Investment in Electronic Commerce − A Real Options Approach

Abstract

In recent years substantial investments have been made in eCommerce projects. Some of them seem to have been profitable. In other cases there has not yet been enough demand to generate a cash flow large enough to guarantee a financial viability of the projects. The purpose of this project is to develop a set of methods to be used in order to evaluate investments in eCommerce given an uncertain demand. eCommerce investments are sequential in the meaning that initial “platform” expenditures for web services are to be followed by substantial outlays for marketing. In this paper a real options approach is used for their evaluation. Sales and sales income will be described in terms of a binomial process with declining growth rates. A decision to stop the investments in marketing is assumed to put a cap on that growth. The paper shows that the real options approach is a suitable procedure to evaluate sequential decisions concerning investments in eCommerce. The method is applied on a real case study from a Swedish firm. It is demonstrated that the classical approach of adjusting the discount rate for risk may give quite misleading results.