1. Introduction

The traditional approach to appraising investments is to formulate a broad set assumptions about the key value drivers of a business case and then assess the future financial implications of those assumptions (amount, timing, and risk of future cash flows). If the present value of the future cash flows exceeds the required investment, the project has a positive net present value and we should realize it.

This management and valuation approach is suitable for mature companies with relatively low uncertainty projects. It is discussed in great details in the course section "Foundations of Finance" and "Firm Valuation."

However, especially in the early stages of high-risk ventures, this traditional decision-making approach (but not the NPV-criterion as such!) might be inadequate. Before committing investment capital for a project, it could make sense to validate the key assumptions behind the business case and thereby reduce the uncertainty of the project. This is the basic idea behind Experimentation, a management and product development approach that has recently received a lot of attention in the context of "agility" and "lean startup."

In this section, we take a closer look at the financial angle of experimentation:

  • We start with a simple example to show that many investments that would not be feasible with full up-front investments become financially very attractive once we allow for experimentation.
  • Second, we argue that experimentation factually converts the traditional product development process into a string of options.
  • Third, we look at the key value drivers of experimentation, namely uncertainty, cost of experimentation, and quality of the experiment.