To discover the Option sensitivity to cost of capital, the different values of the project and the options corresponding to different values of cost of capital are calculated. The results are in figure 4.9. The figures 4.9a and 4.9b show the NPV of the project DMZ with option to delay/abandon. The value of the project declines with higher cost of capital, which is
(a) Option to Delay Sensitivity to WACC (b) Option to Abandon Sensitivity to WACC
Figure 4.9: Projects Sensitivity to WACC
expected because the higher discount rate means less value of the money in the present. In case of the option to delay, the increase in discount rate means less value of the expected savings, in addition to the effect of the delay on the payment, because waiting an extra year means discounting for extra year.
In the case of option to abandon, the decline in the project value stems from the decline in the investment value for two reasons. First, the decline in the value of the expected savings reduces the projects value because of the higher discount rate. Second, the probability of abandoning the project means the loss of probable savings which also contributes to the decline in the projects value. From the comparison between the two projects, one can
conclude that the project with option to delay does not reckon for the possibility of giving up the cash savings, unlike the project with the option to abandon, this explains the higher value of the project with option to delay. However, the project with the option to delay exhibits higher sensitivity when the discount rate is between zero and WACC=10% where it rapidly goes frome9.39 million to zero, then it declines gradually to e-5.24 million at WACC value of 8%. The project with option to abandon declines from e6.46 million at WACC=0% to zero at WACC=10%, later it declines to e-4.57 million. These changes suggest that the project with option to delay is more sensitive to discount rate than the latter.
4.6.1 Sensitivity to Probability
To find the impact of probability on the project and option value, the project values corresponding to different probabilities at different phases of the project should be found.
Figure 4.10: Option to delay Sensitivity to probability
The option to delay in figure 4.10, it is noticeable that the project value declines with the increase in the probability to delay the project, this could be related to the discount factor that causes the invested money value to decline. In this case it is also noticeable that raising the probability of success of the project by making the probability of delaying the project zero, makes the project value approach the NPV calculated using the traditional DCF.
In the case of option to abandon, it is clear that the lower the probability to abandon, the higher the value of the project, figure 4.11. On the other hand, it is clear that the earlier in the projects the projects probability to success are raised, the higher the impact on the overall projects value, this can be related to the, it is also noticeable that the projects value is most affected by the probability value at the PoC phase, this has to do with the size of expenditure at this phase where the most expenditures take place at the start of the PoC.
In figure 4.12 the options value increases the lower the probability to abandon the project after the first phase, and this also applies to the probability of abandoning the project at a later phase, where it is noticeable that the higher the probability of success the higher the options value.
Figure 4.11: Option to abandon- Projects value sensitivity to probability
Figure 4.12: Option to Abandon-Sensitivity to Probability
When the probability of success of the project was raised to 100% in all stages, the value of the project went up to e3433914, which is similar to the NPV calculated using the traditional DCF. This is of course the state where the expenditures and the pay offs were 100% certain.
4.6.2 Sensitivity to Changes in Payoffs
The case was evaluated assuming fixed cash savings, but this is not an accurate assump- tion, therefore the projects value was calculated multiple times assuming an 0.01 yearly increase/decrease in the cash savings. The results were not different from expectations because it is axiomatic that if revenues increase, the projects value will increase and vise versa.
Thus, in both the option to abandon and the option to delay, the increase in growth rate of revenue/cash savings causes the projects NPV to increase, and consequently the option value increases, figure 4.13.
Studying the effects of discount rate, the probability of exercising the option and the growth rate, one can use these results to control the direction of the project in the sense that projects stakeholders can in advance monitor the circumstances surrounding the project to minimize the probability of failure thus increasing the value of the project and avoiding the delay or abandonment of the project. In case of the option to delay, extrapolating the discount rates for the coming years may contribute to the decision to
(a) Option to Delay (b) Option to Abandon
Figure 4.13: Sensitivity to change in payoffs
proceed or delay the project to a year with better economic situation. The results of the sensitivity analysis done on the project can be found in the appendix D
This chapter was an analysis of a case study in ORG. First an evaluation was approached by using the risk platform to create the risk adjusted project budget. By creating the risk adjusted budget, an answer was provided to the research sub question ”How can Risk quantification contribute to the projects valuation”. Later, two types of real options were investigated to explore the applicability of the concept of real options and to investigate the possibility of using the real options as a management approach to risk management. This chapter also provided an answer to the research sub question ”How can management approach of risk management contribute to the projects valuation problem?”. This ques- tion was answered partly in section 2.4, where this section explained the real options and how they can be evaluated, and in this last chapter the project DMZ was evaluated using the scenario analysis for real options valuation.
Chapter 5
Discussion
The focus of this research is the risk management in IS/IT projects and its role in projects valuation, in addition to the role of risk quantification in the IS/IT projects valuation. The NPV approach takes partly into account the financial risk, another risks attached to projects are not always fully covered.
In this research the risk platform is an example of the evaluation approach, because it estimates the expected risks and assigns values to them. The real options is the manage- ment approach because it is meant as a tool for managers to be prepared for possible risks and to respond accordingly, which helps on the level of decision making.
It cannot be said that one method excludes the other, it is also not correct to say that one method is preferred to the other.The real options as a management approach is used when there is uncertainty involved in the project, while the evaluation approach can be used for all projects because it has to do with the private risks in a project, thus it is involved in risk management and avoiding failures of the project regardless of the market risks and external factors.
5.1
Projection On The Case Study
In the case study of ORG and the project DMZ, the NPV using DCF is e3.434 million, and the duration was estimated to be 2 years. Later it turned out to be a very optimistic estimation because as was learned later the project lasted much longer than planned, and had the actual costs exceeding the budget.
Adding the risk adjustment reduced the projects NPV to e1.303 million, and added 56 weeks to the estimated time. While embedding an option to delay in the project changed the NPV estimation toe1.121 million, and the option to abandon reduced the projects value toe785.3 K.
In fact, the project DMZ, did suffer multiple delays, it faced risk events, and the value calculated using real options is closer to reality than the NPV, and the actual duration and delays did take place. These facts suggest support the arguments of Ir. Kuiper about the need to quantify risk and add its value to the project budget.