Valuing Risky Projects with Real Options: The Value of High-Risk but Potentially High-Return Technology Projects Can Be Calculated with Boeing's New Real-Option Algorithm

By Mathews, Scott | Research-Technology Management, September-October 2009 | Go to article overview

Valuing Risky Projects with Real Options: The Value of High-Risk but Potentially High-Return Technology Projects Can Be Calculated with Boeing's New Real-Option Algorithm


Mathews, Scott, Research-Technology Management


Project flexibility is inherently valuable. Profitability increases with the ability to change the direction of a project as knowledge is accumulated during the design phase. However, traditional project valuation-modeling methods, such as net present value (NPV), or, as it is occasionally termed, discounted cashflows (DCF), do not appropriately value flexibility or quantify risk. A major shortcoming of NPV analysis is that it fails to recognize that management has flexibility to alter the path of a project, and thus increase overall project value.

In the capital markets sophisticated financial options accurately capture the tradeoff between return and risk to reflect fair market value for securities worth billions of dollars. An options trader would lose his shirt using NPV in the capital markets, so why aren't options more common in the corporate world? Until recently, option techniques were considered too complex to apply to corporate strategic investments. This article introduces a new real options approach developed at Boeing in which these challenges have been resolved through the availability of new spreadsheet add-in software.

Boeing's real option method provides technologists with investment and risk modeling tools and methods that can be incorporated alongside standard systems engineering design modeling techniques. The real option method and its extensions provide a mathematical foundation for a scientific and "engineering-like" approach to identifying risk and quantifying impact. In turn, they enhance the technology managers' level of confidence in reducing risk through targeted allocation of mitigation funds, and help to shape project value outcomes that increase the likelihood of achieving strategic objectives.

Business Case for an Air Freighter Project

To illustrate a real options valuation, let us first examine a project using a simple business case analyzed from an NPV approach. Imagine Boeing has the opportunity to design and build a small aircraft specialized for air cargo transport. This case closely parallels one Boeing asked to be evaluated by a class of students in the Global Integrated System Engineering (GISE) graduate certificate program at the University of Washington.

There is a rapidly expanding market for high-value goods that are shipped efficiently from airports near a manufacturer and directly to airports near consumer market outlet locations. Historically, freighter planes were converted from older passenger planes. Inefficiency in design and weight of converted freighters makes the cost of transported cargo, as measured by ton-mile, uncompetitive with cargo transported by truck or by ship. A new specialized freighter might be competitive for transporting luxury goods. However, the specialty freighter remains a risky investment proposition because the air cargo market is difficult to forecast and therefore unit sales and price forecasts can vary greatly depending upon assumptions about the market.

An actual Boeing business case for an air freighter is complex, involving many factors, such as fuel price volatility, competition and the global economic environment. However, the valuation concepts presented in this paper can be sufficiently illustrated with the following simplified business case.

Table 1 sets forward example projections of revenues and costs using a most-likely NPV scenario based on assumptions about product strategy and market reception. The engineers and marketing analysts are requesting authorization to spend $75M (million) in R&D expenses over the next three years. The objective is to reduce uncertainty in order to be better informed about whether to launch the product. The funding will enable the engineers to develop a preliminary design and better determine recurring and nonrecurring costs. Meanwhile, the marketing analysts will obtain a better estimate on the unit quantity and price of the air freighter. …

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