Academic journal article Journal of Information Systems Education

InterCon Travel Health: Case B

Academic journal article Journal of Information Systems Education

InterCon Travel Health: Case B

Article excerpt

1. INTRODUCTION (1)

CIO Richard Nettleson was surprised to learn the outcome of the claim automation system valuation--the project had been passed over because its 5-year NPV was estimated in the range of $2.1-2.5 million. (2) Moreover, the Monte Carlo simulation showed that the project had about a one in four chance of attaining a 5-year NPV of at least $3 million, InterCon's de facto cutoff for funding. These were not good odds. Nevertheless, he believed that the claim automation application was essential for creating effective and efficient business processes, which would become even more critical as the company grew. He felt strongly that this project should receive funding, and that somehow the NPV analysis was missing some of the value of the project.

Nettleson had at least two alternatives. He could argue before the project evaluation committee that the project was critical to future growth, and that it should go forward despite the unfavorable valuation. The committee had been generally unenthusiastic about and unsupportive of such efforts in the past. Moreover, as a committee member, he had recently voted against funding a different project that was advocated on similar grounds. He could potentially lose credibility were he perceived as applying a double-standard.

Another alternative would be to reframe the claim automation project proposal using real options analysis to value the inherent flexibility provided by either successively staging or stopping different parts of the system over time, depending on how the actual circumstances turn out. Nettleson knew that the prior NPV analysis did not consider such flexibility, and he felt that it must have some value. Having recently read about and heard from others about the use of real options in IT capital investment valuation, he was interested in knowing the valuation level that would result from considering the real options inherent in the claim automation project. He was also interested in better understanding how and why real option valuation models are generally considered more complex than DCF models. (3)

In order to proceed, Nettleson realized that he had to do three things. First, he needed to understand option pricing methodologies in general and how these methodologies might be applied to real assets such as an IT development project. After considerable reading and several consultations with his neighbor Michael, who was a finance professor at a nearby university, he wrote a brief primer to formulate and clarify his understanding. Second, he had to re-conceptualize the IT development project in terms of successive stages, so that any stage can be thought of as creating conditions that can inform management whether or not they should proceed to the next stage. Rethinking the IT development project in this way would be useful to show the inherent flexibility behind staging implementation, and to make the connections between staging IT implementation and real option valuation more salient. Finally, Nettleson had to show specific details about how real option valuation could be applied to the specific IT development project in question.

2. A PRIMER ON OPTIONS PRICING (4)

At its base, real options analysis uses techniques and concepts that are similar to those used to price finance options, such as those used to value call and put options on stocks, commodities, or financial instruments. As a result, a short review of financial options may be helpful. (5)

Financial options give a buyer (6) the option, but not the obligation, to buy (call) or sell (put) an underlying instrument such as a stock or commodity at a specified price on a specified date. (7) The specified price is called the strike price, and the specified date is called the expiration date. Between the time that a call (put) option is purchased and the expiration date, the buyer is betting--read hoping--that the current price will rise above (fall below) the strike price to a level that presents a gain situation over and above the cost of the option itself, which is called the premium. …

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