FLEXIBILITY IN DESIGN - Title Page - MIT

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de Neufville + Scholtes D R A F T September 30, 2009• Enable the system manager to control the risks, reducing the downside exposure whilesimultaneously increasing the upside opportunities, thus making it possible fordevelopers to shape the risk profile. This not only gives them greater confidence in theproject, but also may reduce their risk premium and thus further increase value. and• Often significantly reduce first costs of a project – a counter-intuitive result due to the factthat the flexibility to expand easily means that many capital costs can be deferred untilprospective needs can be confirmed.Example: parking garageThe example concerns a multi-level parking garage an entrepreneur plans to build next to a newcommercial center in a region whose population is growing. Details are in Box 3.1. For thepurpose of the example, we assume that the only design parameter of interest is the number oflevels. So the issues addressed are: What is the value of the project? How many levels is itdesirable to build?We use the example in three steps to demonstrate the value of flexibility in design.• Base case: we look at the standard evaluation process, which evaluates a project basedon the most likely forecast.• Recognizing effects of uncertainty: we compare the base case with what happens whenwe realistically recognize that the world is uncertain. The example shows that we not onlyvalue the project quite differently from the base case, but also that the best design canturn out to be different. In short, we show that the standard process is fundamentallydeficient.• Using flexible design to manage uncertainty: we show how the results of the analysisconsidering uncertainty helps us understand how to improve design and value. Inparticular, we show how flexibility enables systems managers to adapt the project to thefuture as it evolves, and thereby avoid downside risks and take advantage of upsideopportunities.[Box 3.1 about here]Base case: standard analysis using assumed projectionThe standard analysis uses a straightforward discounted cash flow analysis. We set up aspreadsheet of the annual costs and revenues for any configuration of the project, sum to find thenet cash flows in each period, and discount these sums using a discount rate appropriate to theenterprise. Table 3.2 shows this layout for a particular design. To find the best design – that is,the one that maximizes value – we use this analysis for all the possible levels of the garage. Wefind out if the project is worthwhile by seeing if the best design leads to a positive net presentvalue (NPV). (Appendix B gives details on the procedure.)Part 1: Chapters 1 to 3 <strong>Page</strong> 46 of 69
de Neufville + Scholtes D R A F T September 30, 2009[Tables 3.2 and 3.3 about here]Applying the standard discounted cash flow analysis to the case, we obtain the results inTable 3.3. As it shows, the project appears to be worthwhile, delivering positive NPV beyond therequired 10% cost of capital. Further, the 6-level design maximizes the NPV. In this case, asoften occurs, the design has a “sweet spot” that maximizes value. The graph of NPV versusnumber of levels illustrates this phenomenon (Figure 3.2). If the garage is too small, it does notgenerate enough revenue to cover the fixed costs. If it is too large, it may not fill up sufficiently tocover the costs of the large size. The right balance between being too small and too large liessomewhere in the middle.This analysis is standard and straightforward. The answers to the basic questions ofevaluation and design appear to be that the• Best design is to build 6 levels, and• Garage is a worthwhile opportunity and delivers an NPV of 2.5 million.Unfortunately, this solution is wrong on both counts. The next sections explain why theseanswers are incorrect.[Figure 3.2 about here]Recognizing effects of uncertaintyRecognizing the uncertainty: The actual evolution of demand for parking will be highly uncertainover the 15-year life of the project. Both the initial and the additional demand over the comingdecade and beyond could be much lower than expected – or they could be much higher.Alternatively, there could be low initial demand and high growth or vice versa. The value of theproject under any of these circumstances would not be the same as that based on the singleprojected estimate. In general, as indicated in the discussion of the flaw of averages, we cananticipate that the actual expected value of the project will be quite different from that calculatedin the naïve case that assumes just one possible outcome.Furthermore, as the example shows, the design that maximizes value can also bedifferent when we look at the realistic situation that acknowledges uncertainty. Such a change inthe optimal design may or may not occur. It is however a distinct possibility. As the exampleindicates, we cannot assume that the ranking of the alternative designs will be the same when weconsider uncertainty.To explore the effects of uncertainty in our simple example, we assume that the threeparameters defining demand can be off by up to 50% either side:• Initial demand can be anywhere between 375 and 1125 spaces;• Demand growth to year 10 can be anywhere between 375 and 1125 spaces; and• Demand growth after year 10 can be anywhere between 125 and 375 spaces.Part 1: Chapters 1 to 3 <strong>Page</strong> 47 of 69
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