2010 International Conference on Challenges in Environmental Science and Computer Engineering

Study on IT Infrastructure Investment Appraisal Based on Real-option Theory

Guo Xiaojian

Jiang Tianci

School of Economics and Management

Jiangxi University of Science and Technology
Ganzhou, Jiangxi Province, China
windtalker12@sina.com

School of Economics and Management

Jiangxi University of Science and Technology
Ganzhou, Jiangxi Province, China
83965104@qq.com

AbstractIn the Information Technology (IT) era, investment

on IT infrastructures plays an important role for it will
influence future competitiveness of enterprises. But up to the
present, the study of applying real-options to IT
infrastructures investment is still in its preliminary stage, and
a general appraisal framework has not been established to
assess IT investment by option model. In this paper, an IT
infrastructure investment appraisal model is set up by realoption theories to help enterprises make the right investing
decision. Finally, by sensitivity analysis, the conclusion is
drawn that factors such as demand volatility and cost
advantage affect the value of IT infrastructures.
Keywords-information
technology;
infrastructure; investment appraisal

I.

real-option;

INTRODUCTION

Financial option is a contract that gives the holders the

right to sell a certain quantity of a financial asset (or
Underlying Assets) to the writer of the option, at a specified
price (strike price) up to a specified date (expiration date),
while real-option is the extension of financial option in
physical investment field. The core idea of real-option is that
uncertainty can increase the value of enterprises investment
and that holders of option can postpone the choice of
whether make investment on the asset so as to minimize the
risk of devaluation and as well as to keep the stability of
holding assets income. In the IT investment study field, there
are there prerequisites to appraise and manage high
technology investment and other similar uncertainty
investments by real-option, that is, the uncertainty of net
income, the irreversibility of investing cost and the flexibility
of project management [1]. The idea of option means that
enterprises are more inclined to IT investment with high
uncertainty and to stopping or adjusting uncertain investment
projects in time.
IT infrastructure, similar to the structure of real-option, is
the basic investment on product investment, which creates a
right for enterprises to continuously develop product [2]. IT
basic investment serves as setting up an initiative option by
which enterprises are able to conduct several new product
developments at the same time, but usually products are
closely related by a general IT infrastructure [3]. So to speak,
the development of IT infrastructure is an investment by
enterprises on package of product development projects that
are more closely related in technology and in strategy,
therefore to create more opportunities for enterprises to
978-0-7695-3972-0/10 $26.00 2010 IEEE
DOI 10.1109/CESCE.2010.51

collect resources so as to realize more values and increase

the competitive advantages.
Bruce and Kulatilaka [4] held the view that option value
of platform investment lies in uncertainty, opportunities
aggregation, management flexibility and decision making
time. IT infrastructure constructs a platform that can create
values, and bring a series of investing opportunities that can
invent or develop follow-up products. It is in the
opportunities aggregation that is the option value of IT
infrastructure lies.
IT infrastructure investment has the characteristics of
growth and providing supportive platform for the following
investment and innovations, in this sense, it has created a
strategic growth option, the evaluation of which is an
important basis of IT infrastructure investment [5]. In this
paper, an option value appraisal model is established to
evaluate IT infrastructure investment quantitatively.
II.

PROBLEM DISCRIPTION

Current income generates from IT infrastructure

investment is not clear, because its value mainly comes from
the application of infrastructure, that is, follow-up
investment income from future investment opportunities.
Since the strategic values of IT infrastructure investment
mainly focus on values brought by future investment
opportunities which allow enterprises to extend r adjust the
basic functions of IT infrastructure to market requirement, it
conforms to the characteristic of growth option.
BalasubramanianKulatilaka and Strock [6] studied on
the problem of how to appraise IT infrastructure investment.
The authors considered IT as a kind of capacity to invest, and
by production possibility frontier, connected investment with
real-option. In the actual real-option appraisal models, it is
also proposed by many documents that real-option idea
should be integrated into the framework of cost-benefit
analysis combining with investment project characteristics.
In the constructing of IT infrastructure investment
appraisal model, this paper begins from the cost-benefit
analysis of IT investment. Considering that market demand
volatility of follow-up investment projects is the key factor
to determine IT platform value, market demand preference is
viewed as random variable. The IT infrastructure investment
appraisal model is set up in this paper based on such method
as Black Scholes option pricing equation. Six basic
elements and their corresponding factors in IT infrastructure
growth option are generalized in Table 1.

159
158

TABLE I.

THE CORRESPONDING FACTORS IN IT INFRASTRUCTURE

GROWTH OPTION

Financial Option
Underlying asset
Price of underlying
asset
Market volatility
Striking price
Expiration date
Option premium

III.

Real-option in IT Infrastructure
Commercial applications based on certain IT
infrastructure and follow-up investment
projects that may exist.
Values (returns) from follow-up investment
projects
Market demand uncertain of follow-up
investment projects
Cost payment of follow-up investment projects
Time of gaining the IT infrastructure resources
to losing the following investment
opportunities
Expenditure of IT infrastructure

MODEL CONSTRUCTION

A. Description of Investment Cost

If an enterprise decides to invest on IT infrastructure for
the time being, it is equivalent to creating a strategic growth
option by some cost. The investment cost K includes the
purchase cost the enterprise pay for software and hardware,
and internal cost such as development and training, and study
in absorption. Existing IT infrastructure will influence the
input cost of IT infrastructure for the next stage. Since an
enterprise has conduct investment on IT infrastructure for the
time being, it has gained the right to develop and to conduct
follow-up investment according to market requirement in
some future, which is similar to the situation in financial
market where enterprises decide whether execute call option
or not.
In order to calculate the cost for investment in the next
stage, product performance parameter s is introduced. A
good performance parameter (high s value) means a high
cost while bad performance parameter (low s value) means
a lower cost. The performance parameter s covers a wide
range, including product quality, differences, advances and
etc. If the enterprise conducts investment for the next stage,
the cost paid now will be: fixed cost fs 2 that is related to
product performance parameter, variable costs cd that
changes with the demand d , in which f and c are both
constant parameters.
If the enterprise does not invest on IT infrastructure for
the time being, in order to gain the same product
performance parameter s in the future, the enterprise will
have to bear the penalty cost of not investing in time when it
conduct the same investment. The penalty cost includes the
extra time, cost and human resource to meet the follow-up
investment demand. Factor > 1 is used to indicate
the effect postponing IT infrastructure investment has on the
fixed cost of follow-up investment therefore fixed cost rise
from fs 2 to fs 2 . Factor is influenced by the utilization of
IT infrastructures, organization study barriers and technical
progress.
Case 1: if IT infrastructure investment is conducted for
the time being, Cost of Initial Investment on IT
Infrastructure

CII = K > 0

Executing
Opportunities

Cost

for

the

Follow-up

(1)
Investment

ECFIO = fs 2 + cd

(2)
Case 2: if IT infrastructure investment is not conducted
for the time being, Cost of Initial Investment on IT
Infrastructure
CII ' = K = 0
(3)
Executing Cost for the Follow-up Investment
Opportunities
ECFIO' = fs 2 + cd
(4)
B. Demand Function
Suppose the equation of linear demand function is
d = s p
(5)
In the above equation, d means the demand for
derivatives from follow-up investment; s means product
performance parameter; while is random variable that
indicates demand preference for product with some
performance parameter s , and p , the price. We can see from
the above equation that product demand increases with the
increase of demand preference , so obviously supposed
>0.
Suppose demand preference is subject to Geometry
Brownian movement, with its expected value as 0 and
volatility as . Then according to the property of Lognormal
Distribution function, it could be

1

ln ( ) ~ ln 0 2 , 2
2

(6)

C. Investment Expected Return

1) In case 1, if IT infrastructure investment is conducted
for the time being, the return from follow-up investment can
be deducted as follows:
Investment = pd fs 2 + cd
(7)
With (5) being put in (7), we get
Investment = fs 2 + ( p c )s + pc p 2
(8)
Since the enterprise is recipient of market price, first
the optimal product performance parameter s that can
maximize return should be chosen. According to the first-

order condition

=0
s

the optimal product performance

parameter s t is gained as s* =

pc

2f

Under this the optimal product performance parameter,

the maximum return from follow-up investment project is
Investment
max
=

( p c)2 2 4 fp( p c )
4f

(9)

If and only if it is profitable, that is, Investment > 0 , it is

possible for the enterprise to execute the following
investment opportunities, or the enterprise will wait or give
up. So return function of the follow-up investment project
will be

159
160

0 ( < 1 )

Investment = ( p c )2 2 4 fp( p c )

4f

(10)

( 1 )

Therefore, if IT infrastructure investment is conducted

for the time being, the overall expected return, with followup investment project profits from IT infrastructure under
consideration, is as follows:
Investment( ) = E Investment 1 Pr( 1 ) K (11)
2) In case 2, if IT infrastructure investment is not
conducted for the time being, the return from follow-up
investment can be deducted as follows:
Noinvestment = pd fs 2 + cd
(12)
With (5) being put in (12), we get
Noinvestment = fs 2 + ( p c )s + pc p 2
(13)
If and only if it is profitable, that is, Noinvestment > 0 , it is
possible for the enterprise to execute the following
investment opportunities, or the enterprise will wait or give
up. So return function of the follow-up investment project
will be

0 < '
1

Noinvestment = ( p c)2 2 4fp( p c)

4f

1'

(14)

Therefore the expected return from project investment

will be

Noinvestment ( ) = E Noinvestment 1' Pr 1'

(15)

D. IT Infrastructure Investment Appraisal Model

IT infrastructure value, that is, IT infrastructure strategic
growth option value, and also created investment
opportunity value, is equal to the difference of overall return
from investment now and investment someday in the future
between whether conducting IT infrastructure investment or
not.
With (11) detracted from (13), we can get
G ( ) = V Investment ( ) V Noinvestment ( )
(16)
When G ( ) 0 it means that IT infrastructure investment
is not valuable, and investment can be omitted to avoid
useless waist. On the contrary, when G ( ) > 0 it means that
investment value of IT infrastructure is positive, and
investment is worthwhile conducting.
CALCULATION OF THE SOLUTION

IV.

A. Analysis on the Deduction of Solution

In order to get accurate figure of IT infrastructure asset,
analytical solutions of G ( ) should be deducted. Elaborate
Integral on 11 and 15 which means functions of
expected project investment return under different conditions
respectively, analytical solutions of each function can be
gained, and by putting it in16, we can get G ( ) .
First, Elaborate Integral on11

< 1 Give up following investment

Case 1: IT infrastructure
investment conducted

4f

f ( ) d ( ) K

( p c )2 2 e 2 (a ) p( p c )(a ) K
1
2
0
4f

In which

opportunities
( p c )2 2 4 fp( p c )
4f

ln 0 + 3 2
1
a1 =
2

, a2 = a1 2 , ()

means accumulative probability distribution function that

obeying standardized normal distribution .
Similarly, by Elaborating Integral on (15) we can get its
analytical solutions
V Noinvestment ( 0 , ) =

( p c)2 2 e 2 (a ) p( p c) (a )
3
4
0
4 f

(18)

< 1' Give up following investment

opportunities

In

=0

ln 0 ' + 3 2

1
which a 3 =
2

a 4 = a 3 2

IT infrastructure investment value

G ( 0 , ) = V Investment ( 0 , ) V Noinvestment ( 0 , )

Case 2: IT infrastructure

1' Execute following investment

investment not conducted
opportunities

(17)

=0

1 Execute following investment

Figure I

( p c )2 2 4 fp( p c )

opportunities

K0

V Investment ( 0 , ) = E Investment 1 Pr ( 1 ) K

( p c )2 2 4fp( p c )
4 f

IT infrastructure investment situations decision tree

(19)

B. Analysis on Sensitivity
According to the characteristic of IT product, data
simulation method can be used to analyze the influence
different factors have on IT infrastructure value and on
enterprises investment decision. We can suppose the value
of relative parameters, without loss of generality, that K = 3
f = c = 1 0 = 5 , = 1.1 . IT infrastructure value is

160
161

IT Infrastructure Value G()

Cost Advantage
Figure Analysis on Sensitivity

calculated by Excel software with equaling to 0.20.5

1.01.5 respectively, and analysis result is drawn based on
outcome of the calculation as Fig. 2.
V.

advantage in IT application and development, even though

there is big uncertain in future demand.
Conclusion 2: When the demand volatility is very high,
the effect cost advantage has on IT infrastructure value is
more evident.
As we can see from Fig. 2 that in the 4 curves, curves
with higher has a bigger slope. So Fig. 2 bring a
conclusion that has not been reflected in general standard
analyzing model, that is, if enterprise conduct IT
infrastructure investment for the time being, it has
undoubtedly gain cost advantage in seizing future investment
opportunities; but if future product demand volatility is so
low that it has only slight influence on infrastructure
investment, increasing future product demand volatility will
intensify this cost advantage greatly and enhance the effect
of investing now. Consequently, when selecting IT
infrastructure project, more attention should be paid to the
influence cost advantage has on IT infrastructure value, if
demand volatility of expected follow-up project or of
extended application is significant.

CONCLUSIONS

Conclusion 1: The higher the demand volatility is, the

more valuable IT infrastructure is.
The market demand volatility is represented here by .
The bigger , the less stable the market demand is and thus
higher risks. Four curves are drawn in Fig. 2, is upwards
equal to 0.20.51.01.5 respectively, and we can see
that the value of influence G ( ) greatly. The higher G ( )
value is, the less stable product demand preference is from
the market and the more valuable IT infrastructure
investment is. This conclusion conforms to that of option
pricing model, that is, option value increases with the
increase of underlying asset volatility.
Therefore, when making decision on IT infrastructure
investment, the key point is to focus on the demand for
follow-up product from IT infrastructures. When there is a
high potential demand for these product, enterprises should
invest on IT infrastructures actively so as to get first mover

REFERENCES
[1]

[2]

[3]
[4]

[5]

[6]

161
162

Fichman, R.G., Keil, and M. Tiwana, A Beyond Valuation: Options

Thinking in IT Project, Management, Boston College working
paper, July 2004, pp. 116123.
Thatcher.M, and Oliver.J, An economic model of product quality
and IT value, Information System Research, vol 15, August 2004, pp:
268286.
Taudes, A Software growth options, Management Inform Systerms,
vol 15, May 1998, 15(1), pp. 165185.
Kogut.B, and Kulatilaka.N, Option thinking and platform
investments: investing in opportunity, California Management
Review, December 1994, pp. 235242.
Barua.A, and Kriebel.C.HIT and business value: An analysis of
strategic information technology investments, MIS Quarterly, vol 15,
September 1991, pp. 313331.
Balasubramanian, Kulatilaka, and Storck, Managing information
technology investment:Using a real options approach, Journal of
Strategic Information Systerms, vol 9, March 2000, pp. 3962.