A real options approach for prioritization of a portfolio of information technology projects: a case study of a utility company

The valuation of information technology (IT) investments is particularly challenging because it is characterized by long payback periods, uncertainty, and changing business conditions. Corporate budgeting methods use accounting-based criteria like return on investment (ROT), internal rate of return (IRR), and payback period which were designed for projects with no option features. However, the uncertainties underlying IT investment decisions and the inability of traditional discounted cash flow (DCF) methods to incorporate the impact of flexibility on project valuation, force executives to rely on gut instinct when finalizing IT investment decisions. Real options analysis (ROA) has been suggested as a capital budgeting tool because it explicitly accounts for the value of future flexibility in management decision making. This paper deals with the application of a nested real options model to evaluate and prioritize a portfolio of information technology projects. It elaborate the valuation and prioritization of a real-world portfolio of IT initiatives under consideration for funding. It is illustrated using real world data from EnergyCo, a large utility facing challenges on many fronts due to uncertainties surrounding energy deregulation and Internet-based energy trading.