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

2. 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

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

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

5. 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

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

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

8. 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

9. 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.

10. Example of Option to Expand
Assume there is 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.

11. 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

12. 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

13. 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

14. 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

15. 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

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

17. 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.

18. 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

19. 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.

20. 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

21. 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

22. 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.

23. 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 $ $
0.25 $
0.30 $ $ $ $ EV
VAR 28
130
Std. Dev. $ $

24. Prob.
Stock A
Value of Option A
Stock B
Value of Option B
0.10 $ $ $
0.25 $
0.30 $ $ $ $ $ $ $ $ EV $ $
VAR
28.00
13.71
130.00
51.96
Std. Dev. $ $ $ $

25. 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

26. 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.

27. 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

28. 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

29. 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

30. 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).

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

32. 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

33. 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).

34. 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

35. 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

36. 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

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

38. “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).

39. 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

40. 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

41. 3 Phases of Trigeorgis’ Framework

42. 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

43. 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

44. 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

45. 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

46. Resources for More Methodologies
Applied information economics
Balanced scorecard
Economic value added

47. Resources for More Methodologies
Economic Value Sourced
Portfolio management
Real option valuation

48. Value Management Framework Examples

49. Application of Expanded Value Management Framework

50. 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

51. 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