Formulation of Financial Valuation Methodologies for NASA’s Human Spaceflight Program (Hawes & Duffey, 2008)

Real Option Modelling of Projects

Hawes, W. Michael; Duffey, Michael R.: Formulation of Financial Valuation Methodologies for NASA’s Human Spaceflight Program; in: Journal of Project Management, Vol. 39 (2008), No. 1, pp. 85-94.

In this article Hawes & Duffey explore real option analysis as a financial management tool to evaluate projects. The basic idea behind that is management can make go/no-go decisions thus eliminating the downside variability of the value of the project. In short you can always kill a project gone bad of course with sinking some costs.
[Some might call again for Occam’s razor and argue that it is sufficient to model this into the cash flow, because for the option price you need a cash flow anyway. But the authors ]

To put the classical Black-Scholes formula to use the authors look for equivalents to the input variables. More specifically they analyse NASA’s space flight program and valuated projects in respect to their go/no-go decision after the conceptual design. The authors used as input variables

  • NPV of project cash flow = Asset-value (S)
  • Actual one-time development costs = Exercise cost of the option (X)
  • Time until go/no-go decision = Expiry time of the option (T)
  • 5% treasury bill rate of return = Risk-free rate of return (R(f))
  • Historical data on initial budget estimate vs. actual development costs = Distribution of underlying (σ²)

Hawes & Duffey then compare the Black-Scholes pricing to the NPV and find that projects with higher volatility and longer time until decisions are higher priced than short-term decisions with less volatility (i.e. history of cost overruns).

I do find the managerial implications quite counter-intuitive. I modelled some Black-Scholes pricing for a real life project I worked on. My project had a NPV of 48 Mio. EUR but only an option price of 17 Mio EUR since the company had a history of cost overruns and a lot of front-loaded costs, in fact 70% of total expenditures would be spend before the go/no-go decision.
That is all very well and I can clearly see how that improves the decision making,
but if I look into the sensitivity analysis the longer the time to decision and the higher the volatility the higher is my option’s price. This is where I do not fully understand the managerial implication. Given that a similar judgement rule to a decision based on NPV comparison, I would favour a project where I decide later and I would favour projects from a department with higher variability in costs, because this gives me a higher degree of flexibility and higher variability can yield a higher gain. Surely not!?!?

4 Responses to “Formulation of Financial Valuation Methodologies for NASA’s Human Spaceflight Program (Hawes & Duffey, 2008)”

  1. admin sagt:

    Well, I spoke to another colleague of mine who mastered in Financial Engineering, he was telling me that the real option pricing for projects is kind of bogus. According to him, the risk is already properly accounted for in the Cash Flow.

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