Valuation of Information Technology Investments as Real Options

This article describes a methodology for evaluating information technology investments using the real options approach. IT investment projects are categorized into development and acquisition projects depending upon the time it takes to start benefiting from the IT asset once the decision to invest has been taken. A couple of models that account for uncertainty both in the costs and benefits associated with the investment opportunity are proposed for each of these project types. Our stochastic cost function for IT development projects incorporates the technical and input cost uncertainties of Pindyck’s model (1993) but also considers the fact that the costs of some IT assets (e.g., hardware) decrease rapidly even if no investment takes place. In the case of IT acquisition projects, benefits are modeled as a stream of stochastic cash flows and this provides a more realistic approach for the analysis of projects in which the value of the underlying asset is difficult to estimate.