Managing Information Technology Investment Risk: A Real Options Perspective

Abstract:

• Past information systems research on real options has focused mainly on evaluating information technology (IT) investments that embed a single, a-priori known option.
  • However, since real options are not inherent in any IT investment, they usually must be planned and intentionally embedded in a target IT investment in order to control various investment-specific risks, just like financial risk management uses carefully chosen options to actively manage investment risks.
  • Moreover, when an IT investment involves multiple risks, there could be numerous ways to reconfigure the investment using different series of cascading (compound) options.
  • In this light, we present an approach for managing IT investment risk that helps to rationally choose which options to deliberately embed in an investment so as to optimally control the balance between risk and reward.
  • We also illustrate how the approach is applied to an IT investment entailing the establishment of an Internet sales channel.

Introduction:

• Clemons and Weber [10] have recognized early on the role that real options (deferral, piloting, outsourcing, abandonment, etc.) could play in managing information technology (IT) investment risk:
  • “A number of forms of risks arise in undertaking [strategic] IT programs. … These risks need to be recognized, and in some cases, the risks can be hedged, through out-sourcing and joint development, or by investing sequentially and scaling the project up or down as uncertainties become resolved.” (p. 21)
• They also illustrate how certain investments have, or could have, been configured to manage risk using real options.
  • “The initial versions of Merrill’s Cash Management Account and McKesson’s Economost were initially rolled out as prototype versions […]. When market response permitted more precise and accurate estimation of their impact, these prototypes were replaced by full implementations. … In the early 1980s, Manufacturers Hanover built GEONET, a $300 million international X.25-based telecommunication network […].
  • Actual volumes reached only 50 percent of the estimates, well below capacity, and well below the level needed for recovery of the system’s cost. And yet, since virtually all of the technology was acquired from a third-party provider of packet-switching services, it is likely that initial capacity could have been leased.
  • Necessary expertise would have been acquired, and the bank could have begun conversion of existing applications as well as development of new applications to exploit packet-switching technology.
  • This, too, is equivalent to a call option: if demand had materialized, the bank would have been in a position to respond rapidly with its own network.” (p. 22)
• With the growing acceptance of Real Options Analysis (ROA) as a modern approach to investment analysis [2,14,32], several information systems (IS) researchers have tried to apply ROA to IT investment decision-making.
  • Early proposals were put forth by Dos Santos [15] and Kambil et al. [19].
  • More recent IS work operationalizes 2 these proposals. For example, Benaroch and Kauffman [3] examine the theoretical foundations of ROA and their relevance to IT investments.
  • Additionally, several published case studies use ROA:
    • to analyze the growth opportunities that prototyping yields relative to the launching of a new IT infrastructure [33],
    • to study an IT investment in document image processing and workflow management [23],
    • to determine the optimal timing of IT investment in point-of-sale debit card services [4], and
    • to justify an IT platform adoption decision to upgrade from SAP/R2 to SAP/R3 [31].
• There is one notable characteristic of this IS research.
  • All the work cited above considers only IT investments that embed a single a-priori known option.
  • That is, only once the option embedded in a target IT investment has been recognized, does this work use ROA to evaluation the recognized option.
  • In practice, however, real options are not inherent in any IT investment.
  • Rather, they usually must be planned and intentionally embedded in a target IT investment so as to enable a beneficial configuring of the investment.
  • Additionally, as we show shortly, optimally configuring an IT investment may require embedding in the investment a series of cascading (compound) options that are difficult to value.
  • These two complexities remain to be addressed by IS research on real options.
• This paper presents an approach that uses ROA to actively configure IT investments for the purpose of managing the balance between their value and risk.
  • More precisely, building on the notion that real options can control IT investment risk [10], the approach uses ROA to decide on how to optimally configure an IT investment by creating the set of options that maximally contributes to that investment value. Before we proceed, we must distinguish between two classes of real IT options: operating options that allow to flexibly change investment configuration features (timing, scale, scope, etc.), and strategic growth options that spawn new investment opportunities.
  • The approach we present focuses on the use of operating options; however, we discuss the issues involved in extending the approach to growth options as well.
• The rest of the paper is organized as follows.
  • Section 2 motivates the need for the proposed approach by looking at the modeling and valuation issues involved in optimally configuring a realistic Internet-based IT investment example.
  • Section 3 reviews the links between three fundamental concepts underlying our approach: risk, operating options, and risk management.
  • Section 4 presents the approach along with a detailed illustration of how it is applied to the Internet-based investment example.
  • Section 5 discusses strengths and limitations of the approach as well as presents key questions for future research. Section 6 offers some concluding remarks.

IT Risks-Options Mapping

Steps in the Option-Based Approach to Managing IT Investment Risk

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IT investment risks mapped to operating options that could mitigate them (Cells painted in gray correspond to risks and options relevant to the ISC investment.)

Key Necessary and Sufficient Existence Conditions:

• Defer:
  • Investment opportunity is not "now-or-never"
  • Investing firm is operating as a monopoly, or it is not exposed to a serious competitive preemption threat
  • Deferral can resolve some uncertainties
• Stage/development:
  • Full-scale development effort is decomposable into a series of steps that can be performed one at a time
  • Certain steps in the development effort are more risky than others
  • Series of development steps can be performed non-linearly, with the most risky steps moved at early or as late as possible in the building stage
• Explore (pilot/prototype):
  • Investment can be made operational at a reduced scope of a pilot / prototype
  • Pilot / prototype can be developed using existing resources at a fraction of the full-scale investment cost (i.e., relatively minor investment in resources is needed)
  • Some risks can be investigated without making the full-scale investment
  • Killing an operational pilot / prototype carries no reputation, competitive or regulatory consequences
• Expand/Contract:
  • It is possible to increase / lower the investment “output” rate per unit time or to lengthen / shorten the investment life
  • Implementation with higher / lower maintenance costs relative to initial development costs is viable – this feature allows to lengthen / shorten the investment life or to expand / contract the operating scale by increasing / lowering maintenance expenditures
  • Implementation with higher / lower variable operating costs relative to the fixed operating costs is viable
  • Expanding / contracting the scope or scale of capabilities the investment yields can increase the investment payoffs / lower the operating (maintenance) expenditures or improve the capabilities’ quality
• Abandon:
  • Alternative implementations exists with different “acquisition”-cost to “resell”-cost ratios
  • Investment resources have alternate uses
  • It is possible to kill the operational investment without sever regulatory, competitive or reputation consequences
• Outsource/development:
  • Investment does not involve core (or strategic) business processes and capabilities
  • Third parties with different investment-realization (development) risk profiles exist
• Lease:
  • Some investment resources can be leased (hardware, networking, software, etc)
  • Third parties with different resource-ownership risk profiles exist (i.e., they are willing to offer cancelable lease contracts because the salvage value of leased resources is greater for them than for the firm)

Conclusion:

• This paper expands IS research on the use of ROA in the context of IT investment decision-making.
  • Previous IS work in this area has focused mainly on using ROA to evaluate options already known to be embedded in an IT investments.
  • The present paper focuses on issues pertaining to how to apply ROA from a risk management perspective.
  • In particular, this paper presents an approach that exploits real option concepts in order to optimally configure an IT investment in light of its risks.
  • The paper also presents a relevant illustration of the approach in action.
  • Finally, a critical examination of the approach and the accompanying example helps to identify several issues along which the approach can be expanded.
  • Future research aimed at addressing these issues could expand our work in two ways.
  • It could broaden the scope of our approach to handle IT investments involving growth options and, in turn, portfolios of IT investments.
  • Additionally, it could permit developing decision support tools that would facilitate applying the approach with greater ease, even to the most complex IT investments.