schilling, Technological Lockout: An Integrative Model of the Economic and Strategic
Factors Driving Technology Success and Failure, Academy of Management Review, 23/2
(1998): 267-284.
Taudes, Feurstein, and Mild, op. cit.
A. Taudes, Software Growth Options, Journal of Management Information Systems, 15/1
(1998): 165-185.
S. Panayi and L. Trigeorgis, Multi-Stage Real Options: The Cases of Information Technology
Infrastructure and International Bank Expansion, Quarterly Review of Economics and Finance,
38/4 (1998): 675-692.

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21. J.D. Hofman and J.F. Rockart, Application Templates: Faster, Better, and Cheaper Systems,
Sloan Management Review, 35/1 (1994): 49-60.
22. R.G. Fichman and C.F. Kemerer, Incentive Compatibility and Systematic Software Reuse,
Journal of Systems and Software, 57 (2001): 45-60.
23. R. Howe, At Starbucks, the Future Is in Plastic, Business 2.0, 4/7 (2003): 56-63.
24. The Rubenstein binomial model allows non-constant variance in expected payoffs, and the
additive form of the model forms also allows expected payoffs to be normally distributed
with the potential for non-negative values. The latter form of flexibility is important since it
allows for the possibility that an IT system will actually decrease the performance of the
firm. For further explanations, see T. Copeland and V. Antikarov, Real Options: A Practitioners
Guide (New York, NY: Texere, 2001), p. 372.
25. T. Copeland and P. Tufano, A Real-World Way to Manage Real Options, Harvard Business
Review, 82/3 (March 2004): 90-99.
26. Schwartz and Zozaya-Gorostiza have developed an OPM that explicitly models uncertainty
in the cost of follow-on projects and allows an additional form of uncertainty, which is the
possibility of catastrophic event during development. E.S. Schwartz and C. Zozaya-Gorostiza, Valuation of Information Technology Investments as Real Options, #6-00, UCLA, Los
Angeles, CA, p. 37. In addition, Monte Carlo simulation methods can be used that permit a
great deal of flexibility in modeling options. See Amran and Kulatilaka, op. cit., p. 246.
27. For more discussion of challenges to the use of OPMs in practice, see R. Fink, Reality Check
for Real Options, CFO Magazine, 17/9 (2001); E. Teach, Will Real Options Take Root?, CFO
Magazine, 19/9 (2003): 73-75.
28. For more details on counter-arguments and remedies to OPM challenges, see M. Benaroch
and R.J. Kauffman, A Case for Using Real Options Pricing Analysis to Evaluate Information
Technology Project Investments, Information Systems Research, 10/1 (1999): 70-86; Copeland
and Tufano, op. cit.
29. N.A. Nichols and J. Lewent, Scientific Management at MerckAn Interview with CFO
Judy Lewent, Harvard Business Review, 72/1 (January/February 1994): 88-99; P. Buxbaum,
Tapping Into Real Options, Computerworld, 36/2 (2002): 28-29; E. Teach, Will Real
Options Take Root? CFO Magazine, 19/9 (2003): 73-75.
30. See the following for discussions of the limitations of decision trees Benaroch, op. cit.;
Copeland and Keenan, op. cit.
31. An example of a qualitative approach to valuating real options in the context of R&D is
provided in R.G. McGrath and I.C. MacMillian, Assessing Technology Projects Using Real
Options Reasoning, Research Technology Management, 43/4 (2000): 35-49.
32. Useful advice on managing real options is also provided in: Amran and Kulatilaka, op. cit,
p. 246; Copeland and Antikarov, op. cit., p. 372; Copeland and Tufano, op. cit.; W.F. Hamilton, Managing Real Options, in G.S. Day, P.J.H. Schoemaker, and R.E. Gunther, eds.,
Wharton on Managing Emerging Technologies (New York, NY: John Wiley & Sons, 2000).

California Management Review

University of California F501 Haas School of Business #1900
(510) 642-7159 fax: (510) 642-1318 e-mail: cmr@haas.berkeley.edu

Berkeley, CA 94720-1900
web site: www.haas.berkeley.edu/cmr/