# Technology investment decision-making under uncertainty

- 1.2k Downloads
- 8 Citations

## Abstract

Innovations involving information technology (IT) provide potentially valuable investment opportunities for industry and government organizations. Significant uncertainties are associated with decision-making for IT investment though, a problem that senior executives have been concerned about for a long time. The uncertainties include consumer, market and regulatory responses, IT-driven changes in operational and transactional performance, technology standards and competition, and future market conditions. All these things have an impact on organizations’ willingness to adopt. As a result, traditional capital budgeting, investment experience, and intuition have not been very effective in IT investment decision-making. We propose a new option-based stochastic valuation modeling approach for IT investment under uncertainty that incorporates a mean reversion process to capture cost and benefit flow variations over time. We apply the proposed approach in two industry settings: to a large-scale IT investment in the consolidation of data marts at a major airline, and to a mobile payment system infrastructure investment on the part of a start-up. The applications supported the evaluation of the proposed methods, and offered some illustrations about the kinds of managerial insights that can be obtained. We also report on several extensions that demonstrate how the creation of useful management findings from the modeling approach can be supplemented with project value sensitivity analysis and the use of simulation-based least-squares Monte Carlo valuation. The findings are useful to assess the power and value of the approach.

## Keywords

Decision-making under uncertainty Economic analysis IT investment Mean reversion process Mobile payments Real option analysis Technology valuation## Notes

### Acknowledgments

We acknowledge the following people who offered comments at the conferences and workshop, including Eric Clemons, Juan Feng, Kim Huat Goh, Kunsoo Han, Sangpil Han, Kailung Hui, Eric Johnson, Mei Lin, Holger Schrodl, Avi Seidmann, Richard Shang, Hock Hai Teo, Kanliang Wang, Sunil Wattal, Thomas Weber, Yinping Yang, Byungjoon Yoo and Jennifer Zhang. We also benefited from discussions with Zhiyong Cheng, Ying Ding, Ming Gao, Jianfeng Hu, Jianhui Huang and Peiran Zhang. We also appreciated comments from the co-editors, Ray Patterson and Erik Rolland, and anonymous reviewers at *Information Technology and Management.*

## References

- 1.Alvarez LH, Stenbacka R (2007) Partial outsourcing: a real options perspective. Int J Ind Org 25(1):91–102CrossRefGoogle Scholar
- 2.Amram M, Kulatilaka N (2000) Strategy and shareholder value: the real options frontier. J Appl Corp Finance 13(2):8–21CrossRefGoogle Scholar
- 3.Andersen LBG (2000) A simple approach to the pricing of Bermudan swaptions in the multi-factor LIBOR market model. J Comp Finance 3(1):5–32Google Scholar
- 4.Banker, RD, Wattal S, Plehn-Dujowich JM (2010) Real options in information systems: a revised framework. In: Proceedings of 31st International Conference on Information Systems, St. Louis, MO, DecemberGoogle Scholar
- 5.Barr A, MacMillan D, Rusli EM (2014) Mobile payments startup discusses possible sale. Wall St J, April 21Google Scholar
- 6.Benaroch M (2002) Managing information technology investment risk: a real options perspective. J Manage Inf Syst 19(2):43–84Google Scholar
- 7.Benaroch M, Jeffery M, Kauffman RJ, Shah S (2007) Option-based risk management: a field study of sequential information technology investment decisions. J Manag Inf Syst 24(2):103–140CrossRefGoogle Scholar
- 8.Benaroch M, Kauffman RJ (1999) A case for using real options pricing analysis to evaluate information technology project investment. Inf Syst Res 10(1):70–86CrossRefGoogle Scholar
- 9.Benaroch M, Kauffman RJ (2000) Justifying electronic banking network expansion using real options analysis. MIS Q 24(2):197–225CrossRefGoogle Scholar
- 10.Benaroch M, Lichtenstein Y, Robinson C (2006) Real options in information technology risk management: an empirical validation of risk-option relationships. MIS Q 30(4):827–864Google Scholar
- 11.Benaroch M, Shah S, Jeffery M (2006) On the valuation of multistage information technology investments embedding nested real options. J Manag Inf Syst 23(1):239–261CrossRefGoogle Scholar
- 12.Bloch M, Blumberg S, Laartz J (2012) Delivering large-scale IT projects on time, on budget, and on value. McKinsey, New YorkGoogle Scholar
- 13.Bloch M, Hoyos-Gomez A (2009) How CIOs should think about business value. McKinsey, New YorkGoogle Scholar
- 14.Bollen N (1999) Real options and product life cycles. Manag Sci 45(5):670–684CrossRefGoogle Scholar
- 15.Boyle PP, Broadie M, Glasserman P (1997) Monte Carlo methods for security pricing. J Econ Dyn Control 21(8–9):1276–1321Google Scholar
- 16.Brandenberger AM, Nalebuff B (1996) Co-opetition: a revolutionary mindset that combines competition and cooperation. Doubleday, New YorkGoogle Scholar
- 17.Brennan M, Schwartz ES (1977) The valuation of American put options. J Finance 32(2):449–462CrossRefGoogle Scholar
- 18.Brennan M, Schwartz ES (1978) Finite difference methods and jump processes arising in the pricing of contingent claims: a synthesis. J Financ Quant Anal 13(3):461–474CrossRefGoogle Scholar
- 19.Brigo D, Dalessandro A, Neugebauer M, Triki F (2007) A stochastic processes toolkit for risk management. Department of Mathematics, Imperial College, LondonGoogle Scholar
- 20.Clemons EK, McFarlan FW (1986) Telecomm: hook up or lose out. Harv Bus Rev 64(4):91–97Google Scholar
- 21.Crunchbase (2014) Square: company overview, July 2Google Scholar
- 22.Cutler KM (2010) Twitter creator Dorsey’s Square counts Mayer, Rose, Dyson among angels. VB News, January 26Google Scholar
- 23.Dai Q, Kauffman RJ, March ST (2007) Valuing information technology infrastructures: a growth options approach. Info Technol Manag 8(1):1–17CrossRefGoogle Scholar
- 24.Dixit AK, Pindyck RS (1994) Investment under uncertainty. Princeton Univ Press, PrincetonGoogle Scholar
- 25.Dos Santos BL (1991) Justifying investments in new information technologies. J Manag Info Syst 7(4):71–90Google Scholar
- 26.Duliba KA, Kauffman RJ, Lucas HC Jr (2000) Appropriating value from computerized reservation system ownership in the airline industry. Org Sci 12(6):702–728CrossRefGoogle Scholar
- 27.Fenn J, Linden A, Cearley D (2000) Hype cycle for emerging technologies. Monthly Res Rev, Gartner, Stamford, CTGoogle Scholar
- 28.Fichman RG (2004) Real options and IT platform adoption: implications for theory and practice. Info Syst Res 15(2):132–154CrossRefGoogle Scholar
- 29.Fouque JP, Papanicolaou G, Sircar R (2000) Derivatives in financial markets with stochastic volatility. Cambridge Univ Press, CambridgeGoogle Scholar
- 30.Glasserman P (2004) Monte Carlo methods in financial engineering. Springer, New YorkGoogle Scholar
- 31.Griffith K (2014) Square might be making more on transaction fees than anybody thought. BusinessInsider.com, May 15
- 32.Gustin M (2011) Google bursts onto mobile-payments scene with wallet, offers. Wired, May 26Google Scholar
- 33.Harmantzis FC, Tanguturi VP (2007) Investment decisions in the wireless industry applying real options. Telecommun Policy 31(2):107–123CrossRefGoogle Scholar
- 34.Heinrich B, Muller MP, Stockl SM, Zimmermann S (2013) A step towards a well-founded valuation of real options on IT investments: a multidisciplinary literature review. Working paper, University of Innsbruck, Innsbruck, AustriaGoogle Scholar
- 35.Huchzemeier A, Loch CH (2001) Project management under risk: using the real options approach to evaluate flexibility in R&D. Manag Sci 47(1):85–101CrossRefGoogle Scholar
- 36.Hughes N (2014) Mobile payments still facing the same big obstacles. Street Fight, October 28Google Scholar
- 37.Jaimungal S, Souza M, Zubelli J (2013) Real option pricing with mean-reverting investment and project value. Eur J Finance 19(7–8):625–644CrossRefGoogle Scholar
- 38.Jensen R (1988) Information cost and innovation adoption policies. Manag Sci 34(2):230–239CrossRefGoogle Scholar
- 39.Johnson D (1997) The triangular distribution as a proxy for the beta distribution in risk analysis. Statistician 46(3):387–398Google Scholar
- 40.Kauffman R, Kumar A (2008) Network effects and embedded options: decision-making under uncertainty for network technology investments. Inf Technol Manag 9(3):149–168CrossRefGoogle Scholar
- 41.Kauffman RJ, Li X (2005) Technology competition and optimal investment timing: a real option perspective. IEEE Trans Eng Manag 52(1):15–29CrossRefGoogle Scholar
- 42.Kauffman RJ, Liu J, Ma D (2013) Technology investment decision-making under uncertainty: the case of mobile payment systems. In: Sprague R (eds) Proceedings of 46th Hawaii International Conference on System Science, Maui, HI. IEEE Computer Society Press, WashingtonGoogle Scholar
- 43.Kauffman RJ, Walden E (2001) Economics and electronic commerce: survey and directions for research. Int J Electron Commer 5(4):5–116Google Scholar
- 44.Kim YJ, Sanders LG (2002) Strategic actions in information technology investment based on real option theory. Decis Support Syst 33(1):1–11CrossRefGoogle Scholar
- 45.Kotz S, van Dorp JR (2006) A novel method for fitting unimodal continuous distributions on a bounded domain utilizing expert judgment estimates. IIE Trans 38(5):421–436CrossRefGoogle Scholar
- 46.Longstaff F, Schwartz ES (2001) Valuing American options by simulation: a simple least-squares approach. Rev Financ Stud 14(1):113–147CrossRefGoogle Scholar
- 47.Lucas HC (1999) Information technology and the productivity paradox. Oxford Univ Press, New YorkGoogle Scholar
- 48.Mariotti M (1992) Unused innovations. Econ Lett 38(3):367–371CrossRefGoogle Scholar
- 49.Mason R, Weeds H (2010) Investment, uncertainty, and pre-emption. Int J Ind Org 28(3):278–287CrossRefGoogle Scholar
- 50.McCardle KF (1985) Information acquisition and the adoption of new technology. Manag Sci 31(11):1372–1389CrossRefGoogle Scholar
- 51.McDonald R, Siegel D (1986) The value of waiting to invest. Q J Econ 101(4):707–728CrossRefGoogle Scholar
- 52.Mendelson H, Pillai R (1999) Industry clockspeed: measurement and operational implications. Manuf Serv Oper Manag 1(1):1–20Google Scholar
- 53.Merton RC (1976) Option pricing when underlying stock returns are discontinuous. J Financ Econ 3(1–2):125–144CrossRefGoogle Scholar
- 54.Merton RC (1988) Applications of option pricing theory: twenty-five years later. Am Econ Rev 88(3):323–349Google Scholar
- 55.Merton RC (1992) Continuous-time finance. Wiley-Blackwell, CambridgeGoogle Scholar
- 56.Montgomery KC (2012) Testimony on developing the framework for safe and efficient mobile payments. U.S. Senate Hearing, WashingtonGoogle Scholar
- 57.Nash KS (2000) Companies don’t learn from previous IS snafus. Computerworld, October 30Google Scholar
- 58.Office of the Chief Information Officer (2014) IT investment performance measurement and performance reporting policy. U.S. Department of Commerce, WashingtonGoogle Scholar
- 59.Parkinson M (1977) Option pricing: the American put. J Bus 50(1):21–36CrossRefGoogle Scholar
- 60.Perez S (2014) ISIS, the mobile payments initiative from AT&T, Verizon & T-Mobile, launches across the U.S. TechCrunch, November 14Google Scholar
- 61.Pindyck RS (1993) Investments of uncertain cost. J Financ Econ 34(1):53–76CrossRefGoogle Scholar
- 62.Pymnts.com (2014) It’s only a matter of time: EU mobile payments regulation. Cambridge, MA, November 14Google Scholar
- 63.Reinganum JF (1981) On the diffusion of new technology: a game theoretic approach. Rev Econ Stud 48(153):395–405CrossRefGoogle Scholar
- 64.Romann R (2014) Cash is trash: the future of mobile payment. Forbes, January 23Google Scholar
- 65.Rusli EM (2011) Mobile payments start-up Square raises $100 million. Dealbook, New York Times, June 29Google Scholar
- 66.Sarkar S (2003) The effect of mean reversion on investment under uncertainty. J Econ Dyn Control 28(2):377–396CrossRefGoogle Scholar
- 67.Schwartz ES (1997) The stochastic behavior of commodity prices: implications for valuation and hedging. J Finance 52(3):923–973CrossRefGoogle Scholar
- 68.Schwartz ES, Zozaya-Gorostiza C (2003) Investment under uncertainty in information technology: acquisition and development projects. Manag Sci 49(1):57–70CrossRefGoogle Scholar
- 69.Singh C, Shelor R, Jiang J, Klein G (2004) Rental software valuation in IT investment decisions. Decis Support Syst 38(1):115–130CrossRefGoogle Scholar
- 70.Stein EM, Stein JC (1991) Stock price distributions with stochastic volatility: an analytical approach. Rev Financ Stud 4(4):727–752CrossRefGoogle Scholar
- 71.Stentoft L (2004) Convergence of the least-squares Monte Carlo approach to American option valuation. Manag Sci 50(9):1193–1203CrossRefGoogle Scholar
- 72.Tallon PP, Kauffman RJ, Lucas HC Jr, Whinston AW, Zhu K, Lichtenstein Y (2001) Real options analysis is entirely appropriate for evaluating uncertain it investments. In: Proceedings of 22nd International Conference on Information System, New Orleans, LAGoogle Scholar
- 73.Taudes A (1998) Software growth options. J Manag Inf Syst 15(1):165–185Google Scholar
- 74.Techopitayakul D, Johnson B (2001) ASP-based software delivery: a real options analysis. In: 5th Annual Conference on Real Options Theory Meets Practice, Univ California, Los Angeles, CAGoogle Scholar
- 75.Teece DJ (1986) Profiting from technological innovation: implications for integration, collaboration, licensing and public policy. Res Policy 15(6):285–305CrossRefGoogle Scholar
- 76.Teece DJ (1992) Competition, cooperation, and innovation: organizational arrangements for regimes of rapid technological progress. J Econ Behav Org 18(1):1–25CrossRefGoogle Scholar
- 77.Webster K (2013) Apple’s m-payments strategy: wait and see. Pymnts.com, Cambridge, MA, April 25
- 78.Widman J (2008) IT’s biggest project failures—and what we can learn from them. Computerworld, October 9Google Scholar
- 79.Wilhelm A (2014) Putting Square’s $5B valuation into context. TechCrunch, January 13Google Scholar
- 80.Yang LT (2005) Impact of budget uncertainty on project time-cost tradeoff. IEEE Trans Eng Manag 52(2):167–174CrossRefGoogle Scholar
- 81.Yang SB, Lim JH, Oh W, Animesh A, Pinsonneault A (2012) Using real options to investigate the market value of virtual world business. Inf Syst Res 23(3):1011–1029CrossRefGoogle Scholar
- 82.Zhang SX, Babovich V (2011) An evolutionary real options framework for the design and management of projects and systems with complex real options and exercising conditions. Decis Support Syst 51(1):119–129CrossRefGoogle Scholar