NPS-FM-18-009 ACQUISITION RESEARCH PROGRAM SPONSORED REPORT SERIES Business Case Valuation of Strategic Flexibility in Shipbuilding: Justifying and Assessing the Value of Flexible Ships Design Features in New Navy Ship Concepts 15 November 2017 Dr. Johnathan Mun, Professor of Research, Information Science Dr. Thomas Housel, Professor, Information Science LCDR Lauren B. Majchrzak Graduate School of Business & Public Policy Naval Postgraduate School Approved for public release; distribution is unlimited. Prepared for the Naval Postgraduate School, Monterey, CA 93943. Acquisition Research Program Graduate School of Business & Public Policy Naval Postgraduate School The research presented in this report was supported by the Acquisition Research Program of the Graduate School of Business & Public Policy at the Naval Postgraduate School. To request defense acquisition research, to become a research sponsor, or to print additional copies of reports, please contact any of the staff listed on the Acquisition Research Program website (www.acquisitionresearch.net). Acquisition Research Program Graduate School of Business & Public Policy Naval Postgraduate School Abstract To successfully implement the Surface Navy’s Flexible Ships concept, PEO- SHIPS requires a new methodology that assesses the total future value of various combinations of Flexible Ships design features and how they will enable affordable warfighting relevance over the ship’s full-service life. Examples of Flexible Ships design features include decoupling payloads from platforms, standardizing platform- to-payload interfaces, implementing allowance for rapid reconfiguration of onboard electronics and weapons systems, preplanning access routes for mission bays and mission decks, and allowing for sufficient growth margins for various distributed systems. This research analyzes the application of strategic Real Options Valuation methodology within the Integrated Risk Management process to assess the total future value of Flexible Ships design features and for use in the Future Surface Combatant Analysis of Alternatives. The current research has the explicit goal of proposing a reusable, extensible, adaptable, and comprehensive advanced analytical modeling process to help the U.S. Navy in quantifying, modeling, valuing, and optimizing a set of ship design options to create and value a business case for making strategic decisions under uncertainty. Acquisition Research Program Graduate School of Business & Public Policy - i - Naval Postgraduate School THIS PAGE LEFT INTENTIONALLY BLANK Acquisition Research Program Graduate School of Business & Public Policy - ii - Naval Postgraduate School NPS-FM-18-009 ACQUISITION RESEARCH PROGRAM SPONSORED REPORT SERIES Flexible and Adaptable Ship Options: Assessing the Future Value of Incorporating Flexible Ships Design Features into New Navy Ship Concepts 15 November 2017 Dr. Johnathan Mun, Professor of Research, Information Science Dr. Thomas Housel, Professor, Information Science LCDR Lauren B. Majchrzak Graduate School of Business & Public Policy Naval Postgraduate School Disclaimer: The views represented in this report are those of the authors and do not reflect the official policy position of the Navy, the Department of Defense, or the federal government. Acquisition Research Program Graduate School of Business & Public Policy - iii - Naval Postgraduate School THIS PAGE LEFT INTENTIONALLY BLANK Acquisition Research Program Graduate School of Business & Public Policy - iv - Naval Postgraduate School Table of Contents Introduction ................................................................................................................ 1 Research Process and Layout of the Paper .............................................................. 5 Literature Review ......................................................................................... 5 The Theory of Strategic Real Options, Knowledge Value Added, and Integrated Risk Management .................................................... 5 Real Options Valuation Applications in the U.S. Department of Defense ........................................................................................................ 5 FASO/MAS at PEO-SHIPS: AWS Options for the DDG 51 Flight III......................................................................................................... 6 Conclusions and Recommendations ............................................................ 6 Literature Review ....................................................................................................... 7 Flexible and Adaptable Ship Design .................................................................... 7 Royal Danish Navy .............................................................................................. 9 Flyvefisken Class (SF 300) ........................................................................... 9 Absalon Class Support Ships ..................................................................... 11 Iver Huitfeldt Frigates ................................................................................. 13 German Navy .................................................................................................... 15 French Navy ...................................................................................................... 16 Aquitaine Class .......................................................................................... 17 FTI Class .................................................................................................... 19 Royal Australian Navy ....................................................................................... 20 Future Frigate Mandatory Design Characteristics ...................................... 21 Potential Designs ....................................................................................... 22 American Navy .................................................................................................. 23 LCS—Freedom .......................................................................................... 24 LCS—Independence .................................................................................. 25 Small Surface Combatant ........................................................................... 25 Real Options Valuation with Flexible Ships ....................................................... 27 The Theory of Strategic Real Options, Knowledge Value Added, and Integrated Risk Management ............................................................................................................ 41 The Real Options Solution in a Nutshell ............................................................ 43 Industry Leaders Embracing Strategic Real Options .................................. 44 Knowledge Value Added (KVA) ......................................................................... 48 Integrated Risk Management (IRM)................................................................... 52 Acquisition Research Program Graduate School of Business & Public Policy - v - Naval Postgraduate School Real Options Valuation Applications in the U.S. Department of Defense ................ 57 Option to Wait and Defer (Ability to Wait Before Executing) .............................. 57 Option to Switch (Ability to Switch Applications) ................................................ 58 Simultaneous Compound Option (Parallel Development) ................................. 59 Portfolio Option (Basket of Options to Execute) ................................................ 59 Sequential Compound Option (Proof of Concept, Milestones, and Stage-Gate Development) .................................................................................................... 60 Expansion Option (Platform Technology with Spinoff Capabilities) ................... 61 Abandonment Option (Salvage and Walk Away) ............................................... 62 Contraction Option (Partnerships and Cost/Risk Reduction) ............................. 63 FASO/MAS at PEO-SHIPS: Flexibility Options for Guided Missile Destroyers ........ 65 DDG 51 FLIGHT III ............................................................................................ 65 Step 1: Identification of FASO/MAS Options ..................................................... 66 Power Plant Options ................................................................................... 66 Vertical Launch Systems ............................................................................ 68 Step 2: Cost Analysis and Data Gathering ........................................................ 71 Step 3: Financial Modeling ................................................................................ 73 Static Portfolio Analysis and Comparisons of Multiple Projects .................. 76 Step 4: Tornado and Sensitivity Analytics ......................................................... 78 Step 5: Monte Carlo Risk Simulation ................................................................. 84 Simulation Results, Confidence Intervals, and Probabilities ....................... 84 Probability Distribution Overlay Charts ....................................................... 85 Analysis of Alternatives and Dynamic Sensitivity Analysis ......................... 86 Step 6: Strategic Real Options Valuation Modeling ........................................... 88 Real Options Valuation Modeling ............................................................... 89 Step