Abstract
Though IT investments are risky by nature, most of the traditional investment valuation models do not have risk in account, leading to erroneous choices. This chapter bases itself in the dogma that flexibility is the key to handle the uncertainty and risk of the future, and therefore is also a philosophy that must be in the very foundations of IT investments, since IT is the basic foundation of so many businesses. How do we value a risky IT investment is the underlying subject of this chapter. Having the previous dogma as a basis, the authors state that flexibility is a vaccine against risk. As such, this flexibility must have a value. The problem they attempt to solve in this chapter is the quantification of such value. To achieve this goal, the authors propose a real options-based framework to value IT investments, having risk in account.
TopIntroduction
The pure Taylorism saw its end on October 24, 1929 – the Black Thursday – when the Wall Street Stock Market crashed yet again, this time with violence (Henin, 1986).
Years later, in the 80’s, Michael Porter popularized the ideas of the value chain, focused on maximizing value creation and minimizing costs (Porter, 1985) which, in the end, were exactly the same goals of Taylor.
As an example, the Ford Motor Company applied Taylor’s methodology and was able to implement a Just-In-Time production, so called “Dock to Factory Floor” since it demanded an almost inexistent warehouse stock.
Now what is wrong with Taylorism or Porter’s value chain? Nothing. The problem is not with the models, but rather on how Ford and others applied them. Among other problems, Ford failed to create a value chain starting at the customer and ending at the suppliers, culminating in a super production crisis.
Japan understood this chain issue back in the 50’s, and met an astonishing growth in the 60’s, known as the Japanese Miracle.
As an example, by the middle of the past century, the Toyota Motor Company implemented a new methodology for building cars also with smaller economic lot sizes but, more important, targeted for flexible factories capable of shifting production in a matter of days.
More recently, we have other success examples, such as Zara, which was able to create a flexible production, parameterized by its costumers’ demand, collected on a daily basis.
As odd it might seem, usually only marketing disciplines have this market or customer-oriented value chain as a basic pillar. Only with this view, a competitive advantage can be sustained.
Even odder, we are constantly assisting a dummy first mover’s dictatorship. For instance, take the example of the third generation (3G) mobile communications. As soon as the first communications operator introduced 3G services, all the others followed, investing heavily on the infrastructure. However, there is still no market demand for 3G (Hearts, 2002; 3G.co.uk., 2004).
Bottom line, companies need to be flexible to provide customers with products that meet their ever changing needs. Unfortunately, mankind doesn’t deal well with flexibility, or it wouldn’t have only started accentuating its evolution 10,000 years ago, when it got sedentary, and thus more stable, in Neolithic.
Key Terms in this Chapter
Custom Software Development: The process by which an information system is developed, not recurring to any pre-existing package or solution sold as a product. Used when the required information system is too specific for any pre-existing product to be applicable, or when the information system needs to be flexible to cope with change or fuzzy requirements.
Risk: Denotes the potential impact on an attribute of value that a future event may cause. In finances, represents the variability of returns a given investment may have. In the context of this chapter, risk is reflected, among other variables, in the uncertainty of the requirements a custom enterprise application may need to fulfill in the future.
Volatility: A measure of the variation a given asset may have on its price over a given time period. In the context of this chapter, volatility is the percentage of needed changes or extensions a custom enterprise application may need, when compared with its initial state.
Adjusted Present Value (APV): The APV extends the basic NPV to account for related investments that have impact on the organization’s capital structure. Is usually calculated adding the basic NPV of the investment and the related investments NPV.
Option: Is a contract that gives the holder the right but not the obligation to buy or sell the underlying asset for a certain price at a certain date.
Real Option: An opportunity that becomes available after a particular investment is made. The opportunity can be exercised or not, thus leading to impacts on the investment value or not.
Flexibility: The ability to adapt to expected and unexpected changes in the environment. In the context of this chapter, flexibility is quantifiable by the amount of changes introduced in a custom enterprise application over a given time period, as measured by its complexity.
Net Present Value (NPV): Is the present value of an investment in the future, usually calculated by the difference between the present monetary values of the costs and the benefits of the investment.