Real Options in Information Systems - a Revised Framework

We propose a new performance metric by which to evaluate capital budgeting proposals. Our metric is derived from a decision theoretic view of the firm’s problem in deciding whether to invest in a risky project. Our approach contrasts considerably from the Black-Scholes method, specifically by not making the same assumptions regarding the properties of the underlying asset on which the option may be exercised, such as its tradability in a public financial market. By not making these stringent assumptions, we allow for greater flexibility and accuracy in calculating the business value of a real option. In numerical exercises, we show that, on average, the BlackScholes model overestimates the option value by more than 10 times. Furthermore, our model is robust to distributional assumptions about the returns on underlying assets, suggesting that the consequences of choosing an incorrect distribution are not severe.