VinayDatar,

by ScottMathews,The BoeingCompany,
StanfordUniversity
and BlakeJohnson,
SeattleUniversity,
he field of real options has beenslow to develop
becauseof the complexity of the techniques
and the difficulty of fitting thenr to the realitiesof corporatestrategicdecision-rnaking.Such
complexity, and the resulting challengeof gettitg senior
management"buy-in," has been a major barrier to wider
corporateadoption of real option techniques.
To overcome this barrier, The Boeing Comp any has
invested heavily to develop state-of-the-artmethods and
tools. The goal is to createa real options approachthat uses
the languageand f,rameworksof standardDCF analysis-a
frameworkthe company'sfinancialanalystsand managersare
alreadyfamiliar with and feel comfortableusing.The result
has been a method of valuation (referredto at Boeing as the
"f)M" Methodl) that, while algebraicallyequivalentto the
Black,scholesformula for valuing financial options,2uses
information that arisesnaturally in a standardl)CF project
'
financialvaluation.
The main advantageof the DM Method is its sirnplicity
and transparency,which allow for more insightful strategic
design
planning and evaluation,and help decision-makers
strategieswith high-benefit outcomesthat also minimize
risks.By contrast,the traditionalNPV methodleavesdecision
makerswithout essentialinformation about the impact of
market dynamics and sourcesof uncertainty.
The DM Method has the look and feel of an extended
NPV analysis.Becauseit is easilymodeled in a spreadsheet
using off-the-shelfsirnulationsoftwareto incorporateuncertainty and the timing of decisions,analystsrapidly learn the
method and areableto benefitfrom the associated
risk analyses.Furthermore,executivesqui.kly begin to appreciatethe
effectivenessof the DM method in identiSring investments
that maximize the likelihood of success,thereby limiting
downsidelosses.Finally,the rnethodcan be usedto givestrucstrategicdiscussions
and soprovide
ture to earlyscenario-based
of subjectingproblenlsto quantitativeanalysis.s
^wry
1. The method has been patented by The Boeing Company (U.S. Patent 6862579\
as the Datar-MathewsMethodfor QuantitativeRealOptionValuation,@ 2001, The Boeing Company,All RightsReserved.
2.Yinay Datarand Scott Mathews,"EuropeanRealOptiofls:An IntuitiveAlgorithmfor
Formula,"Journalof Applied Finance,Vol i4 (1), 2A04.
the Bfack-Scholes
3. The Boeing LeadershipCenterhas begun exposingthe company'sfinancialand
engineeringmanagersin the properuse of the DM Method.The aim of the course"Critical Thinking"is to help managerslearnto identify,analyze,and managerisk in waysthat

Journalof AppliedCorporate
Finance. Volume19 Number2

Decisisrlr
TheNpVCase
An trnvestrnent
To illustrate how the DM Method works, we first examine
a simpleinvestmentdecisionusing standardNPV analysis.
Boeing currently builds a small experimentalunmanned
aerial vehicle (UAV), or pilotlessdrone aircraft, that has a
includingthe monitoring of
numberof possibleapplicatiotrs,
electricaltransmissionand pipe line safery,foresthealth,and
bordersecurity.Thesekinds of nronitoring arecurrently done
by trained pilots fying small planesover remote stretches
of back countr y-a fironotonous,hazardous,and expensive
undertaking. \Wecan envision a new market for a UAV that
promisesreducedcost and higher efficiencies.But the developnrent of that market dependson advancesin the current
technologiesin aviationcontrol systems,remotesensirg,and
globalpositioning.
Of course,the actuallrusinesscasefor the UAV is complex,
involving many factors,including critical FAA.certification.
But we can illustratethe conceptsof this paperusinga much
sirnplifiedbusinesscase.Table 1 setsforward sampleprojections of revenuesand costsfollowirg the standard practice
for NPV-type businesscaseestimationusingthe most-likely
scenario.There is an immediate$ 15million outlayfor R&D
engineeringeffortsin aviationcontrolsystems,
remotesensing,
and global position technologythat are expectedto take up
to two years.After that point, contingenton the successof
the R6cD effortsand for..ast of pro-ising market recep"
"
rion, Boeing then expecrsro spend$325 million ro launch
the product, a one-time outlay for UAV design,testing, and
factory tooling. The estimatedoperating profit frorn UAV
salesdependson assumptionsabout product strategyand
market receptionthat are surnmarizedin Table 1.
Basedon a corporatehurdle rateof 15o/o,rheprojectI{PV
is estimatedto be a negative$ 19 million, which suggests
that
the project is not worth undertaking. But the rnanagermay
overridethe NPV resultsbecauseshebelievesshecan fexibly
managethe marketresearch
and the technologyR&D efforts,
are consistentwith growing the business.ln addition, the Global IntegratedSystems
(GISE)program,a graduatelevelinterdisciplinary
programofferedjointly by
Engineering
the Universityof Washington'sCollegeof Engineeringand the BusinessSchool in collaborationwith The BoeingCompany,providesinstructionin the DM Methodas a means
to solvedifficultengineeringand financialtradeoffs.The GISEprogramemphasizessystems engineering,project rnanagement,and finance to produce a new generation of
complexsysternsthinkerswho can excelin a global businessenvironment.

. Spring2AO7
A MorganStanleyPublication

95

f;asefor UAVProject
NPVffiusiness

TableI
Scenario

Strategy

MostLikely

in linewith the ma*et at about15% per year.Initialsalestargetwill be moderate.

Productsalesgrowthis approximately

DiscountRateAssumptions
ProjectRiskRate

L5%

Year

NPV Calculations
PVnOperatingProfits
PVuLaunchCost
R&D Expenses
TotalProjectNPVValue

$242
($246)
( $15)
( $19)

Most Likely0p Profits

$ 0 $ 0 $ 5 2 $ 6 2 $74 $tt
LaunchCost
$0 ($325)
($15)
R& DE xpenses

and becausethe market for UAVs might havea plausible,if

lower-probability,upside.Somemanagersmight be tempted
to declare the UAV project "strategic" and invest anyway
in order to preservethe opportunity to explorethe market
poterltial.But this would meansacrificingthe authority and
discipline that comesfrom managers'being required to use
quantitativemethods,and thus defeatthe purposeof having
any kind of rigorousanalysis.
Given the uncertainty of the market and thus of the
project outcorrle, there are good reasonsfor rnanagersto
lre skepticalabout the recommendationbasedon the NPV
analysis.For starters,while there is likely to be a range of
possibleoperating profit outcomes projected for the UAV
project,the mathematicsof the NPV method requireuseof
a singlevaluefor eachtime period. (This limiting approachis
formatting that constrains
further reinforcedby spreadsheet
low-probability
As
a
consequence,
value.)
a
single
eachcell to
and
only the mostfrom
the
analysis,
eliminated
ourconlesare
likely survivesthe process.
Further,in this case,and in most NPv-basedapproaches,
all cashfows are discountedat a singleprojecthurdle rate,
regardlessof possiblediffbrencesin risk. In sum, the NPV
analysiscan biasdecision-makingagainstprojectslike UAV
with major uncertaintiesthat areexpectedto be resolved-in
this case,within two years.NPV analysistends to reflect
its conservativeorigins in the banking industry by favorirg annuity-like investments.Real options, by contrast,is
well suited to evaluatinginvestmentswith fexibility, critical
decisionpoints, and major discontinuities.

RealOptionMethod
The Dntar-fulsthew$
beginwith scenarioplanning exerMany srrategydiscussions
cisesdesignedto embracenew technologiesand products.The
scenariosare the outcome of the forecastsand insightsgenerated by gatheringsof technologistsand engineers,Progranl
and seniorexecand marketingmanagers,financespecialists,
96

Finance- Volume19 Number2

Journalof AppliedCorporate

$89 $104 $122

utives.The typical output from such meetings,more often

than nor, is a seriesof scatterednotesand drawings,generally
providirg little coherent basis for meaningful quantitative analysis.Much of the difficulty refects the challengeof
propositionsthat incorporatenebulous,
srructuringlrusiness
contingentdecifactorssuchasuncertaittay,
disparate-seerning
timing, and risk versusreturn.
sions,probability of success,
The DM Method, and what we call "real options thinking,"
has the potential to extract significant value from scenario
planning by providing a structurethat lendsitself to quantitative analysis.
In conrrastto the NPV approachthat aims to reduceall
to a singlemost-likelyscenario,the more strategicapproachis
aroutrdthe variousscenariosrefectto stimulatediscussions
i.g differenr market conditions that could be encountered
at the time of product launch. Such discussionsalso focus
on other relevantfactorssuch as the current technologyor
product readiness,the funding and time required to launch
the product, and project contingencyplans in the eventthe
engineersare unableto developthe necessarytechnologyor
the marketoutlook turns unfavorable.The underlyingreality
is that as eventsunfold prior to the launch date and one
or another scenariobegins to play out, decisionmanagers
havethe ability to increaseproject value by identifying and
respondingto technology or market opportunities. Unlike
the NPV approach,real options analysisis able to capture
the valueof such fexibility.
The advantageof the real options approach,then, is
its ability to take the wide range of "strategicintelligence"
produced by the scenariodiscussionsand translate it into
a businessplan with flexibility and critical decisionpoints.
For example,the UAV strategydiscussionsresult in three
scenariossimilar to those shown in Table 2. Providedwith
the scenarios,Boeing'smarketing department then helps
quantify eachof them lry providing revenueforecasts,while
the engineeringdepartmentprovidesestimatesof one-time
. Spring2007
A MorganStanleyPublication

Table2

RealSpti*nsBusine$s
Casefor UAVFrcject
Strategy

Scenario

Probability

Optimistic

productoutsells
25"/"peryear;thereafter
7O"/"
Superior
the marketwithsalesgrowthuplo 40o/oin thefirstyears,thenaveraging
slowing.
probabilityInitialsalestargetis highdueto earlymarket
spadework.

MostLikely

Productsalesgrowthis in linewith the marketat about15% peryear.Initialsalestargetwill be moderate.

Pessimistic l0%
limitssalesgrowthto 5%peryear,witha potential
market
Initialsalesarelow
Intense
competition
downturn
owingto a weakeconomy.
probabilitybecause
manufacturing
costsarehigher
thanexpected.
($ M) Year

0123

Optimistic

$0

$0

$ 8 0 $ i 1 6 $ 1 5 3 $r77 $223 $268 $314

MostLikely

$0

$0

$52 $62 $74 $77 $8e $104 $122

Pessimistic

$0

$0

$20 $23 $2+ $ 1 8 $ 2 0 $ 2 0 $ 2 2

LaunchCost

$o ($325)

launch and recurring manufacturing costs.

As can be seenin Figures 1 and 2, the three scenarios
result in three operatingprofit estimatesfor each year,with
the optimistic and pessimisticscenariocash flows each
assigneda l0o/oprobability.The threeestimatescan be viewed
asrepresentingthe cornersof a triangulardistribution (shown
in Figu re 2) that refects a range of forecastsand thus the
uncertainty about annual operatingprofits.4LJrirrgMonte
Carlo software,we createdsuch a triangular distribution for
each yearof the operatingprofit forecast.5
The Monte Carlo simulation providesa way of translatitg the market forecastuncertaintiesorigin ally envisioned
into the variabilityof the project
in the scenariodiscussions
cash fows. The Monte Carlo application works by takitg
random "drawsr"o, "trials," from all the operating
successive
profit cash-fow distributions,with the most frequentdraws
nearestthe most-likelyvalues.Eachtrial is a plausiblescenario
and is calculatedthrough in Excel, resulting in a cornplete
profit/lossanalysisfor that one scenarioinstance.A typical
comprehensivesimulation analysisconsistsof hundredsor
eventhousandsof trials.6
The output of the simulatedoperatingprofits depictedin

Figures3 and 4 underscores

the meaningof market uncertainty.
The bar graph in Figure 3 showsthe Optimal-Most LikelyPessinristic
rangesfor eachyear(with the thicker middle section
running from the 20th to the B0th percentilesof the distribution). The ExcelNPV Function discountsto the presentthe
operatingprofit for eachtrial, and the Monte Carlo simulation
softwarecreatesa histogramdistribution (seeFigure4) for the
hundredsof trials.This distribution of discountedcashfows,
which is called a PresentValue Distribution, representsthe
rangeof presentvaluesof future operatingprofits.
Eachtrial fbrecastsa plausibleUAV businesscasescenario.
But beforecalculatingthe net presentvalue,w must determine the appropriate discount rate for the various cash
fows within a single trial. Most NPv-based businesscases
use,incorrectly,a single discount rate (such as I5o/o)for all
cashfows regardlessof their different risk levels.tVith real
options,we can usedifferent discountratesthat reflectthe risk
of the different cashflows.The operatingprofits are subject
to market risk and so the appropriatediscount rate fbr these
cashfows is the project'srequiredrateof return, I5o/o.
In c6ntrast,the launch cost cashfow (or "strike price")
hasrelativelylow risk becausemanagementcontrolsthe funds

4. Distributionsotherthan triangularcan be used. Most risk distributionsare skewed,

includingthe triangulardistributionsusedin the case.A skeweddistributioncapturesthe
phenomenon.A lognormal
riskyprojectconceptof a low likelihoodbut high consequence
distribution,used in formal optionstheory,is a type of skeweddistribution,but its defining parameters,such as mean and standarddeviation,are more difficultto determinein
the contextof standardengineeringand businesspractices.The easilycornprehensible
parametersMax-Most Likely-Minthat definea skewedtriangulardistributioncan more
or less approximatethe formal lognormaldistributionwithout materialimpact on analytical results.Also note that thoughthere existsthe NPV techniqueof multiplescenario
of the probabilanalyses,some of its shortcomingsare that 1) there is no understanding
ity of any one of the scenarios,and 2) there is no way to determinewhich of the several
valuationresultsought to apply to the projectinvestmentdecisionat hand.
5. SpreadsheetMonte Carlo software(such as CrystalBall or @Risk) can be used to

build the triangulardistributionsand add other simulationspecificfunctionality.Monte

generallyincludesa correlationfunctionthat enablesany one distributionto
Carlosoftrruare
be "co-related"with other distributions.For example,if there is one year of higVlow operating profits,then we can forecast,with some degreeof predictability,that nextyear's operatingprofitsmay also be high/low.In the UAV project,we estimatethe correlationto be
abclut70% basedon historicalevaluationof similarprojects,and have usedthis value in
the correlationfunctionrelatingall the years'distributions.lf there is little or no correlation
in year-over-year
operatingprofits,then the simulationresultscollapseto a simple average
scenario,negatingscenariovariability,and effectivelynullifyingany strategicoptionality.
6. We recommendabout 500 trials for preliminaryresultsand about 2,000 trials for
final results.The more complex and uncertainthe analysis,the more trials are required.
Someanalysesrequiringsubstantialprecision,such as that illustratedin Appendixll, need
upwardsof 10,000 trials, AnotherMonte Carlofunctiondetermineshow draws are made;
we recommendLatin Hypercubeto obtain good samplingof all the variabledata.

Journalof AppliedCorporate
Finance. Volume19 Number2

. Spring2007
A MorganStanleyPublication

97

Figure1 ReaiSpticnsSperatingFrofitSusiness
Case$cenarios

RealOptionsScenarios

an
+t
0

"r-'"s:*
-il-

0ptimistic

Pessimistic

MostLikely

l-

ou0
E
+t
(g

(u
o.

Figure2

Mod*lingScenarios
usingRangeForecastDistributions
for OperatingProfits

Optimistic

MW

Most urkely

AnnualForecasts

RangeForecast

Most Likely

PesSimistic

Optimistic

1C
o
o

:=
q)
l.

and is expectedto incur the launch costonly if therearegood

prospectsfor a successfuloutcome.Consequently,the launch
cost discount rateof 5o/o,termedthe investmentrare,is setat
Boeing'scorporatebond rate.' By thus applying an observablediscountrate,the realoptionsbusinesscaseis grounded
in the realitiesof the capital markets,putting the resulting

profit and loss calculations on par with how shareholders

might perceivethe valueof the samebusinessopportunity, a
compellingargumentfor seniormanagement.s
The net profitsand lossesfor all UAV scenarioscollectively
determine tire real option value for the project. The option
valuecan be bestunderstoodasthe appropriatelydiscounted

7. Within Boeing,the corporatebond term rate is used in option valuation,Applying

a bond rate instead of the more standard risk-freerate has little material impact on the
valuationand final decision-makingprocess,while significantlyimprovingmanagement
understanding.Here the low rate, our least expensivesourceof capital, can be understood as the resultingbenefitof a diversifiedportfolioeffectof a generalobligationcorporate bond. One view of real options is that it contraststhe value of prospectiverisky
project operating profits against paying off corporate bondholders.For illustration purposes,the risk-freerate can be used to derive a "market-based"valuationof the option.

8. The degreeof risk aversionreflectedin the option value is a function of the differential discountrates.A risk neutraloption valuationoccurswhen the two discountrates
are equal, say 5%. Alternatively,
settingthe ProjectRisk Rateto 20% while maintaining
the InvestmentRate at 5%, will increasethe risk aversion,decreasingthe option value.
DM Method uses risk-aversecash flow values, the same values as directly used and
providedby marketingand engineering.There is no need to convertto risk-neutralvalues
and probabilitiesas requiredby some other real option methods,a barrierto transparency and intuitiveness.ln passing,we note that we could apply,correctly,the differential
discount rates to the NPV businesscase, but the resultingexpectedloss would be even
larger,-$69 million insteadof -$19 million,

98

Journalof AppliedCorporate
Finance. Volume19 Number2

. Spring2OO7
A MorganStanleyPublication

with Uncertainties
Figure3 UAVFrojectCashtlows

$400

$200

$0M

, *l l l l l
Year

t$?001

OperatingProfits

LaunchCosts

ffi R&DExpenses

{$4S0}

Figure 4 PresentValueSistributionof the SperatingFrofits

(J

o
3
cr
(t'
l-

IL

averagenet profit, assumitg the project is terminated if a

lossis forecast.\Wecan seethis visually in Figures5 and 6.
The dark shadedsection on the right of the presentvalue
distribution in Figure 5 correspondsto successfuloutcomes
in which the discountedoperatingprofits exceedthe launch
cost of $295 million. The areato the left of the launch cost
consistsof trials in which the cost is anticipatedto exceedthe
operatingprofits. In thesecases,managementis expectedto
rationally avoid the lossby terminating the project.
The net profit-equal to the difference between the
operating profit and launch cost in a successfuloutcome and
zerowhen the pro ject is terminated-also has a distribudon.

Figure6 showsthis payofffrequencyhistogrxrrr,with the terminatedcases(600/o)having azerooutcome,while the remaining

successfulcasesyield a range of expectednet profits.e The
averagevalueof this PayoffDistribution is the realopdon value,
approxirnately$23 million in this example.This value is our
bestestimatetodayof the discountedfuture expectednet profit,
contingenton rationaldecisionmaking at the time of launch.
Table 3 summarizesthe calculationsand showsthat the
total projectvalueis $ B million-the differencebetweenthe
$23 million oprion value and the $ 15 million RS.D cosr.
Therefore the project is worth undertakirg. The formal
calculationof the real option value is done using the Boeing

9. The term "non-linear"is often appliedto real options.This simply meansthat the
project payoff has two different outcomes: zeto for the terminated casesand a positive
net profit for the successfulcases, reflectingthe contingentdecision-making.A real option valuation is always positivedenotinga rational decisionto invest the significant
launch costs only if today we forecasta positiverisk-adjustedNPV at launch time. A real
optionvaluationdoesnot precludethat conditionsat launchtime may changenecessitat-

ing a re-valuationof the prospectiveproject NPV profitability,nor that the launch investment decision itself will be financially risk-free.Conversely,in the capital markets the
tacticalrisk of owing the underlyingassetis frequentlyeliminatedby exercisingan in-themoneyfinancialoption call and simultaneouslysellingthe equivalentsharesof stockfor
a cash settlement.

Finance. Volume19 Number2

Journalof AppliedCorporate

. Spring2AA7
A MorganStanleyPublication

99

at TimeO
Basedon RationalDecision'making
OperatingProfitOutcomes
Figure5 Risk-adjusted

(J
E

(u
5
cr
q,
lt

$352

Figure6

UAV Froject Payoff,or Net Frofit, Distrlbution

(J
C

(u

CT

(u
|r.
L

$23M

$150M

Datar-MathewsMethod, which hasthe following spreadsheet averageof all the net profit outcomes.
\Wecan alsoprovidean additionalintuitive understanding
formula:
real
options,which is usefulduring thosestrategydiscussions,
of
as
Realoption value=
by usingan estimatorof the realopdon valuethat is expressed
formula:
following
in
the
outcomes
a function of successful
Average[MAX(operatingprofits - launch cost,0)] .
The formula capturesthe intuition descrilredabo'te.10
The operatirg profits are the rangeof possiblediscounted
valuesin Figurc 4. For eachtrial, Excelcalculatesthe MAX
function, which involvesdeterminingwhetherthe discounted
operating profit exceedsthe launch cost. The function thus
has a rninimum thresholdof zero,which correspondsto the
shadedregion to the left in Figure 5. Calculatingthe MAX
value for severalhundred simulated trials createsthe payoff
distribution in Figure 6, with the option value equal to the
a random
a distribution-formally
bar in the equationrepresents
10. Theoverscore
profitsat time0.
operating
variable-ofthe discounted
10 0

J o u r n a lo f A p p lie d Co r p o r a teF in a n ce. Vo lu m e 1 9 N umber 2

Real option value =

Risk Adjusted SuccessProbabilityx (Benefits- Costs).
probFor example,as reportedin Figure 5, the risl<-adjusted
is 40o/o,and the discountedmean valueof
ability of success
ourcomes("benefits") ir $lSZ million.ll The
the successful
discountedlaunchcostis $295 million. Pluggingthesevalues
into the aboveformula alsoyields a real option value of $23
million, the valueof the projectgiven contingencies:
11. For more on risk-adjustedprobability,see Appendixlll.

. Spring2007
A MorganStanleyPublication

R**i *ptians BusinessCasefor UAVFrcj*ct

icalbut asyet not well articulatedpart of our decision-making

process,applying real options thinking providesa welcome
DiscountRateAssumptions
structureto scenariodiscussions.Moreover,the ability of the
DM method to simpli$r the real option value calculations
ProjectRiskRate
r5%
Rate
5Y"
Investment
to farniliar NPV techniquesand createtransparencyin the
managers'adoption of real option thinkprocessaccelerates
($M)
D-M MethodCalculations
irg. Finally,the DM Method gracefullycollapsesto an NPV
calculationwhen the uncertaintiesare inconsequential(the
PVoOperatingProfits
9242
($2e5)
cashflow distributions convergeto a most-likely point value)
PVoLaunchCosts
and thereare no timed investmentdecisionevents.
ProjectPayoffMAX(OP-lC,0)
$0
Realoptionsmethodswork for strategicdecisionsbecause
Project0ptionValue
$23
($15)
of their ability to simplify and managecomplex investment
R&D Expenses
problems.It's generallynot possibleto know all of the potenTotalProjectValue
$8
tial factorsthat might affectthe outcomeof suchinvestrnent.
But it is suf{icientin an uncertain environment to bound
the problem, yet still be confident in the decision-makitg
Real option value- 4Ao/ox ($lSZ - $295) * $ 23M.
process.By acquirirg the initial resourcesand information
necessa
In sum, real options help addresscontingent srategic
ry for informed decisions,real options allows us to
investmentchallenges,thosethat requirepreparatoryresource "prune" possiblebad outcolnesand concetltrateour resources
on thosetruly promising opportunities.The DM Method
allocation in advanceof an anticipated use.In this case,our
analysistells us that the UAV project hasa contingent present simplifiesthe calculatioubehind this thinking.
The simple UAV example in this article presentsthe
valueof $23 million rwo yearsprior to launch.And sinceour
underlying intuition and basic methodology of the DM
engineershaveinformed us that they need$ l5 million in R&D
Method. But the method can be extendedin a number of
funds today to advancethe necessarytechnology to a stateof
readinessat the time of launch, the UAV project option can waysthat enablebroaderapplications.Sonreexamplesare the
inclusionof a dynarnicmarket demandcurveand production
be purchasedfor $8 million lessthan its estimatedvalue.This
variability,
and the extensionto multi-stage(compound)and
is a good deal for shareholders;the real option value exceeds
and
American
options.
Perhapsmost promising is the method's
the initial RS{D expenserequest,and we should approve
how
ability to show
the option valuecan increasewhile simulfund the R&D portion of the project.
reducing
is
taneously
cost and market uncertainty.Although
Another way of interpretingour findings that the abiliry
high
might
challenges
with
a
this
appear
to
contradict the academicdoctrine on
engineersto solveaviation
of Boeing'"s
in
reality
options,
conrpaniesexert considerableeffort to
degreeof efficiency is a competitive advantage-one that
allows us to "b,ry" the UAV option at below market value. reducecostsand market uncertainty,while alsocounting on
obtainirg the highestvaluefor its products.The richnessof
This contrastswith the NPV analysis,which showsa lossof
resulting
conclusionto abort this business potential applicationsof the DM rnethod, combined with
$ 19 million and the
investment.
While the outcome its intuitive appeal,suggestsit can be a powerful strategic
opportunity with no RBcD
investment
not
be known for some planning and decision-makirgtool.
of the initial RScD
will
time, our expectationis that the R&D will inrproveour insight
Technical
Fellowat The Boeing
is an Assaciate
into the true valueof the project,therebyreducinguncertainty scorr H. tr,rATnE\xrs
Fil n a n cea n d
i
s
f
o
r
l
e
a
d
C
o
r
n
p
u
tationa
the
and putting us in a betterposition to make a correctdecision C o r n p a n ya n d t e c h n i c a
for
andSinrulation
sectionwithin
Fdodeling
team the Madeling
about whetherto fund the much largerlaunchcosts.And if the $tachastic
division.
project is terminated prior to launch becauseof poor forecast the Bo*ingresearchanddevelopment
His areasof
of Financeat SeattleUniversity.
projectionsand no further investmentsarecommitted,our loss vrNAy D,rtAR is Professor
risk.
interestincludefirrance,
international
business
arrdforeignexchange
is limited to the upfront R&D expense.
Table3

Csncl#ding Thcughts
The f)atar-Mathews Real Option Method is gaining acceptanceamong managersat Boeing asa framework for anilyzing
strategicopportunitieswith both high payoffoutconresand
high risk. tVe made the point earlierthat much of the valueof
realoptions residesnot in the actualcalculationof the option
it is a critvalue,but ratherin "realoptionsthinking." Because

. Volume
Journal
of Applied
Corporate
Finance
19 Number
2

AssistantProfessor
in StanfordUniverBLAKEIOHNSOwis Consulting
wherehis
sity'sDepartment
of Management
Scienceand [ngineering,
for
workfocuseson quantification
of riskandflexibility
ancjmanagement
industrialcornpanies.
$pecialthanksto ShenLiu at Eoeingfor helpingto preparethe [xcel
rnodels.

. Spring2OO7
A MorganStanleyPublication

101

Table4

eurnBaringthe SM and Slack-$chslesSptian Methadsin Excel

o..g

$372
($s25)

OperatingProfits
Investment

Time(t)

OperatingProfits
at Time2

RiskFreeRate(Rf)
DiscountRate(Rr)

BlackScholesMethod
Asset(S)

OperatingProfits
Mean
StdDev

5.O%
15.0%

372
105

$150
$372
$600
$ 2 7 5 . 5 8 = EXP(-Rr*t)*(Mean)
$ 2 e 4 . 0 7 ) = EXP(-Rf*t)* | nvestment
^ 2))/SQRT(I)
1 + (StdDev/Mean)
79.6% = SQRT(LN(
*S-(Nd_z*(-X))
=
$ 2 2 . 9 7 Nd_L

(X)
Exercise
Sigma
OptionValue

+ (Rf+ 0,5*(Sigma^ 2))*t)/(Sigma*SQRT(t))

-0.10 = (LN(S/(-| nvestment))
0.46 = NORMSDIST(d_l)
0.35 = NORMSDlST(d_1-(Sigma*SQRT(t)))

d1
N(d1)
N(d 2)

DatarMathewsMethod

$215.58 = EXP(-Rr*t)*OpProfits
($294.A7) = EXP(-Rf*t)*lnvestment
or lF((A>-X),A+X,0)
$0.00 =MAX(A+X,0)

Asset(A)
(X)
Exercise
Payoff
OptionValue

$22.97 =Average(Payotf)

AppendEs
[: ffixtensicns
ts the SM Meth*d

projectoption that combinesthesetwo featuresbecomes:

One of the simplestextensionsis the conversionof the DM

Method formula to an Excel logic function:
Real option value=
Average{if f(ffi-launchcost))
( @- launc hc o s t),0 1 1

Realoption value=
Average[MAX ("peffi

0n
.

- tr"".h .*r, 5)]

A project type that frequently arisesat Boeing is an

opportunity to bid on a fixed price proposal, where the
uncertaintyis the cost ("strike price") of the systenr.In this
case,the traditional option variablesare reversed,with the
benefit, or proposal price, being the fixed value. The DM
Method is able to calculatethe option value of the proposal
bid opportunity:

An advantageof the logic formula is greaterclarity of the

real option strategy,essentiallythe logic of businessdecision-nraking.In addition, businessanalystscan capture
fairly complex what-if scenariosfor "operating profits" and
"launch cost" in spreadsheet
models.For example,operating
Realoption bid value_
profit volatility is more accuratelynrodeledby integratinga
dynamic demand curve and production uncertainty.
Average[MAX ({ixed price - systemcosts,0)].
The DM Method framework can also incorporate
Theseareall call optionsthat will p^y off only if thereis
additional options. For example,the launch cost,which is
fixed for the samplecase,can alsobe a distribution(a "variable an increasein value.A common put option, which will pay
strike" option)-one of the most common situationsin real off if there is decreasein value,such asa serviceguaranteefor
options. \7e can integratethis option togetherwith an exit customerserviceagreements(CSA), or, for expensiveleased
option to either licenseor sell the technology developed, assetssuch as carsand airplanes,a residualvalue guarantee
(RVG). Put options are often usedin contingentclausesin
sayfor $5 million, in the eventof project termination.The
value of the terminated, unsuccessfulproject is therefbre$5
contractsto tailor the value to the performancerisks of the
million, nor $ 0. The spreadsheetformula for the complex contract.The DM Method valuesa put option as follows:
102

Journal
of Applied
Corporate
Finance
19 Number
2
- Volume

. Spring2007
A MorganStanleyPublication

Figure7 OperatingProfitOutcomesBasedon RationalDecision-making

at Year2

C'
g

(u

5
(t
(l,
tl!

$150M

Figure8

$325M

$422M

SecisionTreeat Year?

RiskNeutralProbabilities '-67o/"
-

$97M
$422- $325)

$o
33%

Realput option value=

AverageIMAX (guaranteevalue- actuallrilue, 0)]"

allowsit to betterdeal with the realworld deviationsfrom the

strict theoreticalassumptionsof Black-Scholes.
For example,
the DM Method can easilydeal with non-lognormal cashflow distributionsand random exerciseprice.

AppendlxIl; Ccsnparing
the DM Methodto Black$chsl*s

Appendix
lll: HowRiskUndercuts
ilecisionTrees

The DM Method is mathematicallyequivalentto the Blaclc

Scholesformula undercertainassumptions.
Table3 illustrates
this with a simplebut typical DCF analysis.The DM Method
usesthe distribution of forecastedcashflowsto find the option
value,whereasBlack-Scholes
usesthe volatility, o.r2 Furthermore, the DM Method implicitly adjuststhe discount rate
to accourltfor the underlying risk. The option valueis easily
understood as the expected payoff resulting from rational
exercisedecisions.The fexibilitv of the DM Method also

Decisiontreesprovidea graphicrepresentation
of the possible
pathsfor the project outcome,but they do not correctlyvalue
the project. WhereasNPV analysistypically undervaluesa
project becauseit doesnot include the value of flexibiliry, a
decisiontree usually overvaluesthe pro ject becauseit does
not appropriatelyadjust the investmentrisk.l3
To see*hy, we construct a decision tree for the UAV
project. Monte Carlo simulations applied to the information in Table 2 createthe distribution for operatirg profits

1 2 . T h e DM fo rmu l ai s: C 0 = E [e - pt 5- . - tt X ]* ,
an expectationwhere 5 is the randomvariablefor operatingprofits,p and r are the
risky-assetand the risk-freediscount rates, respectively,and + is the MAX function.
The simulationfor the DM Method is typicallyrun for 10 - 20,000 trials as it gradually
convergeson the Black-Scholes
value.
The Black-Scholes
formula is:
C o = s 9 N(d1 )- X e -tT trt{d2)

Journalof AppliedCorporate
Finance. Vofume 19 Number2

13. Remarksalsogenerallyapplyto a closelyrelateddiscipline,decisionanalysis.Decision analysispracticeincludesthe applicationof utility curvesto assessa project manager's risk aversionand thereforeassignan appropriaterisk-adjusteddiscount rate, which
can differfrom, sometimessubstantially,the corporatehurdle rate. However,in my observationsthe utility curve assessmentis very infrequentlyconductedowing to its subjective
nature,which runs counterto the corporateneedfor intuitiveand transparentanalysis.

. Spring2OO7
A MorganStanleyPublication

103

in Figurc7'
discountedto Year2, the decisiondate' As seen
operatitF
67a/oof the outcomesare a success,with a mean
A
million'
profit of $422 miltion and a net profit of $ 97
illustrares
8
,i.rrpl. decisiontreewith rwo br"nchesin Figure
net p.rofit
the decisionourcomesat Year2. Discounting.the
milliol'
ar 15o/otoTime 0 valuesthe project at around $49
value.
$ze million higher than the option
the two
The differJnt valuesare a consequenceof how
valuaneutral
methodshandlerisk. A decisiontreeappliesrisk
ay
to_p
$49
tion. A personwho is risk neutral*ould be willing
However'
advance'
million-for the UAV project two yearsin
a'd
there is a fair chancethat th. projectwill be terminated
cares
investor
averse
the original investmentforfeited.A risk
takesthis inro
about this loss,a'd the real options merhod
effectively
million
account.The estimatedprojectvalueof $23
at risk.
capital
of
amounr
lessensthe invest'r's .*por,rre to the
rate
higher
fot.1
i'vesror
The smallerinvestm.ri poritionsthe
successfu['1'*
of return should the UnV projectbe
in Figures5 and 7 dlffet because
The successpercenrages
at Time 0,
the former is basedo' the risk aversePercenmges

atYear 2.
while the latter showsthe risk neurral percenrages
sum of
substantial
a
because
severe
Time 0 risk aversioncan be
viable'
is
oPPorty"iry
launch
the
money is investedwell before
of
chances
the
in
reduction
perceived
This translatesinto a
probabilities
the
adjusts
implicidy
The DM M.tfrod
success.
initial investto accounrfor risk aversiorr.fh. intent of the
ByYear
uncerrainties.t5
project
the
of
many
menr is to resolve
examipe
can
andwe
past,
the
in
is
2, someof the ulcertainty
At that time,
the launch prospectsin a lessrisky framework.
requiredrate
our
meets
project
the
we call d...r*it. *hether
analysis'
NPV
standard
of return of !5o/ousing
f)ecisior,,r.., ,rrd"birromiallatticeshavea more practical
limitation. They are not easyto implement.in-spreadsheets'
business
the indusrryrr"nd"rd for buri'.rs casernodels.Most
variables,
of
hundreds
occasionally
and
casesinvorvedozens,
can quickly
with multiple sourcesof uncertainty that
* p-toi".tly
Instead,
tree.
decision
,pr."dsheet
overwhelm'"
embedded
with
case
business
srrucruredrpr.odsheet-based
the branchirg
Monte crrlo simulation adequarelyrecreares
of a decisiontree.

14. An option'srateof returnis givenby:

In(cr-/c-o).,
CT
=whereCois the optionvalueat Time0, or $23 million;
llimplied
th.el
at Year2, or $97 million'.Il,,"o'.0
Ou.hion-making
is the projectvatuetril, r,uiio^ui
areacandtherefore
investments
equafs72%.Optionsare riskybut highryreveraged
with siginvestments
hrghnot, trot. that highlyreveraged
by a sufficientry
companied
wellw''thourconceptof the natureof R&D
nificantbut riskyratesof returncorrespond
"rateof learning
," againfor the natureof
the
termed
is
Occaiionarfy
limprieri
investments.
the rateof
pr is "implied"because
investments.
R&b'tiitrr;orogy
on
returns
reveraged
104

1 9 N umber 2
J o u r n a lo f A p p lie d Co r p o r a teF in a n ce' Vo lu m e

oncethe optionvaluehasbeencalculated;
returnof the optioncanonrybe determined
priori'
a
determined
be
cannot
limoriec
I observe
andprobabirities
on riskaversion
phenomenon
rerated
r 5, Thereis a crosery
to 'purgroups.I will oftenoffermy audience
or business
whenI lectureto universities
a cointoss,otherwise,$0. I
chase,alottery,nrtprvr out $100 on a correctCallof
of theaudience,
riskaversion
rarelygetpurchai.oti.r, above$40 (or 40%)owingto the
gambre
shouldbeworth$50 (50%)'
the
indicate
probabirities
objective
the
though
even
probabilities'
shiftsthe perceived
Riskaversion
a riskneutralinvesiment.

' Spring2OO7
A MorganStanleyPublication