APPLICATION SUCCESS STORY

Analyzing Engineering Projects Using Real Options -- Intelligent Investments in the Face of Uncertainty

By Scott H. Mathews
Mathematical Modeling Analyst
The Boeing Company

Boeing performs extensive financial modeling, a requirement given the technical complexity and the long life cycle of our products. One of the techniques we use is called "Real Options," an advanced financial modeling technique that (1) extends standard net present value (NPV) to evaluate risk-adjusted return on investment and cost-versus-risk issues and (2) optimists R&D and strategic project portfolios. Boeing senior management recognizes that business cases for visionary, strategic projects must go beyond NPV analyses, requiring quantitative data on cost and market uncertainty, analytical insights such as risk-adjusted profits, and conclusions about where to invest to increase the probability of project success.

Real Options allows a corporation to be technologically daring while maintaining fiscal discipline. In other words, Boeing can be a leader in aerospace and satisfy Wall Street at the same time. Options have their origin in the financial markets where traders attempt to place a dollar value on a stream of future "risky" (or "contingent") cash flows. An option is defined as the ability, but not the obligation, to exploit a future profitable opportunity. In engineering terms, an option is a trade space between uncertainty and costs or profits. A Real Option can be thought of as the value of risk-adjusted profits generated by a prospective successful project. Real Options is quickly becoming another engineering tool, that can help determine the worth of investing in a prospective project that has uncertainty such as significant technical risk, or market or sales unpredictability.

A Real Options model, shown in the figure below, was built in Excel and functioned as a trade space to interplay the knowledge and understanding contributed by marketing, finance, and engineering experts. Crystal Ball, an Excel add-in, was used to model technical risk and cost uncertainty ("uncertainty modeling"). A "profit optimizer" was built that calculated "unit price" and "unit sales" to maximize profits. Finally, a feedback loop using a "learning curve" model was included to adjust unit cost based on quantity of unit sales. Both the optimizer and the feedback loop utilized the Macro feature of Crystal Ball, allowing the Forecasts to collect optimized data. The output of the Real Options model provided the project manager critical decision information about the option value of the project, a visualization of project risk, and risk-adjusted profits. A sensitivity analysis determined where the limited project funds should be invested to reduce risk and improve project success.

An approximate option value of a project can be calculated as follows (all present values):

However, often of greater importance than the final option value itself is the creation of the project Real Options model trade space and analysis of the intermediate results. S. L Mintz, CFO Magazine Getting Real, states this case well: "By quantifying the fuzzy realm of strategic judgment, where leaps of faith govern decisions, real options analysis fosters the union of finance and strategy and presents a more realistic view of an uncertain world beset by constant shifts in prices, interest rates, consumer tastes, and technology."

Wall Street heavily rewards those corporations that have lots of "options" for future growth; that is, a portfolio of many prospective business opportunities and the discipline to exploit (exercise) those options. Inserting options into a project increases its value, provided the project manager has the flexibility to position the project to take advantage of opportunities which arise in a rapidly changing business and technical environment. Examples of project options include having several market outlets to choose from, numerous technical solutions to reduce risk or a customer contract with contingencies (imbedded options). In addition, discipline implies that senior management must act quickly to terminate early potentially unsuccessful business ventures. Finally, strategic investments in critical technologies and markets are required to set up the availability of these options.

A decision to invest in an option is not an easy one, because it involves tradeoffs between risk and potential profit. How much would you invest today in a strategic project (start date 2007) with the payoff profile shown in the figure on the right? There is a 21% chance of a wide (10%-90%) profit range (median $2.3B). Simulation indicates a 79% chance of a mean project loss of $1.7B owing to high uncertainties and non-recurring costs. Keep in mind that incremental current investments in engineering design or marketing studies will reduce many of these uncertainties, perhaps sufficiently to close the business case. Still, a project review process will stop the project if it cannot be shown profitable, so potential losses are significantly smaller. What is the option worth? What is your risk tolerance? Real Options can help get beyond a simple expected value, and provide a risk-adjusted answer this question.

Uncertainty modeling, Real Option valuation, and other sophisticated modeling techniques are being applied on a number of important Boeing projects where strategic project investment decisions must be made.