Real Options Analysis in Strategic Information Technology Adoption

Real Options Analysis in Strategic Information Technology Adoption

Xiaotong Li (University of Alabama, USA)
DOI: 10.4018/978-1-60566-026-4.ch511
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Abstract

Many information resource managers have learned to be proactive in today’s highly competitive business environment. However, limited financial resources and many uncertainties require them to maximize their shareholders’ equity while controlling the risks incurred at an acceptable level. As the unprecedented development in information technology continuously produces great opportunities that are usually associated with significant uncertainties, technology adoption and planning become more and more crucial to companies in the information era. In this study, we attempt to evaluate IT investment opportunities from a new perspective, namely, the real options theory. Its advantage over other capital budgeting methods like static discounted cash flow analysis has been widely recognized in analyzing the strategic investment decision under uncertainties (Amram & Kulatilaka, 1999; Luehrman, 1998a, 1998b). Smith and McCardle (1998, 1999) further show that option pricing approach can be integrated into standard decision analysis framework to get the best of the both worlds. In fact, some previous IS researches have recognized the fact that many IT investment projects in the uncertain world possess some option-like characteristics (Clemsons, 1991; Dos Santos, 1991; Kumar, 1996). Recently, Benaroth and Kauffman (1999) and Taudes, Feurstein and Mild (2000) have applied the real options theory to real-world business cases and evaluated this approach’s merits as a tool for IT investment planning. As all real options models inevitably depend on some specific assumptions, their appropriateness should be scrutinized under different scenarios. This study aims to provide a framework that will help IS researchers to better understand the real options models and to apply them more rigorously in IT investment evaluation. As the technology changes, the basic economic principles underlying the real options theory do not change. We do need to integrate the IT dimension into the real options based investment decision-making process. Using electronic brokerage’s investment decision in wireless technology as a real-world example, we show the importance of adopting appropriate real options models in IT investment planning. By specifically focusing on the uncertainties caused by IT innovation and competition, our study also gives some intriguing results about the dynamics between IT adoption and the technology standard setting process.
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Real Options Theory

It is generally believed that the real options approach will play a more important role in the highly uncertain and technology driven digital economy. Before reviewing the real options literature body that is growing very rapidly, we use an example to give readers an intuitive illustration of the values of real options and their significance in financial capital budgeting.

Key Terms in this Chapter

Net Present Value (NPV): The present value of an investment’s future net cash flows minus the initial investment.

Option: The right, but not the obligation, to buy or sell an asset by a pre-specified price on before a specified date.

Switching Costs: Switching costs refer to the hidden costs consumers face when switching from one product or technology to another in the marketplace.

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