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Applying Real Option Theory to Software Architecture Valuation

Applying Real Option Theory to Software Architecture Valuation. Yuanfang Cai University of Virginia. Outline. Issues that are Unsolved by Information Hiding Options: What and Why? Summer Efforts Real Options in Avaya Summary and Discussion. Issues that are Unsolved by Information Hiding.

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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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