Valuation of Information Technology Investments as Real Options

Abstract

This article describes a methodology for evaluating information technology investments using the real options approach. IT investment projects are categorized into development and acquisition projects depending upon the time it takes to start benefiting from the IT asset once the decision to invest has been taken. A couple of models that account for uncertainty both in the costs and benefits associated with the investment opportunity are proposed for each of these project types: a) The first model is suited for the evaluation of IT projects in which a firm invests an uncertain amount of money over an uncertain period of time to develop an IT asset that can be sold to third parties or used for its own purposes.In this model, the stochastic cost function incorporates the technical and input cost uncertainties of Pindyck's formulation for investments of uncertain cost, the uncertainty in the time required for developing the IT asset and the possibility that a catastrophic event causes the permanent abandonment of the development effort. Benefits are summarized in the value of an underlying asset that also evolves stochastically over time. b) The second model is suited for the valuation of investments in which a firm acquires an IT asset for its own use. In this model, investment is assumed to be instantaneous and the benefits associated with the investment are represented as a stream of differential cash flows over a period of time in which the technology is considered to be useful. This type of project is similar to an exchange option in which the exercise price (the cost) and the asset received are both uncertain. In contrast with previous work, both models take into consideration the particular decay in costs experienced by some IT assets (e.g., hardware) over time even if no investment takes place. The paper also illustrates the application of the IT acquisition model for the valuation of a real world example involving the deployment of point-of-sale debit services by a banking network in New England.