DYNAMIC STRATEGIC PLANNING

1. DYNAMIC STRATEGIC PLANNING USING REAL OPTIONS TO IMPROVE SYSTEMS DESIGN

2. CONCLUSIONS • “OPTIONS THINKING” WILL DEEPLY CHANGE THE WAY DESIGNERS THINK ABOUT SYSTEMS DESIGN • “OPTIONS ANALYSIS” WILL ENABLE DESIGNERS, REALLY FOR FIRST TIME, TO VALUE FLEXIBILITY CORRECTLY AND THUS IDENTIFY WHAT KINDTO INSERT IN THEIR CREATIONS

3. ORGANIZATION • PART 1 -- WHAT IS THE POSITION OF OPTIONS ANALYSIS IN SYSTEMS DESIGN? • PART 2 -- WHAT ARE ITS IMPLICATIONS FOR PRACTICE?

4. A HISTORICAL PERSPECTIVE • “SYSTEMS ANALYSIS”, “SYSTEMS DESIGN” A PHENOMENON SINCE 1950s • DUE TO NEW TOOLS (COMPUTERS) AND METHODS (OPTIMIZATION, ETC...) • EARLIER, SYSTEMS IMPLEMENTED WITHOUT SYSTEMS ANALYSIS • SYSTEM DIVIDED INTO INDEPENDENT BITS • BRIDGE JOINTS; HIGHWAY LENGTHS

5. 3 DEVELOPMENT PHASES OF SYSTEMS ANALYSIS / DESIGN • OPTIMIZATION -- PRIMARY TO 1970s • DECISION ANALYSIS -- PRIMARY 1970s TO 1990s • “REAL” OPTIONS ANALYSIS --2000s

6. OPTIMIZATION • POWERFUL ANALYSIS OF Z = f(aX) Subject to g(cX) < B • EXCELLENT ON IMPORTANT PROBLEMS • BUT: LIMITED SENSITIVITY ANALYSIS -- ASSUMES PARAMETERS KNOWN • UNSUITED FOR UNCERTAIN CONTEXT

7. UNCERTAINTY IS FUNDAMENTAL • “THE FORECAST IS ALWAYS WRONG” -- AMPLY DOCUMENTED, ALL FIELDS • ANY SYSTEM WILL HAVE TO PERFORM IN BROAD RANGE OF CIRCUMSTANCES • UNCERTAINTIES ARE: • TECHNICAL • ECONOMIC (PRICES, ECONOMIC CYCLE…) • INDUSTRIAL (STRUCTURE OF COMPETITION) • POLITICAL (REGULATORY, LEGAL…) • ETC...

8. DECISION ANALYSIS • FOCUS ON SEQUENCES OF CHOICES, FROM PRE-DETERMINED POSSIBILITIES • NOTABLE LESSONS • FLEXIBILITY HAS VALUE • SECOND-BEST SOLUTIONS OPTIMAL • HOWEVER, NO PROCESS FOR • DETERMINING DESIRABLE POSSIBILITIES • RISK-ADJUSTED DISCOUNTED CASH FLOW

9. RISK-ADJUSTED DISCOUNT RATE • HIGHER RATE FOR HIGHER RISK (CAPM CAPITAL ADJUSTED PRICING MODEL REFLECTS RISK AVERSION) • THROUGH TIME, ACCORDING TO EVENTS, RISK LEVEL CHANGES • NO SINGLE DISCOUNT RATE APPLIES • DECISION ANALYSIS WITH CONSTANT DISCOUNT RATE IS INACCURATE

10. OPTIONS ANALYSIS • PROVIDES CANONICAL MEANS TO ACCOUNT FOR VARYING RISK (BLACK-SCHOLES, WIENER PROCESS) • BOTH TECHNICAL AND MARKET RISK • NOBEL PRIZE WINNING EFFORT • FOCUS ON PRICING OF FLEXIBILITY, OF “OPTIONS”

11. WHAT IS AN OPTION? • A PRECISE MEANING -- NOT “CHOICE” • OPTION IS “RIGHT, NOT OBLIGATION” TO TAKE AN ACTION, A CAPABILITY ACQUIRED AT SOME EFFORT • CALL CONTRACT TO BUY STOCK AT $X • CONTRACT TO BUY EXPANSION SITE • “REAL” OPTIONS ARE PHYSICAL • R&D TO PERMIT PRODUCT LAUNCH • DUAL-FUEL BURNERS FOR POWER PLANTS

12. “REAL” OPTIONS ANALYSIS • IDENTIFIES VALUE OF DESIGN ELEMENTS PROVIDING FLEXIBILTY • GIVES DESIGNERS ANALYTIC BASIS FOR DESIGN CHOICES • DIFFERS FROM RELIABILITY ANALYSIS -- INCLUDES MARKET RISKS

13. EXAMPLE: VALUE OF R&D? • TRADITIONAL ANALYSIS • WHAT IS EXPECTED VALUE OF EFFORT • OPTIONS ANALYSIS • R&D IS AN OPTION • CAN BE EXERCISED IF MARKET IS POSITIVE • IF MARKET OR TECHNOLOGY POOR, DROP • BECAUSE POOR OUTCOMES DROPPED • VALUE AS OPTION > EXPECTED VALUE

14. PRACTICAL IMPLICATIONS • GREATER VALUE, THUS EMPHASIS ON FEATURES NOT TRADITIONALLY CONSIDERED AS OPTIONS • RESEARCH, PRODUCT DEVELOPMENT • DESIGN CHOICES (FACILITY SIZE) • DESIGN CONFIGURATION (INTERNET) • DESIGN OPERATION (SHARED FACILITIES) • OPTIONS “THINKING” • EXPLICIT FOCUS ON FLEXIBILITY

15. EXAMPLE -- PRODUCT DEVELOPMENT AT FORD • R&D INVESTMENTS • AS OPTIONS ON THE POSSIBILITY OF A NEW PRODUCT, NOT PRODUCT DECISIONS, R&D IS AROUND 20% MORE VALUABLE (Neely) • BALLARD, FUEL CELL VEHICLE • NESTED OPTIONS, ON MARKETS FOR VEHICLES AND POWER SOURCES • INVESTMENT GOOD -- EVEN IF ON AVERAGE FC CAR NOT REASONABLE (Oueslati)

16. EXAMPLE -- FLEXIBLE PRODUCTION • DUAL-FUEL POWER PLANT (Kulatilaka) • DEVICES TO PERMIIT OIL/GAS SWITCH COST • VALUE IS USE OF CHEAPER FUEL • DEPENDS ON FUTURE MARKETS • CAR MANUFACTURE (Toyota, Komatsu) • AIRPORT DESIGN (Shared Gates) • ENABLING FLEXIBLE PRODUCTION • => TRACKING OF VOLATILE DEMANDS

17. EXAMPLE -- NATURAL RESOURCE EXTRACTION • OIL PLATFORMS (Hibernia / Smets) • TRADITIONAL: DESIGN TO TARGET PRODUCTION RATE • OPTIONS ANALYSIS: LARGER SIZES GIVE OPTION ON FASTER EXTRACTION • DESIGN OF MINE DEVELOPMENT (Peru) • EXPLORATION, INFRASTRUCTURE PROVIDE OPTION ON EXTRACTION • WHAT TO BUILD, WHEN?

18. EXAMPLE -- COMPUTER ARCHITECTURE • MODULARITY (Baldwin and Clark) • HOW MANY MODULES? • COST VS. VALUE OF FLEXIBILITY • LOCATION OF NETWORK INTELLIGENCE • CENTRALLY -- AS IN TELEPHONE COMPANY • AT EDGES -- EXTRA EXPENSE CREATES OPTION ON INNOVATION -- USERS CAN EASILY CHANGE DISTRIBUTED DEVICES

19. OPTIONS THINKING… • IF OPTIONS ANALYSIS IMPRACTICAL? • MARKETS POORLY UNDERSTOOD • HISTORICAL RECORDS ABSENT • OPTIONS THINKING • USE DECISION ANALYSIS AS A PROXY • EXTENSIVE SPREADSHEET ANALYSIS • EXAMPLE -- KODAK (See Faulker)

20. CONCLUSIONS • “OPTIONS THINKING” WILL DEEPLY CHANGE THE WAY DESIGNERS THINK ABOUT SYSTEMS DESIGN • “OPTIONS ANALYSIS” WILL ENABLE DESIGNERS, REALLY FOR FIRST TIME, TO VALUE FLEXIBILITY CORRECTLY AND THUS IDENTIFY WHAT KINDTO INSERT IN THEIR CREATIONS

21. REFERENCES -- theory • Trigeorgis, L. (1996) Real Options, Managerial Flexibility and Strategy in Resource Allocation, MIT Press, Cambridge, MA. • McDonald, R. (2000) “Real Options and Rules of Thumb in Capital Budgeting,” in Project Flexibility, Agency and Competition, Brennan and Trigeorgis, Oxford Univ. Press, Oxford, UK, pp. 13-33

22. REFERENCES -- applications • Amran & Kulatilaka (1999) Real Options, Managing Strategic Investment in an Uncertain World, Harvard Business Sch. • Faulkner T.W. (1996) "Applying Options Thinking to R & D Valuation," Research Technology Management, May, 50-56. • Nichols, N. (1994) "Scientific Management at Merck: An Interview with Judy Lewent," Harvard Business Review, Jan. 89-99. • Baldwin and Clark (2000) Design Rules, the power of modularity, MIT Press.

23. RECENT THESES • NEELY -- Ph.D. -- Practical Method for Valuing “Real Options” • Applied to Research Projects at Ford • (with J. Clark, D. Lessard) • OUESLATI -- Method for Valuing Real Options for Multiple Markets • Applied to Ford’s Investment in Fuel Cells • SMETS -- Application to Hibernia Platform