Elsevier

Decision Support Systems

Volume 38, Issue 1, October 2004, Pages 115-130
Decision Support Systems

Rental software valuation in IT investment decisions

https://doi.org/10.1016/S0167-9236(03)00081-2Get rights and content

Abstract

The growth of application service providers (ASPs) is very rapid, leading to a number of options to organizations interested in developing new information technology services. The advantages of an ASP include spreading out payments over a contract period and flexibility in terms of responding to changes in technology. Likewise, newer risks are associated with ASPs, including pricing variability. Some of the more common capital budgeting models may not be appropriate in this volatile marketplace. However, option models allow for many of the quirks to be considered. Modification of the option pricing model and an analytical solution method incorporated into a spreadsheet for decision support are described and illustrated. The analytical tool allows for better decisions compared to traditional value analysis methods which do not fully account for the entry and exit options of the market.

Introduction

Renting applications as opposed to purchasing expensive shrink-wrapped or packaged software solutions is becoming an attractive proposition. Business firms are increasingly looking to the application service provider (ASP) model for managing copious information and streamlining complex processes [30], [38]. An ASP is the entity that “offers an outsourcing mechanism whereby it develops, supplies, and manages application software and hardware for its customers” [21]. The firm receiving contractual service from an ASP is commonly known as the application service recipient (ASR). According to the International Data Corporation, global spending for ASP offerings in 2004 is expected to reach US$7.8 billion, a 52% growth rate from the base year 2000 [8]. The Gartner Group predicts that the worldwide revenues in the ASP market will grow by approximately US$24 billion by the end of 2004 [20].

In an Internet-powered economy, the ASP model has emerged as an alternative to purchasing software applications because it enables renting these applications as well as related services from the developing firm or a licensed third party [8]. Renting has been likened to outsourcing the company's IT department or service so that systems, applications, and subsequent support reside with an independent entity organized to provide such services [17]. ‘Hosting’ and ‘renting’ are sometimes used interchangeably, although the former entails a higher level of investment on the part of the service provider. For example, a firm may actually ‘rent’ the applications software under some lease-type agreement, such that the firm is responsible for software installation and subsequent upgrades. By virtue of such an agreement, the firm must also support a staff of highly skilled personnel trained to troubleshoot computer-networking, systems-administration, and applications-deployment issues. The advent of an ASP-type model shifts IT resource costs (including software and hardware installation and technical know-how) to the ASP.

The integration of the Internet into enterprise resource planning strategies has fundamentally redefined the IT landscape and increased the difficulty of many software decisions [41]. The opportunities that the Internet affords for electronic commerce, information exchange, supply-chain management, and economies of scale and scope have grown at an astounding pace in the last decade. The business world is recognizing the ASP model as a practicable means of capitalizing on these opportunities by delivering related solutions to end users [43]. For example, IT solution providers, with intent to tap into the profit potential generated by electronic commerce, are rushing to provide Internet-managed and delivered services, from web-based application hosting to custom application development and management.

Although the ASP model has surfaced as a feasible IT investment alternative [31], its continuance as a business solution rests upon the operation of the firm deploying the model. The rental services are likely terminated if the ASP's operations are disrupted due to bankruptcy or consolidation. Due to the fact that numerous ASP contracts compete on the basis of pricing in a dynamically charged IT environment, the problem of selecting an appropriate outsourcing solution poses a veritable challenge to the decision maker. Evidently, at the core of pricing inconsistencies observed in the market for rental applications software lies the more fundamental issue of investment valuation. Traditional capital budgeting techniques, such as the discounted cash flow (DCF) or net present value (NPV) analysis, may not adequately serve as a “barometer” of investment value. The weaknesses of traditional capital budgeting techniques are noted in the literature [3], [4], [13], [27], [33], [35], [36].

This paper primarily makes two contributions to the IT field dealing with investment decisions under uncertainty. First, a new type of investment in the form of an ASP offering is formally introduced and reviewed in the realm of IT investment decision making that accommodates the fluid entry and exit options. Second, we establish the validity for employing a real-options framework to evaluate flexibility inherent in outsourcing IT applications under the terms of a software rental agreement (SRA). The Black–Scholes OPM is modified according to the work of Margrabe [29] to obtain the value of SRA-embedded flexibility (i.e., the option price). The model is employed using spreadsheets to enable the decision power of easy generation of alternatives and incorporating what-if scenarios.

Section snippets

Background

The growth in the use of ASPs is due to certain advantages gained in investment requirements and potential response to technology changes. There are also certain problems that exist in terms of control and risk. ASP pricing structure, and market risks associated with rental contracts can overcome some of the benefits as well as lend difficulty to the analysis of the options. Option pricing models from the finance literature may help reduce the decision burden.

Financial options paradigm

Options pricing theory investigates the issues concerning the valuation of derivative assets. Cox and Ross [10] define a derivative asset as “a security whose value is explicitly dependent on the exogenously given value of some underlying primitive asset.” Call and put options are two commonly traded derivatives written on an underlying share of stock. Black–Scholes [5] first expressed the call option value c as a function of five parameters—the underlying stock price S, the fixed cost of

Decision methodology

To evaluate the exit flexibility embedded in SRAs, we employ the exchange offer method developed by Margrabe [29]. The decision to rent software applications is essentially an investment in the underlying commercially available package with an option to terminate enjoyment of outsourcing benefits on a designated date. At contract expiration, the ASR has the right to exit the original contract and undertake an alternative investment that is technologically efficient. Thus, an implementation

Conclusions

The Magrabe exchange-offer valuation model [29] is applied for evaluating the flexibility inherent in rental software investments. A rapidly growing ASP market is expected to mature in the next 4 years. The IT landscape founded on the potential advantages of outsourcing business applications is evolving from a hybrid environment of failing and thriving niche firms to a tightly consolidated marketplace of few entrenched software solution vendors.

The applications software alternatives available

Dr. Chaitanya Singh is a faculty member of Lyons College. He obtained his D.B.A. in Finance at Louisiana Tech University in 2002. He served as Controller at a software firm that develops applications for petroleum distributors. In addition to managing corporate financial operations, he developed database applications and analyzed software value. His research interests include financial modeling of information technology, sequential IT project valuation, and market efficiency.

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    Dr. Chaitanya Singh is a faculty member of Lyons College. He obtained his D.B.A. in Finance at Louisiana Tech University in 2002. He served as Controller at a software firm that develops applications for petroleum distributors. In addition to managing corporate financial operations, he developed database applications and analyzed software value. His research interests include financial modeling of information technology, sequential IT project valuation, and market efficiency.

    Dr. Roger Shelor is Professor of Finance at Ohio University. His doctorate is from The University of Kentucky. Previously he was the Balsley-Whitmore Endowed Professor in Business at Louisiana Tech University and was on faculty at Eastern Kentucky University. He has published in The Journal of Risk and Insurance, The Journal of Financial Services Research, The Journal of Real Estate Research and Real Estate Finance and Economics. He is an Associate Editor of Financial Decisions and serves as a Reviewer for Journal of Risk and Insurance, Journal of Insurance Issues, Review of Financial Economics, Journal of Economics and Finance, Journal of Empirical Finance, Journal of Small Business Finance, Journal of Real Estate Reasearch, Financial Review, and Business and Economic Review.

    Dr. James Jiang is Professor of Management Information Systems at University of Central Florida. He obtained his Ph.D. in Information Systems at the University of Cincinnati. His research interests include IS project management, marketing category management dynamic modeling, and IS personnel management. He has published over 100 academic articles in these areas in the journals such as Decision Support Systems, Decision Sciences, MIS Quarterly, Journal of Management Information Systems, Communication of ACM, IEEE Transactions on SMC, IEEE Transactions on EM, IEEE Transactions on PC, Journal of AIS (JAIS) and others. He teaches programming, data base management, and IS project implementation and management. He has made professional presentations on IS project management in the U.S. and Taiwan where he had been a visiting professor to National Tsing-Hua University and National Chung-Cheng University. He is a member of IEEE, ACM, DSI, and PMI.

    Dr. Gary Klein is the Couger Professor of Information Systems at the University of Colorado in Colorado Springs. He obtained his Ph.D. in Management Science at Purdue University. He previously served as Dean of the School of Business at the University of Texas of the Permian Basin. Before that time, he served with Arthur Andersen & Company in Kansas City and was director of the Information Systems department for a regional financial institution. His interests include project management, knowledge management, system development and mathematical modeling with over 100 academic publications in these areas. In addition to being an active participant in international conferences, he has made professional presentations on Decision Support Systems in the US and Japan where he once served as a guest professor to Kwansei Gakuin University. He is a member of IEEE, ACM, INFORMS, SCIP, DSI, and PMI.

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