Real options valuation on six sigma projects

Economist and financial institutions have long being using option analysis but executives still use the traditional methods for valuing investments (net present value). According to Miller and Park [1], these methods require the assumption of certainty of project cash flows, but fail when used to evaluate strategic investments where payoff is uncertain or at risk. Being uncertainty one of the major issues of long duration projects, practitioners usually use high risk project ratios in order to ensure the viability of the projects. By doing so the threshold that a project has to exceed in order to become viable is sometimes too high, making the company lose potential benefits or market advantages. This study wants to better understand Real Option Analysis, its application into Six Sigma project evaluation models and the added value obtained by the managerial flexibility that the real options offer. To do so it reviews three real option models: (1) Binomial lattice, (2) Pentanomial lattice, and (3) staged R&D model and then compares the results obtained by valuating the same project using the three different approaches and the traditional NPV. With the numerical demonstrations we see that the staged R&D model needs a further adaptation to be able to fully compare its numerical results with the other two models. Also find that Real Option models are still hard to include in the practitioners tool kit due to the necessity to adapt or create an specific model for each individual project.Outgoin