The Engineering Economist, 47(3): 308-353, November 2002.
Commercial software development is an inherently uncertain activity. Private risk is high, schedule and cost overruns are common, and market success is elusive. Such circumstances call for a disciplined project evaluation approach. This paper addresses the of use of market and earned value management data in assessing the economic value of commercial software development projects that are simultaneously subject to schedule, development cost, and market risk. The assessment is based on real options analysis, a financial valuation technique that can tackle dynamic investment decisions under uncertainty. The paper demonstrates the application of real options analysis to a development scenario that consists of two consecutive stages: a mandatory prototyping stage and an optional full-development stage. The full-development stage is undertaken only if the prototype is successful and the market outlook is sufficiently positive at the end of the prototyping stage, thus giving the full-development stage the flavor of an option. The project's staged design increases its value. Real options analysis captures the extra value due to optionality.