Investment decisions and contract evaluation issues in a software product company

Abstract

Managers in technology companies face a common difficulty: new projects or products are fraught with technology and market risk, especially given the rate of technical change. Consequently, they need s07id methods for valuing prospective investments, so that they can justify their development strategies. Their fundamental problem is compounded by a methodological difficulty in that traditional net present value (discounted cash flow) evaluations are inadequate for many risky projects. Planners need to understand that they are consciously managing risk, and will do so most effectively by developing options they can exploit or abandon depending on future events. Real or embedded options are analogs of financial options and can be used for evaluating investment decisions made under significant uncertainty. Real options can be identified in the form of opportunity to invest in a currently available innovative project with an additional consideration of the strategic value associated with the possibility of future and follow-up investments due to emergence of another related innovation in future Our project describes the real options approach of decision-making and illustrates it with an application to decision making in a software product company. This company is referred to as Company X in the report. We also look at ways to evaluate options that are embedded in contracts.