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Valuing Risky Projects with Real Options

OVERVIEW: This article provides technologists with the business-case methods and tools to calculate the value of projects involving risky new technology or markets but that potentially offer higher returns in the long run. A typical business case using NPV analysis is presented for a new product, an air freighter. NPV is first extended to multi-scenario analysis and then to a “what-if” model using Monte Carlo simulation. Finally, a real-option value for the air freighter is calculated. Based on the same concept as traded financial options, a real option is a contingent investment in “real” physical assets such as a corporate technology project. Boeing's new real-option value algorithm, the Datar-Mathews Method, is both intuitive and transparent. It gives technology managers an investment and risk-modeling tool they can incorporate into strategic thinking and contingency planning.