Using Real Options as a Tool to Manage Sequential Information Technology Projects

Situation

Consider a consumer goods company that is considering implementing two, sequential Information Technology projects: $(1)$ a first stage project consisting of a high$-$speed Local Area Network $($LAN$)$ and, $(2)$ a second stage project consisting of an Enterprise Resource Planning $($ERP$)$ System. If the LAN is successfully implemented, managers across different functional areas such as marketing, finance, product$-$design, production, etc., will use the ERP system to make coordinated decisions. The improved decision$-$making will not only reduce costs, but also increase revenue.

Assumptions

$$ The LAN $($by itself$)$ does not bring any benefits. While this is not a reasonable assumption, we will make it to keep things simple. However, the LAN is necessary for the ERP system to work effectively.

$$ The benefit from the ERP system depends on market conditions in the future. If these conditions are favorable, then the ERP system will reap higher benefits.

$$ At the time of the LAN investment, the market conditions are uncertain. However, at the time the ERP investment $(1$ year after the LAN decision$),$ all uncertainty associated with the market will be resolved $($e$.$g$.,$ it can be assumed that here is an important decision that the government will take after $1$ year that will strongly influence the demand, favorably or unfavorably$).$

Data

$$ Cost of the LAN $($in thousands of dollars$)=100$

$$ Time for the LAN to be implemented $($years$)=1$

$$ Cost of the ERP system $($in thousands of dollars$)=250$

$$ Time for ERP system to be implemented $($years$)=1$

$$ ERP benefit if demand is high $($in thousands of dollars$)=500$

$$ ERP benefit if demand is low $($in thousands of dollars$)=100$

$$ Probability that market conditions are favorable $=0\mathrm{.}6$

$$ Probability that market conditions are not favorable $=0\mathrm{.}4$

Question

Should the firm invest in the LAN? For now, ignore discounting.