Architecting flexible projects and systems using portfolios of real options a decision support framework and two case studies

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Architecting flexible projects and systems using portfolios of real options a decision support framework and two case studies

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DECISION SUPPORT FOR ARCHITECTING FLEXIBLE PROJECTS AND SYSTEMS: AN EVOLUTIONARY FRAMEWORK AND TWO CASE STUDIES by Stephen Xu ZHANG (B. Eng., Nanyang Technological University) A THESIS SUBMITTED TO THE DIVISION OF ENGINEERING AND TECHNOLOGY MANAGEMENT FOR THE DEGREE OF DOCTOR OF PHILOSOPHY AT THE NATIONAL UNIVERSITY OF SINGAPORE 2010 i ii ACKNOWLEDGEMENT This dissertation as well as the research is not possible without the many people who have helped me for years. First, the gratitude belongs to my thesis adviser, prof. Vladan Babovic, who has provided inspiration, direction, time, effort, feedback, catalyst, and support continuously throughout the last four years. He knows what I need better than I and provides more guidance than I could expect. Thanks also to prof. Hang for setting up the division of Engineering and Technology Management and for his version and consistent effort, which helps and steers me through the PhD. Thanks are also due to the people and organizations that have provided funding support for the research. The project from Defense Science and Technology Agency (DSTA) in Singapore provided me with an opportunity to make explicit and to develop at some length a real options approach that has been central to much of my research. Another project, done in Singapore Delft Water Alliance (SDWA), permitted me to amend and expand the real options approach through applying it to additional field in a water supply system. Not only I need to thank them for the generous provision of funding, but also the excellent community for carrying out research projects. In the course of carrying out the MDP case study, thanks to Maarten Keijzer for the application of the multiple-objective evolutionary algorithms into the real options model. He worked patiently with me to set up and make sense of the model immediately after long flights from the Netherland. It went way beyond the call of duty. Thanks also to my other partner in the project, Joost Buurman. It would be hard to imagine a more professional partner. iii Thanks to Nguyen Tan Thai Hung at the National University of Singapore for the development of the MATLAB codes for the water supply system case. His patience and perseverance in working with me was admirable, and the case study would have taken much longer, without working together with him. Thanks are also extended to Joost, Rao Raghuraj, Sarah von Helfenstein, Onion, Yabin, James, S. K. Ooi, Jianghang, Mark Fielding, and Mark Womersley for helping me in writing as well as many valuable conversations. Without their help, this thesis would not have had any chance of being completed by the same time frame at the same quality. Finally, my gratitude goes out to my family. Without their love and support, especially my mom and dad, I would have never made it to a Ph.D. It is unfortunate the thesis is written in a language they know little about, yet it simply confirms again their unconditional love and support on whatever I choose to do. iv TABLE OF CONTENTS ACKNOWLEDGEMENT III TABLE OF CONTENTS V SUMMARY .IX LIST OF TABLES XI LIST OF FIGURES XIII LIST OF ABBREVIATIONS XVII INTRODUCTION . 1.1 MOTIVATION . 1.1.1 Uncertainty and flexibility 1.1.2 Flexibility in the design of systems and projects: a casino example . 1.1.3 Multiple threads of flexibility –their benefits and associated complexity 1.2 RESEARCH OPPORTUNITIES 1.2.1 Research gap 1.2.2 Research question . 10 1.3 RESEARCH APPROACH 11 1.4 ORGANIZATION OF THE THESIS . 15 LITERATURE REVIEW . 17 2.1 INTRODUCTION . 17 2.2 DESIGN . 18 2.3 UNCERTAINTY -A KEY ISSUE IN PROJECT AND SYSTEM DESIGN: 20 2.3.1 Means to reduce uncertainties . 22 2.3.2 Means to cope with uncertainties 24 2.4 FLEXIBILITY 27 2.4.1 Modularity 27 2.4.2 Balancing costs and benefits of flexibility . 29 2.5 OPTIONS AND REAL OPTIONS –FLEXIBILITY FORMALIZED 30 2.5.1 Options . 30 2.5.2 Real options 32 2.6 REAL OPTIONS VALUATION . 35 2.6.1 Options Valuation . 35 2.6.2 Real options valuation 40 2.7 DECISION ANALYSIS AND REAL OPTIONS FRAMEWORKS 48 2.7.1 Decisions . 48 2.7.2 Decision analysis and real options 49 2.7.3 Real options frameworks 51 2.8 RESEARCH GAP ANALYSIS 54 2.8.1 Practical issues of real options related to system and projects design . 54 2.8.2 How the current real options frameworks deals with those practical issues . 56 2.8.3 The techniques used to develop the proposed framework . 57 2.8.4 Evolutionary algorithm . 57 2.9 SUMMARY OF THE CHAPTER 62 PROPOSING A NEW REAL OPTIONS FRAMEWORK BY CONSOLIDATING AND EXTENDING THE PREVAILING REAL OPTIONS PRACTICES BY A STEP OF OPTIMIZATION . 63 3.1 THE PROPOSED REAL OPTIONS FRAMEWORK . 63 3.2 STEP 1: FRAMING . 65 3.2.1 Define system and its objective(s) 65 v 3.2.2 Identify and quantify uncertainties 67 3.3 STEP 2: DESIGN 71 3.3.1 Generate alternative designs 71 3.3.2 Identify and generate options 71 3.3.3 The complexity associated with multiple interacting real options, their costs, benefits and exercising conditions 75 3.4 STEP 3: CHOICES . 76 3.4.1 Simulation-based valuation methods . 77 3.4.2 Issues with using multiple real options in project design . 81 3.4.3 How the prevailing real options frameworks deal with the issues of multiple interacting real options and varying exercising conditions . 84 3.4.4 Issue of the representation of the value of real options from multiple perspectives . 85 3.4.5 Specific methodological challenges to be further addressed . 85 3.5 STEP 3E: THE EXTENDED OPTIMIZATION STEP 86 3.5.1 Overview of the extended step . 86 3.5.2 The mechanism of the proposed framework 87 3.5.3 The partitioning or determination of the exercising conditions of real options . 95 3.5.4 Sensitivity Analysis 100 3.5.5 The focus on searching for better design solutions 100 3.6 THE PROPOSED FRAMEWORK SUPPORTS DECISION MAKERS 101 3.7 THEORETICAL EVALUATION OF THE FRAMEWORK . 103 3.8 SUMMARY . 108 CASE EXAMPLE: MARITIME DOMAIN PROTECTION (MDP) SYSTEM IN MALACCA STRAIT 111 4.1 INTRODUCTION . 111 4.2 BACKGROUND OF MDP SYSTEM 114 4.2.1 MDP system description . 114 4.3 MODEL OF MDP SYSTEM . 119 4.3.1 Uncertainties 120 4.3.2 Options of interest 122 4.3.3 Valuation of real options 123 4.3.4 Optimization by evolutionary algorithms . 127 4.4 RESULTS 131 4.4.1 Project value of a fixed design using deterministic & Monte Carlo simulations . 135 4.4.2 Project value based on the hand-picked real options approach . 135 4.4.3 Project value based on the “EA. selecting real options without exercising rules” approach . 136 4.4.4 Project value based on the “EA. selecting real options together with exercising rules” approach . 138 4.4.5 Real option values in detail using a Value-At-Risk graph . 140 4.4.6 Sensitivity of the value of the real option to the level of the uncertainty . 141 4.5 SUMMARY AND DISCUSSIONS 142 CASE EXAMPLE: SINGAPORE WATER SUPPLY MANAGEMENT SYSTEM . 145 5.1 BACKGROUND 147 5.1.1 Problem statement and approach 147 5.2 SYSTEM DESCRIPTION . 148 5.3 APPLICATION OF THE REAL OPTIONS APPROACH . 152 5.3.1 An overview of the real options model of the water supply system: 152 5.3.2 Objective measures 153 5.3.3 Uncertainties 155 5.3.4 Options of interest 161 5.3.5 Modeling of the water supply system without and with the real options 164 5.3.6 The optimization and selection of option exercising conditions . 169 5.4 RESULTS 170 vi 5.4.1 Sensitivity analysis 173 5.4.2 Determination of option exercising conditions . 180 5.4.3 Discussions 184 5.5 SUMMARY . 187 DISCUSSIONS AND CONCLUSIONS . 189 6.1 A FORMAL METHODOLOGICAL EVALUATION OF THE PROPOSED FRAMEWORK . 189 6.2 DISCUSSIONS 193 6.3 RESEARCH QUESTIONS REVISITED AND CONTRIBUTIONS . 196 6.4 LIMITATIONS 199 6.4.1 Boundary of real options 199 6.4.2 The identification, nurturing and maintenance of real options 199 6.5 FUTURE WORK . 201 6.5.1 The application of the framework 201 6.5.2 The improvement of framework . 202 6.6 SUMMARIZING STATEMENTS . 204 REFERENCES . 205 vii viii SUMMARY The proper decision support to design flexible projects considering downstream decisions under uncertainties is critical yet challenging. While flexibility provides important leverage against uncertainty, decision making that involves the planning and exercising of multiple elements of flexibility under uncertainty is complex, and due to the complexity, organizations often fail in practice to follow a well-structured, accountable and reproducible decision-making process for assessing and selecting flexible projects. This study inherits the prevailing real options practices in framing downstream decisions as real options and establishing the cause-and-effect relationships between flexibility and project value under uncertainty. The study extends that with an optimization step to develop a framework that can handle portfolios of interacting real options in a combinational design space more effectively than humans alone can with bounded rationality. The framework borrows and integrates simulation-based options valuation methods, decision analysis techniques and evolutionary algorithms to search for flexible solutions more effectively. The resulting flexible solutions consist of an initial design and a portfolio of real options with their exercising conditions to adapt according to the manners the future unfolds - in contrast to the common real options practices which primarily aim to derive the option value. Evaluated and exemplified through two real-life cases, the evolutionary framework compares favorably with the traditional fixed design approach and delivers considerable improvements over the prevailing real options practices. In the MDP case study, it is found that designing multiple real options into the MDP system using the proposed framework can increase the system value by 13% beyond that from the prevailing real options practices. In the other case study, it is found that the developments and incorporations of innovative ix water technologies for the water supply system of Singapore are the dominant solutions from multiple perspectives. The proposed decision support framework facilitates the exploration, analysis, optimization, and selection of solutions effectively in a combinatorial solution space – the essence of a design process- and allows the decision process regarding multiple threads of interacting flexibility to be within the bounds of reasonable effort on the part of the decision maker. Therefore, the framework can be used to search flexible designs with portfolios of real options, free up design space, and permit human experts to focus on the more creative process of generating design alternatives to harness more from flexibility. 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IEEE Transactions on Evolutionary Computation 3, 257-271. 220 [...]... design and management of systems and projects Such flexibilities related to systems and projects are specifically known as real options by an analogy with financial options which are purely contractual in monetary terms (Myers 1984, Trigeorgis 1996, Copeland and Antikarov 2001) Both financial options and real options are rights but not obligations to take certain actions at some point of time Real options. .. the feasibility (proof of concept) of the framework in real- world complex and interdisciplinary design problems They also serve to demonstrate and illustrate the practical issues found in the applications of the framework Moreover, despite of the conceptual appeal of real options for designing systems and projects, applications have not been widespread The two cases mark new areas for real options applications... applications of real options but now woven together in a framework to practically design a portfolio of real options in an otherwise intractable design space In order to examine and validate the proposed framework -specifically its effectiveness and efficiency in both finding suitable pieces of real options and formulating a dynamic adaptive plan to increase the project value, the framework is applied to two real- life... Research gap The conceptual appeal of designing systems and projects with real options is strong, however, the valuation and selection of real options to be incorporated in a complex system is non-trivial (McManus and Hastings 2006) The bounded rationality of humans limits our capability to take account of multiple real options and anticipate all the possible 9 contingencies in an inherently combinational... ON PARETO GRAPHS 74 FIGURE 3-5 VAR GRAPH OF THE VALUE OF THE FIXED DESIGN AND THE FLEXIBLE DESIGN WITH REAL OPTIONS OPTIMIZED BY GA – FROM ZHANG AND BABOVIC (201 0A) 80 FIGURE 3-6 VALUE OF SYSTEMS UNDER UNCERTAINTIES THE VALUE OF A FIXED SYSTEM IS DEPICTED IN GRAPH (A) WHEN THE REALIZATION OF DEMAND IS GENERALLY UPWARD AND IN GRAPH (C) WHEN THE REALIZATION OF DEMAND IS GENERALLY DOWNWARD... uncertainty and the interactions among the portfolio of real options where each option may alter the boundary conditions of other options (McGrath 1997) The value of a combination of real options is not the combined value of each option in isolation (Trigeorgis 1993) To value a portfolio of real options, Anand (2007) analyzed the determinants to explain the portfolio effects, and Baldwin and Clark (2000)... prevailing real options practices contain a very selective process so that the number of real options and consequently the design space are both small (Wang 2005), whereas the proposed real options framework relaxes such stringent requirements and considers a larger pool of real options thanks to its expanded capability to value and select them in a large design space (e.g the design space is in the scale of. .. did a similar study for a real option to expand an office building (Figure 1-1) Figure 1-1 A real option to expand an office building in downtown Chicago (Guma 2008) The initial design (a) contains a real option to expand vertically depending on the demand to the building (b) 1.1.2 Flexibility in the design of systems and projects: a casino example Let’s use a simple and general case of building an... infrastructural system with flexibility /options to expand as an example to illustrate the concepts and issues of using real options in real- world projects Suppose the problem at hand is to build a new casino A key problem in designing the casino is that the number of customers the casino will attract in future (i.e the realized demand of the casino) is uncertain On one hand, a capacious casino may not... 10 systems and projects and tests the framework by two cases In doing so, a myriad of intermediate questions arise: • What are the deficiencies of the existing real options frameworks that prevent them from accounting for multiple real options and exercising conditions? • Which parts of the existing real options frameworks can be reused? • Can the proposed framework be built upon the existing real options . 2.7.1 Decisions 48 2.7.2 Decision analysis and real options 49 2.7.3 Real options frameworks 51 2.8 R ESEARCH GAP ANALYSIS 54 2.8.1 Practical issues of real options related to. Options 30 2.5.2 Real options 32 2.6 R EAL O PTIONS V ALUATION 35 2.6.1 Options Valuation 35 2.6.2 Real options valuation 40 2.7 D ECISION ANALYSIS AND REAL OPTIONS FRAMEWORKS . extends that with an optimization step to develop a framework that can handle portfolios of interacting real options in a combinational design space more effectively than humans alone can with

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