In the Classroom II
Managing Risk in Innovation: A Real Options Approach That Works

Using real-options, applying financial options approaches to strategic investments, has always been an attractive idea. Real options are based on the recognition that the kind of small, upfront commitment that an investor might make in an early-stage company or new product is very similar to a financial option. It gives the investor the choice but not the commitment to make larger investments in later stages if the technology or project proved successful. This means an investment that might have a negative net present value (NPV) based on standard calculations could have a positive value if options are considered.

The Problems With Real Options

The reality of real options is not so pretty. "When we talked with CFOs about why they didn't like real-options, they told us that real options often overestimate the value of certain projects," said Wharton Professor Ian MacMillan, academic co-director of the new Wharton executive education program, Managing Risk in Innovation: A Real Options Approach That Works. "In the worst case, they grant excessively ambitious managers a license to gamble with shareholders' money. Risky projects that failed were treated as an inevitable consequence of options-based investing. Real options, as they were applied, tended to encourage managers to package every darn fool risky project as a real-options play."

MacMillan, a leading researcher and consultant to top corporations on corporate ventures joined with colleague Alexander van Putten, who cut his teeth on financial options as a trader in the 1970s, to address these challenges. "We identified all the objections of the CFOs and came up with a methodology that attended to those objections," MacMillan said. "It allows you to make more aggressive investments without increasing your risks."

Driving Down the Cost of Failure

Conventional NPV and real-options analysis have typically been treated as separate worlds. MacMillan and van Putten brought these worlds together into a formula to assess Total Project Value, a combination of a project's real-options value and conventional NPV. This allows managers to assess both types of value and adjust the formula dynamically as the uncertainty is reduced.

"For projects with moderate uncertainty, there is no reason for managers not to make the numbers," said van Putten. "For those projects characterized by high uncertainty, the managerial obligation is to drive down the cost of failure. For uncertain projects, there comes a responsibility to do the hard work necessary to identify, document, and test assumptions at key milestones ahead of major investments. Over time, this discovery-driven process should either reduce the uncertainty, thus justifying more aggressive investment increments, or the project should have been demonstrated as infeasible and terminated inexpensively." In other words, projects either migrate from having options value to having traditional NPV, or they are cancelled.

How It Works

What impact can real options have on evaluating projects? Suppose an innovation team thinks that they can develop and install a new technology that could radically change the way the firm competes. For an R&D budget of $25, they think they can develop a new technology, which will cost $200 to install once developed, for a total budget of $225. There is only a 5% chance that the technology will work, but if the technology works and you install it, this will yield a guaranteed discounted cash flow (DCF) of net revenues of $4,000 (excluding the R&D and installation costs). A conventional NPV analysis would look at the investment as follows:

NPV = Expected Total DCF Cost + Expected DCF Net Revenues
NPV = - (225) + 0.05 x 4000
NPV = - 225 + 200
NPV = - $25

With a negative NPV, senior management would be absolutely right to turn down the project. What this analysis misses, however, is that only the first $25 investment needs to be made to find out if the technology works (as long as the company has a mechanism for stopping the investment if it doesn't work). Now the investment can be looked at as spending $25 on buying a technology option, which gives management the right, but not the obligation, to spend another $200 and thereby secure a DCF of $4,000.

This means that the $25 investment in developing the technology has a 5% chance of precipitating a $200 installation cost but with the same 5% chance of delivering $4000.

NPV = -25 + 0.05 (-200 + 4000 )
NPV = -25 + 190
NPV = $165

This shows that even in cases where there is a high probability of failure (95%), if the upside is very large, and if the firm can capture the right to that potential at relatively low cost, and if the project can be ruthlessly stopped if the option investment fails, it is still a good idea to go ahead. "If any of the above 'ifs' are absent, the project fails the Real Options Discipline (ROD) test and should automatically be subject to conventional NPV criteria," van Putten said.

How the investment in the option is structured and evaluated is critical. Mechanisms that can keep upfront investments low, recognize failure quickly, and pull the plug on the project can increase the options value and reduce risks. This is what the framework created by MacMillan and van Putten helps to do, using discovery driven planning to make assumptions and milestones explicit.

A Competitive Advantage

Such financial tools can offer companies a significant advantage over rivals. MacMillan remembers when companies first started implementing NPV to evaluate returns on projects back when he was an engineer in South Africa in the 1950s. "Mobil used NPV at the time," he said. "The firms that picked up NPV were able to make more effective long-term investment decisions than competitors, pulling ahead of rivals who weren't using it. Those firms that develop methodologies for evaluating and pursuing uncertain investments that are rich in opportunity, while controlling risk, will inexorably outperform more timid competitors who do not. These companies will be rewarded by their investors in the form of increases in the price of the firm's stock."

   

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