Real Options Analysis for Acquisition of New Technology: A Case Study of Korea K2 Tank's Powerpack

Abstract

For sustainable defense management, it is essential to acquire weapons systems that can adapt to future uncertain threats and, at the same time, to invest efficiently with limited budgets. Economic analysis is used to examine the costs, benefits and uncertainties of alternatives. In particular, the use of the real options valuation, which is one of the methodologies of economic analysis, is expanding. The real options valuation has shown effectiveness across various industries to evaluate investment strategies. In this paper, we apply the real options valuation to the weapon systems development case and confirm its usefulness. Unlike previous studies, the real option valuation methodology is applied retroactively to the finished project, compared to existing research mainly applying real options to value research and development (R&D) without knowing how the project completed. We use the following procedure. (1) Define the uncertainties of the three acquisition alternatives (development, technology adoption, and purchase). (2) Calculate the benefits of the three acquisition alternatives with expected and actual data without uncertainties. (3) Model the decision tree without options and with options. (4) Analyze and compare results with benefit and benefit cost ratio. We analyzed the Korea K2 tank powerpack development case by applying real options. We could see that the real options could have reduced the risk of losses when the development risk is high and market uncertainty exists. From the case study of the development of the powerpack, we learned the following three lessons. First, we reaffirmed the importance of objective value analysis in project decision making. Second, we need to analyze the project value continuously and revise the acquisition strategy accordingly. Third, the effectiveness of the real options valuation was confirmed for sustainable defense management. In addition, the real option analysis data acquired from similar finished projects can be useful for establishing a new product acquisition strategy and, at every decision-making phase, the real option evaluation should be continuously performed with updated information. In this paper, we first perform real option valuation of finished weapon systems in the Korean defense field. This paper is valuable in establishing a rational methodology for applying economic analysis to weapon system acquisition projects.