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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

Received 3 February 2004; accepted 25 May 2004

Available online 12 October 2004

In evaluating capital budgeting decisions, quantitative approaches, such as traditional discounted
cash flow 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 difficult, the value of financial 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-quantifiable 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: (T.M. Alessandri), (D.N. Ford), (D.M. Lander), (K.B. Leggio), (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.


T.M. Alessandri et al. / The Quarterly Review of Economics and Finance 44 (2004) 751767

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. Identification 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 firm represents a research focus for
both strategic management and finance 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 finance perspective
focuses on the valuation of risky investment decisions through quantitative frameworks
such as discounted cash flow (DCF) models and real options analysis (ROA). Strategists
focus on the qualitative aspects of projects relating to uncertainties or contingencies that can
be identified 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/finance academic divide,
focusing on improving organizational decision-making when evaluating capital projects,
whether the issues are traditionally considered primarily from the finance domain or from
the strategic management domain.
Definitional issues regarding risk and uncertainty have haunted both strategic management and finance 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 define 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 definition 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 definite probabilities to the occurrence of particular
outcomes (1958, p. 137).1 This definition 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 confidence 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 definitions suggest that quantifiable factors surrounding a capital project represent
risks, whereas qualitative factors that affect decision-makers confidence 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 finance 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, 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 financial 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 finance side of project analysis. The quantitative modeling
frameworks often used for valuation purposes are useful, but their primary function may be to
better qualitatively define, 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 first 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 flexibility in project analysis, thus increasing their optionality and project
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

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 finance/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 flow (DCF) valuation algorithm was originally derived from, and justified
by, valuing passive investments in bonds and known cash flows. This model assumes the
expected values of the future uncertain cash flows are acceptable proxies for the cash flows
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
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 difficulty in gathering and processing information (Maritan, 2001; Sharfman & Dean,

We assume the reader is familiar with discounted cash flow analysis. For a primer on DCF, see Brealey and
Myers (2000).

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Exhibit 1
Summary of Courtney et al. (1997) proposed residual uncertainty framework


Suggested analytical tools

1. Clear Enough Future

A single forecast precise enough

for determining strategy
A few discrete outcomes that define
the future
A range of possible outcomes, but
no natural scenarios
No basis to forecast the future

Market research, value chain

analysis, DCF models
Decision analysis, option valuation
models, game theory
Scenario planning, technology
Analogies and pattern recognition,
nonlinear models

2. Alternate Futures
3. Range of Futures
4. True Ambiguity

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 finding 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 sufficiently 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 difficult to predict which one will occur.
Level 3 uncertainty A Range of Futures exists when a range of potential outcomes
can be identified and the range is defined 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 specific 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
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 finding 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 find 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 uncertainty

High risk

Process: highly analytical

Objective: optimal alternative

Process: qualitative, judgment-oriented

Objective: acceptable alternative

Low risk

Process: less analytical

Objective: optimal 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
financial 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 defining, 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
first 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 finance/accounting,
scenario building in the sense of internal, project based situations which are not readily quantifiable, 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 finance
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 flexibility, 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 quantifiable, 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 firms 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 benefits 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 five scenarios. The
process of establishing the scenarios generally involves the following phases:

Identification of environmental driving forces

Selection of significant 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 specific scenario)

Numerous benefits 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 firm that already
has contingent plans articulated. In short, the scenario planning process brings two major
benefits to our discussion. First it helps in identifying the long-term risks and uncertainties
that impact on the firm as a whole, and second, it assists the executives in defining their
alternatives and options, i.e., increasing their optionality. And, in so doing, scenario plan-


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ning contributes to the firms ability to survive, even under hostile conditions, and to more
proactively exploit more munificent environments. Scenario planning can be limited by the
number of scenarios proposed, and, although the technique is often used at the firm 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 specifically valuing managerial
flexibility. 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 flexibilitythe 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 firms will seek projects with higher
volatility because active management of those projects can create value for the firm. Under
real options thinking, as long as management can control the downside risk of a project,
firms 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 benefit of a real options analysis may not be project
valuation, or quantifiability, 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 firm 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 flexibility 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 firm-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 specifically defining 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 identified. 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
We know managers consider flexibility in project valuations and are often willing to spend
additional funds to achieve flexibility. We thus argue that these two approaches scenario
planning and real options can help managers identify potential areas where flexibility
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 flexibility 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 fulfill 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 finishing 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 flexible 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
To better understand the distinction between the risk and uncertainty, it may be helpful
to apply these definitions in the context of the NIF project. Using our previously stated
definition of risk, risk involves the variance in potential outcome values of the specific
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 first 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 five 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 final 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 finally
approved and funded that project. Therefore the total demand for laser glass is risky. The
ability of glass firms 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
A. Bulls eye (possible, and provides B. X Scores (likely, but leaves NIF
NIF with future flexibility of choice of dependent on one supplier)
lower-cost provider)
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
significant disadvantage to the nation
in not being able to test its nuclear
weapon supply or undertake nuclear
Company Y: development of
the glass manufacturing
application and quality of



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 flexibility 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 significant value in flexibility 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 firm might be heading towards a Quadrant D

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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 difficult 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 sufficient
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
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 identified 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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benefits or costs of investing in a second supplier under different assumptions would be


6. Conclusion
Large complex capital budgeting projects can be difficult to assess and evaluate. Decisions and alternatives are often many and complex, as well as difficult to quantify for
valuation purposes. Additionally, there is frequently not enough quantifiable information
available to perform a valuation analysis. For example, it is very difficult to put dollars on
the impact of the NIF project not being completed successfully. It is often also problematic
to apply financial 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 influence 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 influence 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
Difficulties, 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 firm
and assist them in defining possible alternatives and contingencies. Real options analysis
is helpful in guiding management to consider the non-quantifiable value embedded in a
project by then adding detailed structuring and, thus, allowing for a richer understanding
of the scenarios identified.

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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 field of finance 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 flexibility. 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 finance and strategic management.
Given the information available, managers attempt to make the best decisions possible for
a firm. Analysis techniques that work to reduce uncertainty or plan for uncertain outcomes
are of benefit to managers. Considering optionality or potential future outcomes when a
firm 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 quantified. Whereas finance 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 fields
of both finance and strategic management to be able to value the quantifiable and recognize
and incorporate the qualitative factors in a project. Taking elements from both disciplines
results in a process for firm decision makers to improve project assessment and evaluation.
The fields of finance 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

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