Option pricing AIPM conference 2003

Why do we run projects?

What is competitive advantage? The reasons why a customer uses you and not someone else

What makes up competitive advantage – an example

Yes – increases overall advantage

A sporting analogy – 100 metre sprint Red is fastest out of the blocks Yet blue wins every time

Competitive advantage Red can invest in being even faster out of the blocks Invest in improving latter half of race Or Both

Strategic project “x” Now After project xNegative NPV project After project ySignificantly positive NPV project Finish to Start dependency Did not know of y or z when x was born Vision achieved after project z

PLANACCOMPLISH SOFTHARD LEVEL OF EFFORT TIME PHASE 1 CONCEPT PHASE 2 DEVELOPMENT PHASE 3 IMPLEMENTATION PHASE 4 TERMINATION Project Life Cycle

Variability of Objectives Concept Feasibility +- 50% +- 70% Development +- 20% Implementation Managed through change control Benefits realisation 0 + follow on options

PLANACCOMPLISH SOFTHARD Increasing probability of success TIME PHASE 1 CONCEPT PHASE 2 DEVELOPMENT PHASE 3 IMPLEMENTATION PHASE 4 TERMINATION Stage Gate Finance Business Case Positional Paper Scope of Work Change Control Benefits Realisation

Issues with picking the right portfolio Forecast error Short term EPS reductions Lack of vision Lack of strategic planning

A resolution to issue 1 Option pricing on real assets Allows for more agility Run more projects in concept phase Allows for investing in negative NPV projects

Management options Hold? Sell? Buy? Postpone current project / maintain business as usual Abandon project / business Invest in project / business

Financial options Hold? Sell? Buy? In the money call option/out of the money call option Put option Call option (American with dividends)

Sample scenario – a strategic programme 0 forecast error Present value of cash inflows = $120m Present value of cash outflows = $150m Should programme be approved?

Some changes in assumptions 70% variability on forecast Run a pilot for $10m to test the waters Pilot will run for 12 months All other data is the same Should we run the project?

Benefits of options pricing Links value to competitive advantage Allows for informed decision making Removes a large portion of the gut feel Tests the validity of strategy

Impact on project managers Must include benefits management in scope of projects Model must be updated monthly Communicate results to sponsor Focus more time on movement in project objectives