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Opportunity Engineering

Opportunity Engineering. Harry Larsen The Boeing Company SCEA 2000 Conference. Opportunity Engineering. Probability distributions describe both risks and opportunities This presentation is about how to derive economic merit from those opportunities. The Financial Option.

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Opportunity Engineering

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  1. Opportunity Engineering Harry Larsen The Boeing Company SCEA 2000 Conference

  2. Opportunity Engineering Probability distributions describe both risks and opportunities This presentation is about how to derive economic merit from those opportunities

  3. The Financial Option • A financial option is a contract providing its owner with the right to buy a security at a future date for a specified (strike) price • If the stock price at that future date is greater than the contracts strike price a profit can be realized • The expected NPV of that profit discounted at the appropriate risk* adjusted rate is the options value • *This paper will not address the determination of the risk appropriate discount rate

  4. The Financial Option • A contract to buy a share of stock for $10.00 in one year • The future stock price is described by a lognormal distribution with a mean of $10.00 , a σ of $2.50 and a risk adjusted discount rate of 9% • The value of this option is $1.44

  5. The Program Termination Option • Like a Financial Option • The cash flow of an aerospace developmental program is uncertain • That uncertainty is reduced with investment • Choosing to continue only those programs that have positive NPV of cash flow is an option • Exercising that option increases value • Its value is the expected NPV of the future cash flow less the investment

  6. Expected NPV of Cash FlowThe NPV is positive - Program Go Ahead

  7. NPV Cash Flow Monte Carlo Realizations

  8. The Program Termination Option • The option to terminate is continuous • In these examples the termination option is reconsidered during each program review • The reviews are held at 6 month intervals • It is non revocable • A decision to terminate forgoes all future potential profits or losses • A decision to continue only commits cash flow until the next decision date - 6 months

  9. The Program Termination Decision • The program termination problem is to develop a sequence of decision criteria that maximize expected NPV of cash • The sequence is based on: • The expected NPV of the future cash flow at the time of the decision • It recognizes the differing consequences of program continuation versus termination • The decision criteria set is derive by examining all possible decision criteria sequences and choosing the best • Using a dynamic programming algorithm

  10. Simulation - Background • Monte Carlo, 1000 cash flow iterations • Content, cash flow for: • The design, manufacture, launch, and operation of a communications satellite constellation • Uncertainty in: • Cost (in time domain) • Completion dates • Design parameters (e.g. weight) • Launch success • Satellite orbital reliability • Revenue

  11. Simulation - Cost • Monte Carlo realizations and Expected Value

  12. Simulation - Revenue • Price variation - Monte Carlo realizations and Expected Value • Revenue proportional to satellites in service and service price variation

  13. Termination Review • Termination decision revisited at each program review, held at 6 month intervals • Decision based on expected NPV of cash flow versus simulated NPV • Optimal decision criteria sequence derived via dynamic programming • For each termination decision • Expected NPV estimated using a multiple regression • Multiple regression’s independent variables • Price of service • Cumulative expenditures to date

  14. NPV Estimates • Scatter-grams “actual” versus estimated NPV

  15. Optimal Termination Criteria • Using dynamic programming a search of all possible criteria sequences between the highest and lowest BTG estimates is made • The sequence that yields the highest expected NPV (including sunk cost) is the optimal criteria

  16. Option Statistics • Program without termination option has an expected NPV of $262.6M • With termination option NPV is $299.2M, most decisions made by 6/02

  17. The Program Termination Option • If estimating the NPV of a contract • That contract has an option to terminate • The contract’s cash flow in uncertain • Then the termination option has a value • That value is part of the contract value • If managing a contract/program • The above conditions are met • Then the optimal (Max NPV) termination option policy is determined as illustrated

  18. Other Program Management Options • Revenue determination • In this simulated program, revenue uncertainty is a strong determinant of NPV uncertainty • The program has alternative mechanisms to resolve revenue uncertainty • Design options • The program has choices of how advanced a technology will be employed in the satellite • Whether they are developed in advance of the bulk of the program design activity or concurrently • When the choice between alternative designs should be made

  19. Revenue Determination • The simulated program has a revenue (Market) assessment group • This group can expend significant resources early to resolve revenue uncertainty • The resolution may be done concurrently with the design activity • The resolution may wait until the satellites are deployed • Because of the impact on cash of revenue uncertainty there is merit to its early resolution • However the investment could be large and the resolution incomplete • We will calculate the NPV of alternative plans

  20. Alternative Revenue Resolution Plans • Market analysis beginning June 2000 • Market analysis beginning June 2001 • Market analysis beginning June 2002

  21. Cash Flow - Expected NPV • Three 1000 iteration simulations were run • All parameters were held constant except the phasing of the market analysis team effort

  22. Revenue information becomes available at different times • Scatter-grams “actual” versus estimated NPV at 12/2001 • Plan 6/2000 6/2001 6/2002

  23. Revenue Uncertainty Resolution Statistics • Market analysis beginning June 2000 • Market analysis beginning June 2001 • Market analysis beginning June 2002

  24. Revenue Uncertainty Plan • Beginning the market analysis group effort in 6/2000 has a $185M NPV advantage over beginning it in 6/2001 • This was achieved by terminating an additional 19% of initiated programs beyond 21% in 6./2001 plan • An investment up to $185M NPV could be made (and justified) in the 6/2000 plan to conduct e.g. market experiments • The difference between the 6/2001 and 6/2002 plans is only $13M NPV • With the 6/2000 market analysis plan 3/4 of the termination decisions were made by 12/2001

  25. Design Options Risk mitigation Planning • Decisions between alternative technologies is a fundamental element of the design process • With advanced technologies we have less experience, the outcome is more uncertain, but they have the potential of better performance • With the mature technology we know its performance, but we forgo the possibility of improvement • The simulation • A satellite power supply: performance parameter - weight • Uncertainty evolution: additive time domain brownian motion proportional to effort • Mature 100 pounds EV, Standard deviation 10% • Advanced 80 pounds EV, Standard deviation 40%

  26. Mature Technology • Time evolution of weight parameter without a design option

  27. Design Option • Time evolution of weight parameter with a design option • Mature technology baselined, Decision date 6/2002 • The option process produces a design weight EV below the EV of either option taken alone

  28. Design OptionWhen should the decision be made? • Mature technology baselined, Earlier decision date 12/2001 • Making the decision earlier, with less information, produces poorer results - no better than picking the best EV

  29. Design OptionShould the advanced technology be pre-implemented e.g. an R&D program? • Mature technology baselined, Earlier decision date 12/2001 • Advanced technology pre-implemented - 6 months • More information about advanced technology produces a better decision • Mature technology choice is no better than EV • Program EV is better than either option taken alone

  30. Opportunity Engineering • Cash flow probability distributions often have two tails • The opportunity to take advantage of positive events can be planned into a program • The evaluation of such plans can be made with • the Real Options paradigm - dynamic programming • the time evolution of NPV uncertainty - estimation • Such plans allow us to embrace uncertainty to our benefit

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