A Prospect Theory-Based Real Option Analogy for Evaluating Flexible Systems and Architectures in Naval Ship Design.

Abstract

A constant trend in U.S. Navy design and acquisition programs has been the emphasis on flexible systems and architectures. Modularity and design-for-upgradability are two examples of this trend. Given the increasing importance of flexibility in Naval design, the methods used for valuing Naval assets should adequately capture the impact of such flexibility. Current static budgetary techniques and net present value (NPV) analysis underestimate the value of the embedded ``optionality'' of flexible design features. The use of real options analysis (ROA) has been proposed to correct this underestimation, however the theory is not universally applicable to the naval domain because of key assumptions made by a real options approach.

These deficiencies leave designers and decision makers to rely on their intuition and engineering experience when evaluating flexible systems and architectures. A quantitative evaluation framework would add valuable analytical rigor to increasingly complex designs and demanding mission requirements.

This research presents a novel framework for evaluating flexible Naval assets, called prospect theory-based real options analysis (PB-ROA). The framework abstracts the principles of ROA to suit a wide variety of naval applications. Since naval assets do not generate cash flows, utility theory provides the alternative measure of value within PB-ROA. However, without a market where the assets are traded, a new source for data on prevailing risk tolerances in needed to properly adjust the option's value according to uncertainty. Where some prior research relies solely on utility curves to determine risk aversion, PB-ROA uses a unique mechanism inspired by Prospect Theory to derive the risk-adjusted probability measure from the decision maker's marginal utility curve(s). This enables PB-ROA to include the impact of loss aversion where previously it has been ignored. Game theory is also incorporated into PB-ROA to address the unique characteristic of some naval options which may be leveraged to influence the behavior of other agents in the Navy's environment. With game theory, PB-ROA lends a new perspective on the value of ``game changing'' options, which do not simply react to changes in the environment, but exert a feedback effect on it as well.