Competing for ADVANTAGE

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Chapter 13 Strategic Flexibility and Real Options Analysis

PART IVMONITORING AND CREATING ENTREPRENEURIAL OPPORTUNITIES

The Strategic Management Process

Strategic Decisions

Are complex Are ambiguous Reach across functions Involve sizable resource commitments Prompt rival reactions Require integration of qualitative inputs Are difficult to analyze Are made in the context of uncertainty

Causes of Uncertainty

Economic risks Technological developments Industry convergence Creative destruction Geopolitical crises Global integration of industries

Tools for Dealing with Uncertainty

Environmental analysis

Analysis of competitive rivalry and competitive dynamics

Real options analysis

Strategic Flexibility

Key Terms

Strategic flexibility

Condition existing when a strategy allows a firm to react to changing uncertainties by quickly changing course or, better still, allows the firm to position itself to take advantage of the resolution of uncertainty

Sources of Enhanced Strategic Flexibility

Organizational structures, systems, or other internal resources

Design of investments and operations Incorporating staging opportunities Switching opportunities Articulating the follow-on

opportunities Entrepreneurial activities

Real Options Analysis

Offers a means of quantitatively evaluating the role of uncertainty in firms’ investment decisions

Changes the ways in which strategists think about particular investments and the ways in which they can deliver value to firms

Begins to reconcile strategic and financial analyses in organizations

Real Options Analysis

Key Terms

Real option

A strategic alternative, with an underlying (real) asset, that provides the firm with the right, but not the obligation, to take some future specified actions which will enable the firm to reduce its downside risk while assessing upside opportunities -- a preferential claim to follow up on an investment opportunity

Real Options Criteria

Is a right

Is not an obligation

Specifies a future action

Reduces downside risk

Accesses upside opportunities

Types of Real Options

Types of Real Options

Key Terms Growth options

Investments that enable the firm to expand the investment in the future, if that action turns out to be valuable

Abandonment options

Investments that provide firms flexibility by allowing them to reverse course and exit deteriorating competitive situations

Types of Real Options

Key Terms Switching options

Investments that combine the features of growth and abandonment options by allowing firms to change the mix of outputs or inputs

Options to defer

Investments that recognize a value in waiting

Compound options

Investments that confer multiple options that are built upon one another

Importance of Real Options Analysis

Addresses motives for strategic investments

Reconciles strategic and financial analyses

Shifts investment thresholds Drives actual firm value

Challenging Received Wisdom on Motives for Strategic

Investments Shifts focus from efficiencies of ownership

to potential gains from changes in value chain activities

Central focus becomes operational flexibility rather than operational control

Joint ventures and minority investments have come to be seen as stepping stones (transitional investments) rather than permanent, inflexible arrangements

Reconciling Strategic Analysis and Financial Analysis

Injects strategic reality (e.g., uncertainty, follow-on opportunities, and active management) into financial models of investment

Incorporates the discipline of financial markets and mathematical rigor into strategic analyses

Reconciling Strategic Analysis and Financial Analysis

– A Scenario (1) Expected outcomes

Payoff of V+ = $180 million in “good” market

Payoff of V- = $60 million in “poor” market

Discounted rates of return Risk adjusted rate = 20%

Risk-free rate = 8%

Present value PV = (1 + 0.20)-1 [0.5(180) + 0.5(60)] =

$100 million

Reconciling Strategic Analysis and Financial Analysis

– A Scenario (2) Option: Contract with technology firm for

payment of $180 million in one year PV = (1 + 0.20)-1 [0.5(180) + 0.5(60)] – 100 = $50

million

Discounted rates of return Risk-free rate = 8% (at 100% chance to receive $180

million)

Correct present value for abandonment option PV = (1.08)-1 [0.5(180) + 1 0.5(180)] – 100 = $67

million

Shifting Investment Thresholds

Takes into account the potential for future opportunities that evolve from the project at hand

Makes an argument for retaining assets and operations despite expected gains from divestiture

Suggests that it might make economic sense to accept negative-NPV investments or to avoid positive-NPV investments because these investments are “strategic” and are embedded with valuable options

Driving Actual Firm Value

Expresses the value of a firm in terms of: The value of assets in place

The value derived from assets in their present use

The value of growth opportunities

Uses the value of growth options to determine present value because growth in economic profits reflects the firm’s discretionary future investments

Growth Option Values across Industries 1989 - 2000

Growth Option Values within the Electrical and Electronics

Equipment Industry 1989 - 2000

Drivers of Call Option Value

Two Components of Call Option Value

Criticisms of Real Options Analysis

Overly technical

Beyond the mathematical competence of many managers

Too complex to implement

Assumed correlations with overvalued Internet stocks and corporate scandals

Mental barriers

Benefits of Real Options Analysis

Considerable insights can be gained from relatively simple extensions of existing techniques, such as discounted cash flow models and decision tree analysis.

Firms are likely to benefit from establishing ground rules for the use of this technique and targeting its application to large projects for which the NPV is uncertain.

Transitional Steps

Conduct one or more experimental pilot projects

Get support from top managers and those involved in the project

Codify the real options technique through an expert group and training materials

Institutionalize real options analysis as a way of thinking as well as an analytical tool

Avoiding Problems

Examine a portfolio of projects under the control of management

Distinguish between uncertainties that are under the control and those that are beyond the control of managers

Rely on additional information to judge management performance

Provide incentives for appropriate behavior

Black-Scholes Valuation

1. Calculate the value of the underlying asset and the present value of the exercise price, PV(X).

2. Determine d1 and d2 using these two values as well as σ and t.

3. Use the normal distribution table to find N(d1) and N(d2).

4. Use the Black-Scholes formula to compute the option value.

Black-Scholes Approximation

1. Calculate NPVq.

2. Calculate cumulative volatility.

3. Look up the table value expressing the value of the option as a percentage of the value of the underlying asset.

4. Multiply the table value by the value of the underlying asset in order to calculate the option value.

Binomial Lattices1. Estimate the value of the underlying asset at

time zero and the up/down parameters.

2. Construct an event tree that depicts how the value of the underlying asset increases or decreases over time.

3. Calculate the value of the risk-neutral probabilities used in weighting values in the lattice for discounting purposes.

4. Construct a decision tree that shows how the decision maker chooses to hold open or exercise the option at various nodes in the event tree.

5. Work backwards in the lattice to value the option at all of the nodes.

Constructing Event Trees

Constructing Decision Trees

ETHICAL QUESTION

What are the ethical implications of making an investment that appears to be

a money loser in the short term on the basis that there will be options to make money from the opportunities that the

investment provides in the longer term? For instance, as a shareholder, would you be

comfortable with a management team that routinely makes these types of decisions?

ETHICAL QUESTION

How can a firm include human issues (such as the well-being of employees or

human risk factors) in a real options analysis?

ETHICAL QUESTION

Can real options analysis be used to justify poor decisions? If so, what are the agency implications (e.g., the risks that managers might use the technique to their advantage)? What are the legal

implications?

ETHICAL QUESTION

How can a board of directors ensure that real options analysis does not

result in management decisions that hurt shareholders and other important

stakeholders?