Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 1 of 24 Hybrid Approach to Option Valuation Richard de Neufville Professor of Systems Engineering and of Civil and Environmental Engineering MIT

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 2 of 24 Outline for Real Options l R & D creates options l R & D Evaluation in Auto Industry l Parts of R & D Process l Details of Ford Case l Hybrid Evaluation Strategy and Results l Summary

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 3 of 24 Linear Systems are Common l Many Systems feature “linear” development –They proceed naturally through phases l Example: Oil Development –Acquire Lease –Explore –Test wells –Exploitation l Example: New Products –Basic Research –Applied Research –Development –Production

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 4 of 24 Linear Systems Create Options l Completing 1 st step gives “right, but not obligation” to do 2 nd ; and so on down line l R & D in particular creates options l HOWEVER, optionality of R & D has usually been ignored – projects evaluated by NPV l This means: value of being able to cancel project if appropriate has been ignored l In short that R & D HAS BEEN UNDERVALUED

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 5 of 24 Types of R & D l Traditionally, R & D organizations divide their portfolio of into categories l In Auto Industry –Tier 1: General Research –Tier 2: Future Vehicle Work –Tier 3: Current Vehicle Work –Major Development Effort l In US Department of Defense –Categories: 6.1, 6.2, etc… l Evaluation Criteria for parts may differ…

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 6 of 24 R & D Evaluation in US Auto Industry l Traditional Process –Net Present Value Process –Assumes Development Process carried on through production –possibility of stopping project not in analysis –However, successful prototype production is option for full scale l Is this right? How should Ford evaluate elements of its research portfolio? l This was object of Neely’s research

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 7 of 24 Neely’s Hybrid Approach l Basic idea: Divide the valuation into 2 parts –Use different approach for distinct needs l Financial “options analysis” for market element –uses volatility of stock price to reflection of uncertainty in sales and thus value of product l Decision analysis for technical risks, –Judgment is appropriate -- not volatility l “Render onto Caesar what is Caesar’s… unto God what is God’s”

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 8 of Implement Stop Project Results Promise Results Poor 0.5 Invest Do Not Invest Implement Stop Project High Benefits -Cost(1) -Cost(2) Low Benefits -Cost(1)-Cost(2) -Cost(1) Decision 1 Invest? Contingent Results Uncertainty Resolution Decision 2 Implement? Structure of Investment Choices

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 9 of 24 Implement -R&D Costs - Implement Cost + Revenues Stop -R&D Costs High Demand Phd Implement -R&D Costs - Implement Cost + Revenues Stop -R&D Costs Medium Demand Pmd Implement -R&D Costs - Implement Cost + Revenues Stop -R&D Costs Low Demand Pld High Benefits Phb Medium Benefits Pmb Similar to High Value Branch Low Benefits Plb Similar to High Value Branch R&D Success Ps R&D Fails 1-Ps -R&D Costs Yes No 0 Invest? Initial Investment Choice Technical Uncertainty (Endogenous) Benefit Uncertainty (Endogenous) Market Uncertainty (Exogenous) Implementation Decision Time Detailed view of Probabilities, Decisions

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 10 of 24 Structure of Hybrid Analysis l Risk-neutral treatment of exogenous uncertainties, that is, those due to market l Discount at risk-free rate l Some market-priced asset needed to represent value of project – Neely took the stock price for Ford, assuming it correlated with sales of cars l Direct treatment of endogenous uncertainties, that is, those due to project l Discount at risk-appropriate rate, for example at CAPM

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 11 of 24 Details of Ford Case l Neely collaborated with Materials section of Ford R & D l First table illustrates description of projects l Second table, the data for the projects –Note estimates of probabilities of success ~ 0.8 for Tier 3, Current Vehicle Focus ~ 0.5 for Tier 2, Future Vehicles ~ 0.3 for Tier 1, General Research l Full data sets appended to presentation

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 12 of 24 R & D Project Descriptions CodeProject Area ClassMoney Benefits Other Benefits AVehicle Systems DesignWarranty & Testing Model BEngineDesignPrototype Elimination Weight Savings CPower- train DesignComponent Reduction Model HManufac- turing ProcessProductivity Increase NA JEngineProductNAWeight Savings Sample R & D Project Descriptions:

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 13 of 24 R & D Project Data Code Costs $, millions Benefits $, millions P (Success) Annual R&DImplement A B O.8 HO J Sample R & D Project Data:

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 14 of 24 Results of Hybrid Analysis l Next slide gives: –Value of Each Project, by NPV and Hybrid Analysis –Also ranking of projects by each method l Note that: –When valued as options, the R & D projects always had higher value. This is because, once one recognizes the possibility of canceling projects, one discards negatives that lower value –The rank order is not the same for both methods. –Thus the use of NPV not only gives wrong values systematically biased downward, but recommends some projects in wrong order!

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 15 of 24 Valuation of Projects by NPV and Hybrid

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 16 of 24 Outline for Real Options l The Issue l Criteria of Choice –Analysis Objective – choice or price? –Organizational Decision-Making practices –Analytic Capabilities of Group –Information available l Two Classic Cases – Real Options at: –Merck – Producer of Ethical Drugs –Kodak – Cameras, Copiers l Summary

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 17 of 24 Higher Uncertainty  Higher Value Graph clearly illustrates this basic principle

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 18 of 24 NPV Decision Analysis + Financial Options Decision Analysis Financial Options Exogenous Market Related Uncertainties Endogenous Project Specific Uncertainties High Low Neely’s Guide for Use of Hybrid Method

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 19 of 24 Summary l The Hybrid Method is a Feasible way of Valuing Real Options in Systems l It has the great advantage of combining –Market effects on project (provided a good proxy variable can be found) –Technical uncertainties l It is far from theoretically pure – a “rough and ready” valuation that has the merit of being plausibly better than feasible alternatives l More research needed!

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 20 of 24 References l de Neufville, R. and Neely, J. (2001) “Hybrid Real Options Valuation of Risky Project Development Projects,” International Journal of Technology, Policy and Management, Vol. 1, No. 1, pp 29 – 46. l Neely, J. (1998) “Improving the Valuation of Research and Development: A Composite of Real Options, Decision Analysis and Benefit Valuation Frameworks,” Ph.D. dissertation, MIT, Cambridge, MA.

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 21 of 24 Some Appendix Tables follow …

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 22 of 24 Complete Description of Projects

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 23 of 24 Complete Data for Projects

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville © Hybrid Approach to Valuation Slide 24 of 24