A new approach to valuation of six sigma projects: Real options

Each project contains some degree of uncertainty and risk. Six Sigma projects, especially Black Belt projects, are generally complex, high risk and large-scale projects. These projects which are implemented in uncertain environment, requires multiple resources from many departments of a company and usually do not meet original expectations of cost, time, or benefits. As traditional capital budgeting methods determine the value of a Six Sigma project based on expected cost savings and ignore the uncertainties in project environment, they can not reflect its actual profitability.Recently, reel options theory has brought a new approach to the role of uncertainty on the value of investment projects. It also contributed to the literature through a valuation method which explicitly accounts for managerial flexibilities embedded in projects. This method has arisen as a response to the inadequacies in current valuation approaches and has been suggested as a capital budgeting and strategic decision making tool.This research aims to develop a conceptual framework for analyzing investment decisions and promote practical application of real options approach in the context of Six Sigma projects. Firstly the characteristics of a Six Sigma project are mapped onto the parameters of a stock call option and the estimation procedures for these parameters are presented. Then, a four phased conceptual model is introduced to analyze specifically the effects of uncertainties on the project value and to consider the managerial flexibilities for Six Sigma projects. This model, named as ?Real Option Valuation Model?, is a hybrid model which combines the best features of Monte Carlo simulation and binomial option pricing method. Four phases of the framework are illustrated in a Six Sigma project at a manufacturing company. A sensitivity analysis is also carried out to study the impact of model parameters on option value by using illustrative project data.