Date of Award

Spring 2002

Document Type

Dissertation

Degree Name

Doctor of Business Administration (DBA)

Department

Economics and Finance

First Advisor

Roger Shelor

Abstract

The Applications Service Provider (ASP) arrangement has engendered a revolution in the area of corporate information technology (IT) by transforming software from a packaged off-the-shelf product to an on-line virtual service.

The focus of this study is to establish a sound mathematical foundation for evaluating software rental agreements (embedding exit flexibility) by incorporating a real options framework (based upon the Black-Scholes approach) into the traditional capital budgeting technique. The static discounted cash flow or net present value analysis may not adequately serve as a ‘barometer’ of outsourcing value due to its inherent weaknesses. On the other hand, the options approach to valuing real investments appropriately prices the state-contingent opportunity risk of outsourcing flexibility in the model's variance parameter.

ASP or outsourcing mechanisms embedding the exit (or, deferral) option are developed and examined from the viewpoint of the renter as well as the subcontractor. From the renter's perspective, the value of the flexible outsourcing contract is modeled as a combination of tangible and intangible payoffs. A numerical illustration is used to demonstrate the applicability of the proposed model. The intangible payoff (given applications software alternatives), which is evaluated within the Margrabe's simple exchange option model, is found to increase at higher volatility levels, with the highest option prices (and investment values) tending to occur where the technological divergence between underlying applications environments is the greatest. Therefore, while evaluating rental software alternatives, IT managers should also consider the underlying applications technology in terms of the directional impact of new information.

From the subcontractor's perspective, the value of the flexible outsourcing contract is modeled as a combination of a continuing ASP arrangement and the ‘aggregate’ option premium. A numerical analysis is conducted using actual data to examine model outcomes in the light of some results gleaned from related financial and real options literature. The value of exit flexibility, calculated as a ‘truncated’ nested call within a modified version of Carr's compound exchange option model, is less than the commonly designated upper bound. The analysis also reveals that the intermediate exit options can be expressed in terms of the terminal exit opportunity. Hence, one may obtain the outsourcing value by easily ‘weighing’ the simple option premium for the final decision implementation point with the appropriate ‘probability-discount’ factor. Further, consecutive options in the nested series exhibit a decreasing price trend as is observed under other multi-stage options scenarios. Finally, the study develops a theory of optimal exit times for outsourcing contracts that are designed to continue indefinitely into the future. (Abstract shortened by UMI.)

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