Prospect Theory-based Real Options Analysis for Noncommercial Assets

Abstract

When an engineering system has the ability to change or adapt based on a future choice, then flexibility can become an important component of that system’s total value. However, evaluating noncommercial flexible systems, like those in the defense sector, presents many challenges because of their dynamic nature. Designers intuitively understand the importance of flexibility to hedge against uncertainties. In the naval domain, however, they often do not have the tools needed for analysis. Thus, decisions often rely on engineering experience. As the dynamic nature of missions and new technological opportunities push the limits of current experience, a more rigorous approach is needed. This paper describes a novel framework for evaluating flexibility in noncommercial engineering systems called prospect theory-based real options analysis (PB-ROA). While this research is motivated by the unique needs of the U.S. Navy ship design community, the framework abstracts the principles of real options analysis to suit noncommercial assets that do not generate cash flows. One contribution of PB-ROA is a systematic method for adjusting agent decisions according to their risk tolerances. The paper demonstrates how the potential for loss can dramatically affect decision making through a simplified case study of a multimission variant of a theoretical high-speed connector vessel.