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Effects of time-inconsistent preferences on information technology infrastructure investments with growth options

  • Research Article
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European Journal of Information Systems

Abstract

Increasing information technology (IT) infrastructure spending and the capability of such projects to provide a platform for a firm to realize value from IT marks their importance. Effective management of IT infrastructure investments includes identification of embedded growth options in the infrastructure, and exercising them in a timely manner. Extant research has recognized that while managers could use real options thinking in IT investment management, managerial bias could affect the timing of option exercise and their realized value. We analyze the effect of time-inconsistent preferences of present-biased managers on the exercise time of real growth options and the realized value using a discrete time option valuation model. The results show that present-biased managers are more likely to exercise options early when the net payoffs are low, the option payoffs have high volatility, and the risk free discount rate is small. In addition, present biased managers are more likely to exercise a growth option early in its life when the project is performing well. We provide implications for practice and IT governance.

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Notes

  1. These characteristics are more prominent for IT infrastructures that are built and maintained in-house by the organizations than IT infrastructures that are outsourced, like IT-as-a-service for applications management and cloud computing for data management. In-house IT infrastructures provide firms with an opportunity to expand the use of these platforms via investing in new IT assets. In this study, our focus is the in-house IT infrastructures because they provide the firm with growth options.

  2. The Max function of payoffs in option value function has minimum value of zero, because the initial investment c is a part of the ‘Project Value’ function consisting of certain benefits b, initial investment c and the real option value.

  3. These managers awareness about their self-control (β̂) and their actual self-control (β) is equal to 1. Hence they do not have a bias for present.

  4. These managers awareness about their self-control (β̂) mismatches their actual self-control (β) such that β<β̂ =1. Hence they have a bias for present but they believe that they don’t.

  5. A growth option in an IT infrastructure investment can be viewed as a call option on a non-dividend paying stock, because benefits from such investments are realized later in the future, over the period of time. This is consistent with the current IS literature (Benaroch, 2002; 2006b).

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Authors and Affiliations

  1. Belk College of Business, UNC Charlotte, Charlotte, NC, U.S.A.

    Sarah S Khan, Moutaz Khouja & Ram L Kumar

Authors
  1. Sarah S Khan
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  2. Moutaz Khouja
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  3. Ram L Kumar
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Correspondence to Moutaz Khouja.

Appendix

Appendix

Proof of Proposition 4

An IT manager will exercise the option in t=2 instead of t=3 if V 2, 2⩾V 2, 3. Therefore to find β̄, we solve V 2, 2=V 2, 3 for β̄. As shown in Figure A1, at t=2, the manager may only exercise the option today if uncertainty has resolved in project's favor and payoffs looks relatively certain. This will reduce Eq. (2) for V 2, 2 to:

Figure A1
figure 8

Decision problem of naïve IT manager at t=2.

Full size image

In Eq. (A.1), Max terms are eliminated because by t=2, uncertainty is resolved and the option is only feasible to be exercised today if payoffs moved upward. Hence the downward lattice in Figure A.1 will be eliminated. Also r=1 because of the present nature of the exercise decision.

Similarly, at t=2, Eq. (4) for V 2, 3 will be:

Again, Max terms are eliminated because by t=2, some uncertainty is resolved if option is exercised in the next period. As the payoffs have already moved upward by u at this point, eliminating the downward lattice of the tree at t=2 indicates the adjusted option value for the decline in future payoffs at that time. For the value of option at t=3, the possible movement of future payoffs further by u and d will stay in the valuation because there is still uncertainty around payoffs value at t=3. The possibility of future payoffs recovering from downward movement in t=3 is kept in the V 2, 3. Future payoffs value moving down by d in t=3 after moving up by u in t=2 is equal to future payoffs value moving up by u in t=3 after moving down by d in t=2. As the Max function will possibly not give a zero outcome for Max (0, dub-f) due to our conditions d<r<u and ub−f>b−f>0>db−f, it was kept in the equation. Also discount rate r will apply for only one time period because when the IT manager at t=2, the payoffs in period t=3 are only one time period away.

Solving (A.1) and (A.2) for β̄ gives β̄=(f(p+r−2)−bru)/(bu(2d(p−1)−pu).

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Khan, S., Khouja, M. & Kumar, R. Effects of time-inconsistent preferences on information technology infrastructure investments with growth options. Eur J Inf Syst 22, 206–220 (2013). https://doi.org/10.1057/ejis.2012.4

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