Chapter 14 Assessing the Value of IT Managing the Information Technology Resource Jerry N. Luftman

Chapter Outline Importance of assessing IT value Traditional financial measures to show value Applying improved financial measure Evaluating portfolio of IT investment projects Activity-based management Difference between showing value and measuring value Leveraging assets of IT for competitive advantage How IT governance is shared responsibility How enterprise can benefit from processes

Traditional Financial Approaches Return on Investment (ROI) Used to assess value of IT investments (for whole division) Has limitations Financial Management

Traditional Financial Approaches Residual Income Similar to measure of excess profit Used to assess value of IT investments (for whole division)

Traditional Financial Approaches Economic Value Added (EVA) Uses capital asset pricing model (CAPM) Identifies cost of capital for specific division or business unit Removes distortions to investments decision by GAAP Expenditures should be capitalized & amortized http://www.sternstewart.com/evaabout/whatis.php

Traditional Financial Approaches Net Present Value (NPV) Firm chooses between alternative investment opportunities to advance market value Evaluate projects based on measurable cash flows

Traditional Financial Approaches Modified NPV Evaluate projects based on measurable cash flows

Managerial (Real) Options Investment projects are not necessarily set in concrete once they are accepted Managers can make changes that affect subsequent cash flows and life of project Option to expand (or contract) Option to abandon Option to postpone

Example of Option to Expand Gummy Glue Co. is evaluating a new, revolutionary glue. The company can build a plant that is capable of producing 25,000 gallons of glue a month. The level of production is not economical from either manuf or marketing standpoint. As a result, the project’s NPV is expected to be a negative 3 million. However, the new glue could prove to be a winner. If sales were to increase dramatically, the co. could expand the new plant in 2 years. With the expansion, output would triple, and the plant would be operating at a highly efficient scale. However, the opportunity to accommodate this higher level of demand will not be available unless a first-stage investment is made now.

Example of Option to Expand Assume there is 50-50 chance that the market will be much larger in 2 years. If it is, the NPV of the 2nd stage investment at the end of year 2 will be $15 million. When the value is discounted to the present at the required rate of return, the NPV at time 0 is $11 million. If the market falters over the next 2 years, the company will not invest further, and the incremental NPV at the end of year 2 is zero.

Project Worth = -3M + (.5)(11M) + (.5)(0) = 2.5M (NPV=11M) 2nd Stage Success .50 -3M Invest Fail .50 Do not Invest 1st Stage Do not Invest Project Worth = -3M + (.5)(11M) + (.5)(0) = 2.5M

Example of Option to Abandon Acme Tractor Co. is considering establishing a new facility to produce the Acme III lawn tractor. This tractor will be produced for only 1 or 2 years because a new model will replace it. The proposal will cost $3 million, and the cash flows and their probabilities are: Year 1 Year 2 Joint Prob. Prob (1) Cash Flow Cond. Prob. .25 1.0M 0.0M 0.0625 .50 0.1250 2.0M 0.2500 3.0M 3.5M

MARR = 10% Year 1 Year 2 Joint Prob. NPV P*NPV Pro(1) Cash Flow Pro(2) 0.25 1,000,000 0.0 0.0625 -2,090,909 -130,682 0.50 0.1250 -1,264,463 -158,058 2,000,000 -438,017 -27,376 -355,372 -44,421 0.2500 471,074 117,769 3,000,000 1,297,521 162,190 1,380,165 86,260 2,206,612 275,826 3,500,000 2,619,835 163,740 445,248

Example of Option to Abandon Assume an expected abandonment value of $1.5M at the end of year 1, then the cash flows and their probabilities are: Year 1 Year 2 Joint Prob. Prob (1) Cash Flow Prob (2) .25 2.5M 1.00 0.0M 0.2500 .50 2.0M 1.0M 0.1250 3.0M 0.0625 3.5M

Value of Abandonment = $579,545 - $445, 248 = $34,297 Year 1 Year 2 Joint Prob. NPV P*NPV Pro(1) Cash Flow Pro(2) 0.25 2,500,000 1.00 0.0 0.2500 -727,273 -181,818 0.50 2,000,000 1,000,000 0.1250 -355,372 -44,421 471,074 117,769 3,000,000 1,297,521 162,190 0.0625 1,380,165 86,260 2,206,612 275,826 3,500,000 2,619,835 163,740 579,545 Value of Abandonment = $579,545 - $445, 248 = $34,297

Real Options Decision to pursue investment project can be deferred for period of time Opportunity to create IT investment at future time

Option Pricing Call Option A contract that gives the holder the right to purchase a specified quantity of the underlying asset at a predetermined price (the exercise price) on or before a fixed expiration date. Put Option A contract that gives the holder the right to sell a specified quantity of the underlying asset at a predetermined price (the exercise price) on or before a fixed expiration date.

Valuation of a Call Option Theoretical value of an option: max [(Ps) - E, 0] Ps = market price of one share of stock E = Exercise price of the option Option Value Common Stock Price Theoretical value line 45o Market Exercise price

Example of the Valuation of an Option Theoretical value of an option: max [(Ps) - E, 0] Ps = $10 , E = $5 max[($10)- $5 , 0] = $5 Ps = $15 , E = $5 max[($15)- $5 , 0] = $10 Option Value Common Stock Price $5 $10 Stock appreciates 50% Theoretical option value appreciates 100% Minimum value is 0.

Valuation of an Option Effect of time to Expiration In general, the longer the period of time to expiration, the greater the value of the option relative to its theoretical value. Option Value Common Stock Price Theoretical value line Market value lines Shorter time to expiration

Valuation of an Option Effect of Interest Rate Employed In general, the higher the interest rate, the more valuable of this delay is to the investor. Option Value Common Stock Price Theoretical value line Market value lines Lower Interest Rate

Valuation of an Option Effect of Volatility Volatility: Measure of the amount by which an underlying is expected to fluctuate in a given period of time. Implied volatility is calculated by using an option-pricing model (Black-Scholes for stocks and indices and Black for futures). Historical volatility is calculated by using the standard deviation of underlying asset price changes from close to close trading going back 21 to 23 days.

Valuation of an Option Effect of Volatility Volatility: Measure of the amount by which an underlying is expected to fluctuate in a given period of time. An Example: Prob. Stock A Stock B 0.10 $ 30.00 $ 20.00 0.25 $ 36.00 0.30 $ 40.00 $ 44.00 $ 50.00 $ 60.00 EV VAR 28 130 Std. Dev. $ 5.29 $ 11.40

Prob. Stock A Value of Option A (@$38) Stock B Value of Option B 0.10 $ 30.00 $ - $ 20.00 0.25 $ 36.00 0.30 $ 40.00 $ 2.00 $ 44.00 $ 6.00 $ 50.00 $ 12.00 $ 60.00 $ 22.00 EV $ 3.30 $ 5.80 VAR 28.00 13.71 130.00 51.96 Std. Dev. $ 5.29 $ 3.70 $ 11.40 $ 7.21

Valuation of a Call Option Summary Increase in Variable Resulting Change in Option Value Stock Price Volatility Increase Time to option expiration Interest Rate Exercise Price Decrease Current Stock Price

Hedging with Options Risk-free Hedged position: Price movements in one financial assets will be offset by opposite price movements in the other. Buying & holding common stock + writing options Common stocks ; written options  Common stocks ; written options  In market equilibrium, earns risk-free rate.

Black-Scholes Model for Call Option VO = Value of the option PS = Current price of common stock E = Exercise price of the option r = Short-term, risk free interest rate, continuously comp. t = Length of time to expiration date of the option (in yrs)  = Std. Dev. of annual rate of return

Assumptions of Black-Scholes Model The stock pays no dividends during the option's life European exercise terms are used (option can only be exercised on the expiration date) Markets are efficient No commissions are charged Interest rates remain constant and known Returns are lognormally distributed

Real Options Decision to pursue investment project can be deferred for period of time Opportunity to create IT investment at future time Mapping five characteristics of investment opportunity Reduce uncertainty by deferring decision Interest income can be earned during deferral period Ability to react to changing uncertain conditions during deferral period by altering investment decisions

Mapping IT Investment Characteristics to Financial Call Option Characteristics Source: adapted from Luerhrman, T.A., Capital Projects as Real Options: An Introduction, Harvard Business School Teaching Note (1994).

Applying Real Options Use Black-Scholes Model Excel Financial Calculators Use Table in Figure 14E-1

Decision Tree Analysis Capable of accounting for firm’s revisions of strategies and operations under uncertainty Probabilities derived from past information or future information that can be obtained Management chooses alternative that maximizes risk-adjusted NPV

Decision Tree Analysis vs. Real Option Analysis Source: adapted from Luehrman, T.A., Capital Projects as Real Options: An Introduction, Harvard Business School Teaching Note (1994).

Real Option Valuation of Individual Investment Traditional financial analysis of investment projects has shortcomings Information Economics Buss’s Framework for individual inv. Oracle Corp’s decision model

Buss’s Framework for Individual Investment Investment projects ranked for 4 criteria: financial benefits intangible benefits technical importance fit with business objectives Each criterion comprised of relevant elements Each element scored for IT investment project and total score derived Sum obtained across four criteria used to compare IT investment against competing projects

Oracle Corp. Decision Model Create committee of stakeholders affected by IT investment Define intangible benefits of IT investment Define intangible risks associated with IT investment Establish weights to relative importance of tangible benefits Estimate on scale of zero to five the likelihood of each benefit and risk observed Multiply likelihood estimate by weight established for factor and add up products

Real Options Analysis Build consensus among participants in IT investment decisions They couple financial calculations with intangible benefits and risks, aspects of strategic concern

“Tomato Garden” of IT Investment Project Source: adapted from Luehrman, T.A., 1998b “Strategy as a Portfolio of Real Options,” Harvard Business Review, September-October (1998).

Evaluating IT Investment Portfolio Ensure IT investment proposals are understood in terms of expected business outcomes, efforts needed to reach outcomes, and risks involved Ensure IT investments will advance value of firm Ensure risks associated with IT investments are in line with acceptable risk profile Ensure IT investments are aligned with business strategies

Trigeorgis’ Framework Objective of value management refers to broad measure of NPV Strategic NPV = Traditional NPV of expected cash flows + Value of operating options from flexible management + Investment interaction effects Strategic management of investments requires management of collection of future investment opportunities and options Appropriate control targets are necessary for effective implementation of value-maximizing approach

3 Phases of Trigeorgis’ Framework

Activity-Based Management Measures Activity-based costing Methodology that measures cost and performance of activities, resources, and cost objects Activity-based management Discipline that focuses on the management of activities as the route to improving value received by the customer and profit achieved by providing this value

TCO and TBO Concepts Total Cost of Ownership (TCO) Acquisition cost of materials is only portion of true costs of a product or process Total Benefit of Ownership (TBO) Considers benefits of competing products or processes instead of just focusing on individual costs

TCO Analysis Concerns Addressed Provide predictable costs and level budgets Determine which IT resources can be applied to firm’s core mission How to determine current costs and services How to increase service levels at affordable cost How to track or recognize actual ongoing IT costs How to find cost-effective way of improving IT expertise How to determine most effective implementation strategy to improve effective/ efficient delivery of IT

Differentiating Features of TVO Approach IT and business management must work together Firm needs to move from pure cost center perspective to one emphasizing value creation Managers must evaluate and manage collection or portfolio or projects

Resources for More Methodologies Applied information economics http://www.hubbardross.com Balanced scorecard http://www.bscol.com http://www.aquent.com Economic value added http://www.sternstewart.com

Resources for More Methodologies Economic Value Sourced http://www.metagroup.com Portfolio management http://www.metricnet.com Real option valuation http://www.pwcglobal.com

Value Management Framework Examples

Application of Expanded Value Management Framework

Governance Is Shared Responsibility IT and business managers need to work together Combined application of: Real options Value management Portfolio analysis as tools Metrics Indicators

Enterprise Can Benefit from Processes IT work adds value to business Ongoing process that continues to evolve and change All units must work toward same strategic goals of firm Combination of financial measures, non-financial measures, and partnerships leveraging IT assets Encourage staff to embrace practices