Ready, Fire, Aim! - Mihail's Public Blog: Real Options Valuation (ROV) in Project Analysis

A simple decision such as whether to develop a new technology in-house or acquire it from an outside party illustrates the utility of the decision-tree framework. In-house development requires three years and leads to three possible outcomes. In two of these outcomes, the firm expects to create significant value. But there's also a 25 percent chance that the in-house development would fail; obviously, this outcome would have no payoff. Figure 1 shows this decision using a decision-tree framework. The probabilities of the three outcomes are based on a combination of managers' experience and judgment.

Figure 1

After calculating the value of each alternative, the manager is able to pick the highest-valued alternative. For the acquisition alternative, subtracting the $10 million cost of acquisition from the $20 million payoff yields a value of $10 million. For each of the three outcomes in the in-house development alternative, you have to subtract the cost from the payoff and then multiply the result by the probability of success. Thus, for the most successful of the three outcomes, the expected value would be:

($25 million - $7 million) ¥ .35 = $6.3 million

An expected value calculation—the weighted average of the outcomes, with the probabilities used as weights—is used to blend the value of the three outcomes into a single number. A 10 percent cost of capital is used as the discount rate. Performing this calculation reveals the value of the in-house alternative to be $7.14 million, or less than 75 percent of the value of acquiring the technology from outside.