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Applying Real Option Theory to Software Architecture Valuation

Explore the use of real options theory in valuating software architecture, addressing gaps in current practices and discussing the benefits of employing option pricing models for decision-making in software investments.

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Applying Real Option Theory to Software Architecture Valuation

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  1. Applying Real Option Theory to Software Architecture Valuation Yuanfang Cai University of Virginia

  2. Outline • Issues that are Unsolved by Information Hiding • Options: What and Why? • Summer Efforts • Real Options in Avaya • Summary and Discussion

  3. Issues that are Unsolved by Information Hiding • Difficult Justification of the Cost • Predict future • Study the commonality among family members • Time/Quality Dilemma • Future Prediction Never Happens • Taken Software Design as an Investment Activity, What are the Values of Information hiding Infrastructures?

  4. Current Valuation Practices and their Insufficiency • Valuation by Products • Discount Cash flow (DCF) Present Value = Future Value/(1 + k)t k: Risk Adjusted Discount Rate t: Project Time • Decision Tree Analysis (DTA) • Each possible outcomes in each time period is treated as a branch • Probabilities of each outcome are estimated • Backward Dynamic Programming • Why They are not Suitable for Product Line Architecture Valuation? • DCF: Operational Flexibilities are ignored • DTA: Fixed Discount Rate

  5. Options: What and Why • Financial Origin Financial Options give investors the right without symmetry obligation to buy/sell stocks at a predetermined price (exercise price) before/at a preset time (expiration time). • From Wall Street to Main Street Real Options give investors the right without symmetry obligation to take an action at a predetermined cost (exercise price) at a certain point of time (expiration time). • Options Way of Thinking: Risk Management Strategy • Uncertainties create opportunities • Create Options to manage risks and master the upside • Make minimal investment at the beginning and make incremental investment stage by stage

  6. Options: What and Why • Early Exploration of RO Application in Software Architecture • Modularization create portfolios of options • Information hiding gives the rights without symmetry obligation • Product Line Strategy implies Options way of thinking • Why Option Pricing in Financial and Real Option World? • Why Option Valuation in Software Infrastructure? • Black-Scholes Option-Pricing Model

  7. Options: What and Why • Black-Scholes Option-Pricing Model C(S, ; E) = SN(d1) – Ee-  rN(d2) d1 = (ln(S/E) + (r + 1/22) )/ ( 1/2) d2= d1-  1/2 • Key Elements in the Model • S: Underlying asset value • E: Exercise price • : Standard deviation of the rate of return • : Expiration time • r: Risk free interest rate • C: Option premium/option price

  8. Examples that Show Differences Non-Phased Development vs. Phased Development • A Project Business Case • Five years • Total Investment: $11 Million • Expected Cash Flow in year 5: $21 Million • Non-phased development • NPV computed by Traditional DCF (worst case): $1mm • Phased Development • Phase 1 • First year: I1=$5 Million • The expected Net Cash flow from Local Distribution: V1 = $5 Million • NPV of phase 1 is 0

  9. Examples that Show Differences Non-Phased Development vs. Phased Development • Phased Development • Phase 2 (option) • The second outlay in 3rd year: I2=$6 Million • The expected Net Cash flow from expanding Distribution: V2 = $15 Million • The Uncertainty of V2:  = 0.5 • Value of the Option: $10 Million • Expanded NPV = NPV of phase 1 + option premium of phase 2 = 10 Million

  10. Summer Efforts • Applicability of RO Valuation to Software projects • Recognizing Options in Software Product Line • Data Collection for Valuation on Real Projects

  11. Applicability of RO Valuation to Software Projects • Assumptions • Stochastic Process • No-arbitrage equilibrium • Existence of traded securities to replicate the payoff to options • Communication with RO community

  12. Recognizing Options in Software Product Line engineering • Identify Options: Deferrable, Expiring, Compound and Simple • S: Underlying asset value Net cash flow from family members • E: Exercise price Cost of building new family members • : Standard deviation of the rate of return • : Expiration time Project terminal year • r: Risk free interest rate • C: Option premium/option price The Value of the product line infrastructure

  13. Real Options in Avaya • Fertile Fields • The Need for Real Options Valuation is recognized • Most Data are available • Sterile Fields • Data are hard to get • Insights into Business Data must be improved • Established Ways of thinking

  14. Summary and discussion • Justification of applicability to software architectures • Identification of options in software architectures and product line engineering • There is a big gap between architecture side and business side • Quantification and Ways of Thinking

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