The Quarterly Review of Economics and Finance 44 (2004) 751767

Managing risk and uncertainty in complex capital projects

Todd M. Alessandria,1 , David N. Fordb,2 , Diane M. Landerc,3 , Karyl B. Leggiod, , Marilyn Taylore,4
a Whitman School of Management, Syracuse University, Syracuse, NY 13244, USA Department of Civil Engineering, Texas A&M University, College Station, TX 77843-3136, USA c School of Business, Southern New Hampshire University, 2500 North River Road, Manchester, NH 03106-1045, USA Henry W. Bloch School of Business and Public Administration, University of Missouri at Kansas City, Kansas City, MO 64110, USA e Gottlieb/Missouri Chair of Strategic Management, Henry W. Bloch School of Business and Public Administration, University of Missouri at Kansas City, Kansas City, MO 64110, USA b

Received 3 February 2004; accepted 25 May 2004 Available online 12 October 2004

Abstract In evaluating capital budgeting decisions, quantitative approaches, such as traditional discounted cash ow modeling and real options valuations, are useful when there is a presumed probability distribution for the future forecasted outcomes or for when there are lower levels of uncertainty. As uncertainty increases and forecasting becomes difcult, the value of nancial modeling techniques decreases. Borrowing from the strategic management literature, we argue that it may be useful to employ a qualitative approach to evaluate capital projects when faced with high levels of uncertainty. In order to illustrate our argument, we use a derivative of scenario planning and qualitative real options to evaluate non-quantiable factors in a project for the National Ignition Facility. 2004 Board of Trustees of the University of Illinois. All rights reserved.
Corresponding author. Tel.: +1 816 235 1573; fax: +1 816 235 6606. E-mail addresses: tmalessa@syr.edu (T.M. Alessandri), DavidFord@tamu.edu (D.N. Ford), d.lander@snhu.edu (D.M. Lander), leggiok@umkc.edu (K.B. Leggio), taylorm@umkc.edu (M. Taylor). 1 Tel.: +1 315 443 3674; fax: +1 315 443 5457. 2 Tel.: +1 979 845 3759; fax: +1 979 845 6554. 3 Tel.: +1 603 668 2211x3325; fax: +1 603 645 9737. 4 Tel.: +1 816 235 5774; fax: +1 816 235 2206. 1062-9769/$ see front matter 2004 Board of Trustees of the University of Illinois. All rights reserved. doi:10.1016/j.qref.2004.05.010

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JEL classication: D8; D81; G13; G31 Keywords: Qualitative analysis; Scenario planning; Real options; Capital budgeting

1. Introduction Boards of Directors, executives, and managers need to address the critical nature of risk and uncertainty in the decision-making process. Identication of the risks and uncertainties inherent in a proposed action, assessment of their impact on the possible outcomes, and design of contingency plans to manage them are essential for making sound business decisions. Without completing these activities, decisions made and undertaken are likely to be sub-optimal ones, leading to organizations being less competitive in the marketplace. Furthermore, in the wake of the fall of a number of organizations such as Enron, Worldcom, Parmalat, and HealthSouth, the issue of risk management and its implication for corporate governance has become salient and more critical for decision makers to address. Determining if investment decisions add value to a rm represents a research focus for both strategic management and nance scholars. Both disciplines strive to identify patterns of decisions that lead to the creation of shareholder wealth (Alessandri, Lander, & Bettis, 2002; Bettis, 1983; Kester, 1984; Myers, 1984). The traditional nance perspective focuses on the valuation of risky investment decisions through quantitative frameworks such as discounted cash ow (DCF) models and real options analysis (ROA). Strategists focus on the qualitative aspects of projects relating to uncertainties or contingencies that can be identied and evaluated through a framework such as scenario planning. However, the different theoretical lenses and varying empirical approaches in these two academic disciplines have hindered the understanding of the overall process of strategic decision-making. This research attempts to help narrow this strategic management/nance academic divide, focusing on improving organizational decision-making when evaluating capital projects, whether the issues are traditionally considered primarily from the nance domain or from the strategic management domain. Denitional issues regarding risk and uncertainty have haunted both strategic management and nance academic disciplines for decades. Oftentimes risk and uncertainty have been used interchangeably in the literature, yet they are in fact distinct theoretical constructs (Alessandri, 2003; Knight, 1921; March & Simon, 1958). Given this confusion, it is necessary to dene how we use the terms risk and uncertainty. For the sake of this research, risk represents the probability distribution of the consequences of each alternative (March & Simon, 1958, p. 137). This denition is very similar to Knights (1921) early work on risk and uncertainty. A probability distribution implies an ability to quantify the consequences of an alternative. On the other hand, uncertainty, according to March and Simon, is when the consequences of each alternative belong to some subset of all possible consequences, but that the decision maker cannot assign denite probabilities to the occurrence of particular outcomes (1958, p. 137).1 This denition also corresponds to the earlier work of Knight
1 A concrete example of the differentiation between risk and uncertainty is described in Section 5, evaluating the NIF project.

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(1921), and implies a lack of condence relating to probability estimates or an inability to assign estimates at all, i.e., complete ambiguity. It is important to note that these two constructs are interrelated and do overlap. Furthermore, agreement on the delineation between risk and uncertainty is not universal. These denitions suggest that quantiable factors surrounding a capital project represent risks, whereas qualitative factors that affect decision-makers condence in project estimates represent uncertainties. Given that many investment decisions involve both quantitative and qualitative analyses, the results from differing methods of project evaluation must be reconciled. The questions then become: given varying degrees of certainty surrounding estimates of the drivers of project value, how do decision-makers evaluate capital projects, especially complex capital projects, and how do they address the outcomes from both a strategic management perspective and a nance perspective. Varying levels of risk and uncertainty can affect a decision-makers choice of models, techniques, and processes used for making the investment decision. Courtney, Kirkland, and Viguerie (1997) suggest that managers employ different analytical tools for different levels of uncertainty. As uncertainty increases, these authors propose more qualitative tools be used. In support of Courtney et.al., Alessandri (2003) found that managers tend to use analytical, quantitative approaches in the face of risk to identify the optimal decision. Yet, on the other hand, as uncertainty increases, managers rely on judgment and experience to a greater extent, employing a more qualitative approach to make the decision, even though they still attempt to go through the process of an analytical, quantitative analysis. Finally, Alessandris (2003) results show that when considering risk and uncertainty jointly, the effect of uncertainty is dominant to that of risk. The implication here is that analytical, quantitative tools, even ones that can model dynamic decision-making, are not able to model the more qualitative nature of uncertainty. In our efforts to integrate nancial modeling and strategic decision-making, it may be that we are asking the wrong question. Instead of trying to quantify strategic management, it may be that, in certain circumstances, i.e., in the face of high uncertainty, we should be taking a more qualitative approach to the nance side of project analysis. The quantitative modeling frameworks often used for valuation purposes are useful, but their primary function may be to better qualitatively dene, structure, and understand a projects uncertainties. For example, the real options approach to capital budgeting is a quantitative valuation framework that can value dynamic decision-making. However, its usage has been limited due to implementation challenges (Lander & Pinches, 1998). Due to implementation problems stemming from a lack of data and high uncertainty, Miller and Waller (2003) propose the use of a qualitative, rather than a quantitative, real options approach, in conjunction with scenario planning, to develop a corporate integrated risk management tool. This paper demonstrates the role of a qualitative approach to the examination of complex capital investment projects. The paper discusses the affects of risk and uncertainty on the decision-making process, and the shortcomings of our current quantitative decision-making tools in accounting for uncertainty, especially in complex capital projects. Using a major construction project, The National Ignition Facility (NIF) as an example, we rst describe the project and discuss its complexity and uncertainties. We then discuss designing contingency plans that are generated through a variation of scenario building within an organization. Lastly, we show how using a qualitative, rather than quantitative, real options analysis can

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be an alternative for thinking about and better understanding the uncertainty inherent in the NIF capital project. This paper draws upon multiple perspectives to advance the state of knowledge across practice/academic boundaries and across disciplinary arenas. The goal is to advance current thinking about the risk and uncertainty concepts as applied to strategic decision-making, and to approach the evaluation of projects from different perspectives, moving from theory into practice. We use the example of The National Ignition Facility to illustrate how practicing planners and managers can identify risks and uncertainties in development projects, then use and identify exibility in project analysis, thus increasing their optionality and project worth. The paper proceeds as follows: Section 2 looks at differentiating risk and uncertainty; Section 3 discusses scenario building; Section 4 discusses the real options approach to capital budgeting; Section 5 introduces the National Ignition Facility project as well as scenario building and a real options analysis application; and Section 6 concludes with a discussion of the opportunities for improving our decision-making processes given uncertain business environments.

2. The evaluation of investment projectstheoretical and empirical perspectives 2.1. Contrasting decision-making perspectives Two primary perspectives relevant to the impact of risk and uncertainty on strategic decision-making are economic rationality and behavioral theory. The rationality side is traditionally aligned with a nance/economics approach, where analyses are undertaken under the basic market assumptions of perfect, or close to perfect, information and complete markets (Eisenhardt & Zbaracki, 1992; Fisher, 1907, 1930). In fact, the traditional discounted cash ow (DCF) valuation algorithm was originally derived from, and justied by, valuing passive investments in bonds and known cash ows. This model assumes the expected values of the future uncertain cash ows are acceptable proxies for the cash ows distributions, and that the expected values are given. Additionally, the discount rate is assumed known, constant, and a function of only project risk. Under such assumptions, all of the alternatives are economically modeled and analyzed in order to reveal the optimal decision.2 In recent years, however, more attention has been given to the behavioral literature, such as Kahneman and Tversky (1979, 2000), March and Shapira (1987), Benartzi and Thaler (1995), Thaler, Kahneman, Tversky, and Schwartz (1997), Ordean (1998), Palmer and Wiseman (1999), and Leggio and Lien (2002). This literature argues that decision-makers may not act according to the principles of rationality when faced with risky decisions. The presence of uncertainty appears to affect the decision-making process as well, partially due to the difculty in gathering and processing information (Maritan, 2001; Sharfman & Dean, 1997).
2 We assume the reader is familiar with discounted cash ow analysis. For a primer on DCF, see Brealey and Myers (2000).

T.M. Alessandri et al. / The Quarterly Review of Economics and Finance 44 (2004) 751767 Exhibit 1 Summary of Courtney et al. (1997) proposed residual uncertainty framework Level 1. Clear Enough Future 2. Alternate Futures 3. Range of Futures 4. True Ambiguity Description A single forecast precise enough for determining strategy A few discrete outcomes that dene the future A range of possible outcomes, but no natural scenarios No basis to forecast the future Suggested analytical tools

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Market research, value chain analysis, DCF models Decision analysis, option valuation models, game theory Scenario planning, technology forecasting Analogies and pattern recognition, nonlinear models

Existing empirical evidence suggests that higher uncertainty is associated with a more behavioral approach to decision making (Cyert & March, 1963; Dean & Sharfman, 1993; Maritan, 2001). This nding supports Courtney et al. (1997), who argue for a multiple process, or contingent approach. According to Courtney et al. (1997), the standard practice in strategic planning is to lay out a precise picture of the future, or the most likely outcome, which can then be valued using a DCF model. This approach hides the underlying uncertainties. These authors suggest a topology of multiple levels of uncertainty: Level 1 uncertainty A Clear-Enough Future is sufciently precise for strategy development, as one can usually determine a single strategic direction. Level 2 uncertainty Alternate Futures has few discrete scenarios that are possible. The possible outcomes are clear, but it is difcult to predict which one will occur. Level 3 uncertainty A Range of Futures exists when a range of potential outcomes can be identied and the range is dened by a few key variables. The actual outcome lies along a continuum. Level 4 uncertainty True Ambiguity occurs when multiple dimensions of uncertainty interact to create an environment that is almost impossible to predict. These environments tend to migrate toward one of the other three levels over time. Courtney et al. (1997) go on to suggest that specic decision tools are more appropriate and more useful for some levels of uncertainty but not for others (see Exhibit 1). For example, traditional DCF models may be helpful for Level 1, and possibly Level 2, but they are not appropriate for other levels. In general, as the level of uncertainty increases, managers should employ more qualitative approaches to manage uncertainty in the decision process. Alessandri (2003) shows that risk and uncertainty are, in fact, considered by managers to be distinct constructs, and these two constructs have different impacts, individually and jointly, on the decision-making process. That is, there exists a difference in managers minds between risk and uncertainty and how to respond to each. In terms of individual effects, when managers face risk, they tend to use more analytical, quantitative approaches, and focus on nding the best decision. This is the typical risk-aversion argument: managers are conspicuously sensitive to risk. Not surprisingly, as the risk levels increase, managers increase their efforts to both evaluate the risk and nd a decision that is going to minimize or hedge the risk as much as possible. Alternatively, in the presence of uncertainty, man-

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Exhibit 2 Joint effects of risk and uncertainty on investment decision processes Low uncertainty High risk Low risk Process: highly analytical Objective: optimal alternative Process: less analytical Objective: optimal alternative High uncertainty Process: qualitative, judgment-oriented Objective: acceptable alternative Process: qualitative, judgment-oriented Objective: acceptable alternative

agers employ more judgmental approaches, relying upon intuition or experience in making their decisions. What is interesting here is that managers still went through the motions of completing the standard DCF analyses and had little initial intent to rely on their intuition or experience. However, many projects involve elements of both risk and uncertainty, i.e., a joint effect. Analysis of the joint effects of risk and uncertainty reveal that uncertainty effects were dominant (Alessandri, 2003) (see Exhibit 2). Under low uncertainty, the risk decision process relationships discussed above hold: with higher risk, managers use a more rational or analytical approach, focusing on the optimal decision. But, when there are high levels of uncertainty, no matter how high or low the risk level, managers appear to rely on judgment and experience to justify decisions that have acceptable outcomes. It is important to note that some notions of uncertainty represent a lack of information, and the more that was unknown about a project, the less inclined managers were to rely on either traditional quantitative or qualitative decision-making tools, and the more inclined managers were to depend upon past experience and intuition. Alessandris (2003) empirical results suggest managers are not following traditional nancial theory in analyzing capital budgeting proposals. The work of Courtney et al. (1997) and Alessandri (2003) support the notion that traditional quantitative tools need to be expanded or alternative processes need to be used under conditions of high uncertainty. Yet, we argue that quantitative methods can provide the framework for dening, structuring, and understanding project uncertainties. 2.2. New directions for managing uncertainty There are a variety of tools managers can use to manage uncertainty. In this paper, our focus is on two as suggested by Miller and Waller (2003): scenario planning and ROA. The rst qualitative tool comes from the strategy area. Scenario planning provides managers with a structured way to analyze and evaluate uncertainties and contingencies as well. In this paper, we differentiate between scenario analysis in the sense of its use in nance/accounting, scenario building in the sense of internal, project based situations which are not readily quantiable, and scenario planning in the sense of external, long-range planning. The processes of scenario planning and scenario building are similar. The second tool comes from the nance area. The real options approach to capital budgeting is a quantitative tool that allows one to value dynamic decision-making. However, it also has potential value as a qualitative tool for helping managers think in terms of contingency planning, managing exibility, and designing optionality into large capital investment projects. Kester (1994) noted such competitive

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advantages and recently, we see the advantages of the real options tool becoming recognized as useful in the strategy literature (Abner & Levinthal, 2004; Botteron, 2001; Kogut & Kulatilaka, 2004; Leggio, Taylor, Bodde, & Coates, 2001; Leurhmann, 1998; McGrath, 1999; McGrath, Ferrier, & Mendelow, 2004; Zardkoohi, 2004). The second qualitative tool comes from the strategy area. Scenario planning provides managers with a structured way to analyze and evaluate uncertainties and contingencies as well. These two complementary tools scenario planning, real options offer managers the ability to qualitatively assess risks and uncertainties. Miller and Waller (2003) suggest that an integration of these two approaches can be used to help a company develop a corporate risk management program by helping decision makers identify and integrate exposures at the divisional level. We argue that both approaches can also be used at the project level to help manage uncertainty in complex capital projects.

3. Scenario planning Scenario planning is a qualitative approach to decision-making, used when primary variables are not easily quantiable, and involves the creation of coherent stories about possible futures, with the goal of identifying and evaluating contingencies, uncertainties, trends, and opportunities. It was originally developed during the 1970s by Royal Dutch Shell. The technique was utilized within rms in the early 1970s to generate alternative plausible scenarios regarding the longer-term future of the external environment. Scholars in the strategy realm have pointed out its benets and problems as a planning tool (Henson, 2003; Jennings, 2002; Kennedy, Perrottet, & Thomas, 2003; Mason, 2003; Millet, 2003; More, 2003; Schoemaker, 1993, 1995; Wack, 1985). Today, as organizations have sought ways to manage uncertainty, it has been receiving renewed attention. Generally, the process involves constructing plausible scenarios of the future environment and then designing alternative strategies that would be appropriate under those scenarios. Experts in the scenario planning process suggest the creation of three to ve scenarios. The process of establishing the scenarios generally involves the following phases: Identication of environmental driving forces Selection of signicant forces (or bundles of forces) Consideration of the forces to establish scenarios Writing of the stories or scripts Establishing signposts (i.e., leading indicators suggesting that the environment might indeed be going in the direction of a specic scenario)

Numerous benets of scenario planning are cited by facilitators, consultants, and executives. For example, scenario provides: (a) expanded mutual understanding of potential environmental discontinuities; (b) greater teamsmanship as a result of the process and development of a common language; and (c) increased nimbleness of the rm that already has contingent plans articulated. In short, the scenario planning process brings two major benets to our discussion. First it helps in identifying the long-term risks and uncertainties that impact on the rm as a whole, and second, it assists the executives in dening their alternatives and options, i.e., increasing their optionality. And, in so doing, scenario plan-

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ning contributes to the rms ability to survive, even under hostile conditions, and to more proactively exploit more municent environments. Scenario planning can be limited by the number of scenarios proposed, and, although the technique is often used at the rm level, more frequently what is needed is a project-level perspective.

4. Real options analysis: quantitative and qualitative ROA3 is a controlled means of systematically identifying the interplay between intermediate outcome states and alternative managerial actions and specically valuing managerial exibility. The investment or disinvestment decisions often involve capital assets, and most decisions can be viewed as options on real assets. ROA can value asymmetric payoffs, and by doing so can provide a means of valuing managerial exibilitythe ability of managers to intervene proactively to take action during the time frame when the results of previous decisions are being played out. An option-based approach can incorporate asymmetry into capital budgeting analyses, and it is a reasonable representation of how managers think. The time delayed actions managers might take would be those to enhance the upside effects or to mitigate the downside impact. ROA can lead to a change in decision-making. The traditional DCF analysis wants all point estimates to be as known and certain as possible, and in DCF models, an increase in risk is accounted for by increasing the discount rate, resulting in lower valuations. Thus, under traditional DCF reasoning, risk hurts. In comparison, option value is most often a positive function of the volatility of the underlying asset, as, generally, an increase in volatility leads to an increase in the range of possible future values for the underlying asset. As this line of reasoning quickly suggests, aggressive rms will seek projects with higher volatility because active management of those projects can create value for the rm. Under real options thinking, as long as management can control the downside risk of a project, rms should seek risk, at least to some degree. ROA also shows that sometimes negative NPV projects should be undertaken, given the upside potential embedded in the project. The question we are concerned with is: how can the real options framework, an inherently quantitative framework, be used qualitatively to improve the analyses of capital investment projects with moderate to high levels of uncertainty (i.e., Level 3 or Level 4 in Courtney et al., 1997). The answer is that ROA can systematically organize the analysis and identify the uncertainties. Kemna (1993) notes that a real options analysis provides a richer framework for structuring a project and, just as importantly, brings all decision makers to the table, as well as providing common terminology for discussing a project. ROA allows us to reformulate the problem resulting in more insight into the project and the potential sources of value. The primary benet of a real options analysis may not be project valuation, or quantiability, but the process of describing and understanding the project and the uncertainty embedded therein. As both Kemna (1993) and Lander and Pinches (1998) suggest, a rm can derive a tremendous amount of value from conversations among all of
3 We assume the reader is familiar with the use and valuation techniques of real option analysis. For additional information or background on ROA, see Amram and Kulatilaka (1999) or Copeland (2002) for a more complete discussion of real options.

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the affected managers about project potential and outcomes. The true value of ROA may be the process of thinking about project exibility and project design in a more structured way, and not necessarily the resulting valuation. ROA may become unwieldy due to the number of options embedded in the project, and, although the technique is often used at the project level, what is needed more frequently is a rm-level perspective. At this point it is important to notice the complementarity of scenario planning and ROA, as suggested by Miller and Waller (2003). Although both approaches help to identify critical exogenous variables by specically dening and dynamically modeling the project, pushing the boundaries of possible outcomes, and allowing for designing in contingent strategies or options, they do so in different ways. Scenario planning takes an intentionally qualitative approach to the analysis of a project and involves the creation of coherent stories about possible futures. Real options, on the other hand, takes an intentionally quantitative approach to the analysis, now valuing the coherent stories identied. Thus, ROA, in essence, requires the scenario planning process be done and can be thought of as a follow-on process, adding detailed structuring, and allowing for richer understanding of the scenarios identied. We know managers consider exibility in project valuations and are often willing to spend additional funds to achieve exibility. We thus argue that these two approaches scenario planning and real options can help managers identify potential areas where exibility can be pursued in a project. The following example of the NIF project demonstrates the application of scenario planning and a qualitative real options approach to a complex capital budgeting problem.

5. Evaluating the National Ignition Facility Project 5.1. Risk and uncertainty The issue we now turn to is how can practicing planners and managers use scenario building and a qualitative real options approach to manage uncertainty in practice? We use the example of The National Ignition Facility (NIF) to illustrate how decision-makers identify uncertainty and exibility in project analysis, and by deliberate decision, increase and use their optionality. In 1996, the United States signed The Comprehensive Nuclear Test-Ban Treaty which banned the testing of nuclear weapons (U.S. Department of State, 2003). Testing had previously been used to verify the operability of the aging stockpile of nuclear weapons and to perform specialized research. The treaty ended the use of tests for these purposes, creating a need for new means of stockpile testing and research. To fulll these needs, the U.S. Department of Energy is developing the National Ignition Facility (NIF), a nuclear explosion laboratory. NIF will allow scientists to create what occurs during a nuclear explosion on a much smaller scale and in controlled laboratory conditions. NIF is a large, customized planning, design, and construction project valued at over $2.5 billion. The conceptual design is to generate and direct 192 individual high-power lasers down two bays located along each side of the facility. Precision mirrors redirect the lasers into a target chamber and onto a target that is approximately the size of a grain of rice.

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Focusing the enormous energy from the lasers onto the small target will generate nuclear reactions in the target. Auxiliary lasers and other apparatus allow the scientists to observe the impacts of the reactions. When completed, NIF will be at least an order of magnitude more powerful than previous lasers. At the time of commitment of the Department of Energy to the project, no laboratory laser system the size of NIF had ever been built, and six major subsystems had not been invented or developed. Major technical innovations were required for success. In short, there was a great deal of uncertainty in the project. Project optionality became particularly important in the development of the glass slabs used to amplify the laser beams (one of the six subsystems in the NIF project) because of their critical role in project performance and the high uncertainty in their development. Laser glass procurement requires the production of high quality glass slabs called blanks, the nishing of the blanks, and the coating of the blanks. The NIF laser would be many times larger than existing lasers. Laser development costs increase approximately with the cube of the laser diameter, making a single large laser extremely expensive. A single laser also concentrates risk in one project component. Therefore, instead of attempting to develop a single very large laser, NIF chose a more exible design, building many smaller lasers. This strategy required far more high quality precision glass blanks than a single laser. Laser glass blanks used in previous lasers could be produced in batch processes due to the relatively small size of the lasers. These processes, however, could not produce the quantity and quality of glass needed by NIF in the time available. A new glass production technology had to be developed. There was a great deal of uncertainty and risk concerning whether or how a process to manufacture laser glass of the required volume and quality could be developed, and at what cost since none of the existing glass companies were able to fund the development of this new technology. Therefore the NIF project managers funded the development of a new laser glass production technology. The NIF project management teams approach to this development is the basis for our investigation of risk and uncertainty management. To better understand the distinction between the risk and uncertainty, it may be helpful to apply these denitions in the context of the NIF project. Using our previously stated denition of risk, risk involves the variance in potential outcome values of the specic factors in the NIF project. From an overall project standpoint, the NIF project faces at least three risksperformance levels of the completed project, time required to complete the project, and the cost to complete the project. In terms of the rst factor, very little variance exists due to the mandate of the project. The NIF project must succeed to enable the U.S. Department of Energy to test the stockpile of nuclear weapons.4 However, the cost of the project and the time to completion involve considerable variance in terms of potential outcomes. The NIF project had already exceeded the original budget by over $1 billion, and the estimated time to completion had been extended ve additional years. Thus, although for planning purposes a single point estimate of total costs and time to completion was required by Congress for funding, actually a range of potential nal total cost estimates and time to completion estimates existed. These ranges, or distributions, represent forms of risk.
4 Managements certainty of success stems from the fact that the nuclear arsenal must be tested. Given the restrictions on testing either above or below ground, the alternative is to simulate a test in a lab setting. The projects ultimate success may come at a higher cost or at a delayed time, but the project must ultimately be operational.

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The notion of uncertainty in relation to the NIF project refers to how certain/uncertain the managers feel about the estimates. This degree of certainty varies based upon many factors, including the availability of information, the degree to which the project is new and unknown versus similar to existing projects and familiar to managers in analysis quantity and quality. A lack of information, or a lack of unambiguous information, increases uncertainty (Galbraith, 1974). Furthermore, projects relating to new capabilities lead to more uncertainty in managers minds than ones that are similar to existing projects (Maritan, 2001). Given that the NIF project is unlike any other project, and the six subsystems had to be developed from scratch, it would seem that uncertainty is high for the NIF project; that is, the required point estimates of cost and time to completion were likely generated from information that included many uncertain factors. Changes to funding requests and timing expectations sent to Congress support the lack of certainty regarding cost and timing. The NIF management faced large uncertainties and was equipped with an array of planning and management tools with which to address them. Uncertainty occurs at different levels of aggregation in large engineering projects, including the NIF project. Macro-level uncertainties in the NIF project included the development costs of the six major subsystems, the estimated time to completion for each stage, the likelihood of successful development of the six systems, and the annual level of funding provided by Congress. These project features interact tightly, such as the strong impact of development success and schedule on cost. Many of these dependencies are bi-directional. For example, reduced funding can slow progress and rates of progress can impact future funding. Smaller portions of the project, such as the laser glass procurement, also included numerous uncertainties. Frances Commissariat a lEnergie Atomique is concurrently developing a similar laboratory and may also need laser glass. But France has not nally approved and funded that project. Therefore the total demand for laser glass is risky. The ability of glass rms to develop feasible new glass production technologies and the quality of the glass produced if the production technologies were feasible were uncertain, as were costs and development schedules. The uncertainties at different levels of aggregation are also interdependent, and again, often in bi-directional ways. For example, slow laser glass production technology development could increase costs in other major systems that must wait on laser glass production, which may in turn impact project schedule performance and funding. Which project and laser glass uncertainties threaten the successful development of NIF most? Which should the NIF laser glass procurement managers focus their limited managerial efforts on? How should the uncertainties, their interdependencies, and their impacts on project behavior and performance be modeled to facilitate decisionmaking? 5.2. The application of scenario planning to NIF Scenario planning is not known to have been used explicitly in laser glass technology development at NIF. However, interviews of NIF project managers reveal clear scenario descriptions as a basis for planning. The scenario planning process is used here to formalize the planning practices used on the NIF project, suggest actions if scenario planning had been formally applied, and elucidate the potential impacts of its use. A set of scenarios for the NIF laser glass subsystem project is depicted in Exhibit 3. Once the scenarios are written,

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Exhibit 3 Scenario building for the NIF decision to fund one versus two glass vendors Company X: development of the glass manufacturing application and quality of output Successful A. Bulls eye (possible, and provides B. X Scores (likely, but leaves NIF NIF with future exibility of choice of dependent on one supplier) lower-cost provider) Unsuccessful C. Y Scores (likely, but leaves NIF D. Complete Flop (highly unlikely, dependent on one supplier) but potentially leads to the loss of the NIF project, possible loss of the contract to manage the national lab, and signicant disadvantage to the nation in not being able to test its nuclear weapon supply or undertake nuclear research) Company Y: development of the glass manufacturing application and quality of output Successful Unsuccessful

the executive group can then begin the process of creating strategies that are appropriate to the scenarios. The NIF project team said (in essence), To invest in one vendor costs $12 million. Two things could happen. First the vendor could succeed. The vendor could go through all three steps, funded by us, develop a quality production process successfully on budget and on schedule. Or, the vendor could fail. Vendor failure will delay the project, the deadlines will not be met, and it is likely the entire project will be cancelled. On the other hand, if we invest in two vendors, both of them could succeed. If both vendors succeed the project will be successful and we will have the exibility of purchasing laser glass from either of two vendors down stream. It is also possible that only one of the vendors succeeds or no vendors succeed in a reasonable time frame. The managers in charge of the project knew that to proceed with two vendors doubled the cost. The NIF project managers essentially used scenario building in considering the four scenarios in Exhibit 3. Their intuitive assessment was that Quadrant D was highly unlikely, that B or C was likely, and that A could yield signicant value in exibility on an ongoing basis. The NIF managers planned for these scenarios. If Quadrant A occurs, NIF has the ability to choose the low cost glass provider, thus saving money and it has the ability to reduce risk by purchasing a portion of laser glass from each of the two glass blank providers. If either Quadrant B or C develops, the NIF project continues with glass provided from one supplier. And by thinking through the possible scenarios up front, the project managers have the ability to think through their future actions to prevent Quadrant D from occurring. The managers believed Quadrant D would not occur because they had many tools and opportunities to take evasive action prior to its occurrence, such as increased funding for additional research and development to successfully create the technologies or schedule changes to provide additional time for research and development. By discussing preventive actions, the NIF team has a plan in place to prevent Quadrant D from occurring and to be aware of the danger signs that the rm might be heading towards a Quadrant D scenario.

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5.3. Qualitative real options applied to NIF NIF managers explicitly used real options (without using real options language) to plan laser glass technology development. For example, having the right to not purchase from the high cost vendor is a real option, as is being able to take evasive action to prevent Quadrant D from occurring. However, their decision-making practices were far from the formal valuation tools and methods described in the majority of real options literature. This is primarily because of the complexity of the planning environment. The challenges faced by NIF managers in managing uncertainty in the project and in procuring laser glass were complicated by the breadth of types of input to their decision-making. NIFs new and undeveloped glass procurement process lacked history and therefore data for decisionmaking. Therefore, qualitative factors and approaches had to be used in strategic decisionmaking. Consider, as an example, the decision whether to use one or more contractors to develop laser glass production technology. This depends on, among other factors, the likelihood of success by a single contractor. No data is available to estimate this uncertainty. The NIF project team must assess the performance differentials (e.g., production rates, glass quality) if both vendors succeed and NIF has the ability to purchase the laser glass from the low cost provider. Management of uncertainty was made difcult by the multiplicity of strategies and options. If development is staged, NIF holds an option to abandon that would be exercised by stopping the funding of a contractor that was forecasted to not be successful and continue with funding just the contractor expected to succeed. If multiple contractors are used in parallel, NIF also holds an option to switch from a less successful contractor to a more successful contractor. NIF needed to decide up front if it should stage development and contract with one, two, or more companies to insure glass of sufcient quality and quantity will be available. If forecasted increases in the probability of success or quality of overall project performance exceeded the cost of staging an additional supplier, the investment would improve the NIF project. How did NIF managers actually make these decisions? NIF managers developed qualitative scenario-strategy-outcome sets, each describing a possible path through the future. Path descriptions often took the form of If-Then-Else statements, such as IF we fund two technology developers and one fails THEN we can use the other developer, ELSE (if only one is funded and it fails) we have a big problem. Many paths overlapped by using the same decisions and sharing dependence on the resolution of the same uncertainties. Strategies often returned managers to previously-addressed decisions. If explicitly and comprehensively described, the paths would aggregately describe and structure the planning environment, alternatives and outcomes in a manner similar to a decision tree. Using their knowledge, experience, and intuition, NIF managers tacitly estimated probabilities of uncertainty resolution and valued outcomes to identify more and less attractive paths, informally valuing the available strategies and options as formalized in real options valuation models. Using this approach the managers identied the value of their optionality and decided to include both staging and multiple technology developers in their laser glass strategy. Ford and Ceylan (2002) provide additional details. Perhaps NIF managers were aware of this, tacitly and informally estimating the uncertainty in prices and their impacts on the value of the embedded options, and incorporating them into their decision. But structuring the decision as a real option and then proceeding to quantify the

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benets or costs of investing in a second supplier under different assumptions would be difcult.

6. Conclusion Large complex capital budgeting projects can be difcult to assess and evaluate. Decisions and alternatives are often many and complex, as well as difcult to quantify for valuation purposes. Additionally, there is frequently not enough quantiable information available to perform a valuation analysis. For example, it is very difcult to put dollars on the impact of the NIF project not being completed successfully. It is often also problematic to apply nancial valuation models due to violations of the underlying assumptions (e.g., distributional assumptions). Such practical implementation issues cause the DCF and ROA valuations methods to be ineffective. Moreover, and an issue for future research, is the issue that the frequent use of real options by development project managers, such as those on the NIF project team, violates the assumption that the option holder does not inuence the behavior of the underlying uncertain features that drive option value. Real options valuation traditionally and almost universally assumes that the option holder does not inuence the uncertainties that create option value. Several researchers extend extant real option valuation models to civil infrastructure contexts in which this critical assumption applies (Chareonpornpattana, Minato, & Nakahama, 2004; Ho & Liu, 2003; Ng & Bjornsson, 2004; Ng, Chiu, & Bjoornsson, 2002; Zhao, Sundararajan, & Tseng, 2004; Zhao & Tseng 2003). However, when product development managers use real options to control their own projects they purposefully and strongly contradict the assumption of option holder/uncertainty independence by working to manipulate the uncertainties in their projects through traditional means. Examples of these uncertainty manipulations in project management abound, including options to use overtime or special equipment to control schedule performance, options to take subcontracted work in-house, and construction manager at risk contracts that include options to change builders. The NIF example used here provides a more detailed description of another example, as do Ward, Liker, Criatiano, and Sobek (1995) in an automobile development context. In these cases, real option decisions and project management decisions are tightly linked (see Miller & Lessard, 2000). Therefore real options valuation models that assume independence of option holders and underlying uncertainties may not value strategies accurately enough to guide planners and managers of product development projects. Improved models will explicitly include the impacts of option holder/asset management interactions. Difculties, such as those noted above, in applying quantitative real options in practice, suggests that the application of more qualitative processes such as scenario planning or qualitative real options can improve managerial decision-making. Scenario planning can help managers better identify the long-term risks and uncertainties that impact on the rm and assist them in dening possible alternatives and contingencies. Real options analysis is helpful in guiding management to consider the non-quantiable value embedded in a project by then adding detailed structuring and, thus, allowing for a richer understanding of the scenarios identied.

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We found that NIF managers implicitly used a combination of scenario planning and real options techniques to plan laser glass technology development in their complex strategic environment. These practitioners used primarily tacit methods, processes they design, assess, and use to choose among strategies. In short, and as Alessandri (2002) showed, the NIF case study illustrates that there are gaps between what the eld of nance advocates and what managers are actually doing (see Miller & Lessard, 2000 for more descriptions). Finally, there are numerous uncertainties that interact to affect how successful the project is. We cannot just select one item and say that is the predictor of value. Thinking about how factors interact to affect the value is important. To assist the NIF project team and other managers, we need to be able to help them value and design project optionality. We need to be able to include this multiplicity of uncertainties and multiplicity of options in one method to capture all of the what-ifs in a project. We also need to capture realistic behaviors, and thereby capture the practical value of exibility. In short, we need alternative hybrid modeling approaches. We can take our existing models and expand them and enrich them and bring in other modeling methodologies that may help us capture some of these uncertainties. If we are to look at options from a managerial perspective, we may need to think about some expansions and different kinds of modeling methodologies such as scenario building. Then we can use this hybrid method successfully in nance and strategic management. Given the information available, managers attempt to make the best decisions possible for a rm. Analysis techniques that work to reduce uncertainty or plan for uncertain outcomes are of benet to managers. Considering optionality or potential future outcomes when a rm pursues a project helps to capture additional value in the project. It helps to identify what management knows, but may not be able to be quantied. Whereas nance focuses very heavily on how do we quantify this uncertainty, the real discussion is how do we think about all of our potential opportunities. It requires a thorough understanding of the project to be able to think through all of the opportunities. It takes the best of models from the elds of both nance and strategic management to be able to value the quantiable and recognize and incorporate the qualitative factors in a project. Taking elements from both disciplines results in a process for rm decision makers to improve project assessment and evaluation. The elds of nance and strategic management have developed tools and processes that have commonalties and complementarities. The tools we have discussed are ones that used together can assist executives in managing uncertainties, mitigating risks, and exploiting opportunities.

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