New Venture Strategy

Chapter 4

New Venture Strategy

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Learning Objectives • Understand what makes a decision strategic.• Understand the interrelationships between financing

decisions and other aspects of new venture strategy.• Relate strategic decisions to the entrepreneur’s

objective of value maximization.• Describe strategic alternatives in terms of real

options.• Use decision trees to identify and evaluate real

options. • Use game trees when strategic choices depend on

rival reactions.


What Makes a Plan or Decision Strategic?

• Strategic decisions are consequential i.e. involve commitments of Time and Resources.

• Strategic decisions are both active and reactive i.e. those having competing or complementary objectives and are capable too of acting strategically.

• Strategic decisions limit the range of possible future actions i.e. not costlessly reversible


Interactive Financial Strategy


Financial Implications of Product-Market and Organizational Strategic Choices


An Introduction to Options• Option - A right to make a decision in the future

Call Option: a right to buy a share of stock in future for the price determined today.–E.g. The right to buy the shares of Engro common stock any time during the next Three months at a price Rs. 55.–GAIN: if the Market Price of under-lying asset rises–LOSS: if the Market Price of under-lying asset declines


Con…• Put Option: The right to sell the under-lying asset in

future at pre-determined Price.– E.g. The right to Sell the shares of Engro common

stock any time during the next Three months at a price Rs. 55.

– GAIN: if the Market Price of under-lying asset Declines

– LOSS: if the Market Price of under-lying asset Rises

•


Describing Decision Rights as Options

• The value of the option Depends on Several Factors:– 1. Market Price (Gains/Loses)– 2. Volatility/Risk– 3. Time to Expiration– 4. TVM


Factors affecting Real & Financial Options

Call Option on Stock• Current value of stock•Exercise price •Time to expiration•Stock value uncertainty•Risk free interest rate

Real Option on Project• (Gross) PV of expected cash flow•Investment cost•Time until opportunity disappears•Project value uncertainty•Risk free interest rate •or risk adjusted rate


differences between real options and financial options

1) for real options sometimes are important to consider the time to build the underlying asset;

2) real options in general have longer time to expiration than financial options, sometimes even perpetual real options, as

the case of land. 3) private uncertainties sometimes are very important in

real options models. 4) the decision rule (earlier exercise threshold or critical value) is much more important in real options applications

than in financial options.


Examples of Real Options


Strategic Decision Analysis & Decision Trees

• Decision tree is a way to conceptualize strategic Alternatives.

• It helps Entrepreneurs to Identify and Assess the relevant Real options


Techniques for Reasoning Through Decision Trees

1. Focus on the most important decisions.2. Reason forward to construct the tree.3. Track certainties and uncertainties at each decision

point.4. Calculate backward to evaluate choices.5. Select the tree branch with the highest expected

value.


Decision Tree Example - Assumptions

• Demand may be high (30%), medium (50%), low (20%).• Cost of large restaurant is $750,000.• Cost of small restaurant is $600,000.• Entrepreneur will invest $400,000, outside investor

provides the rest.• Investor requires 1% of equity for each $10,000

invested.• If demand is high - PV large is $1,500,000, PV small is

$800,000.• If demand is medium - PV large is $800,000, PV small is

$800,000.• If demand is low - PV large is $300,000, PV small is

$400,000.


Accept/reject Decision to Invest in Restaurant Business


Evaluation of Accept/Reject Alternatives• Large-scale entry:

NPV conditional on high demand = $575,000NPV conditional on intermediate demand = $120,000NPV conditional on low demand = ($205,000)NPV= Payoff-InvestmentNPV=[0.65(0.3*1500,000+0.5*800,000+0.2*300,000)]-

400,000= $191,500OR

NPV = .3 x $575,000 + .5 x $120,000 – .2 x $205,000= $191,500


Evaluation of Accept/Reject Alternatives (Cont’d)

• Small-scale entry:NPV conditional on high demand = $240,000NPV conditional on intermediate demand = $240,000NPV conditional on low demand = ($ 80,000)NPV = .3 x $240,000 + .5 x $240,000 - .2 x $80,000= $176,000

• Do not enter in small Restaurant because the NPV of Large one (191,500) is greater than small (176,000). So the better choice would be to invest in Large Restaurant.


The Options to wait to invest• Is referred to as a learning option… materially reduce

the uncertainty• In our example of Restaurant, we are waiting for the

restaurant to grow but at the same time attract more competition.

• Because of the competitive entry the Present value of the Restaurant would be decreased.


Restaurant Business Investment With an Option to Delay Investing


Evaluation of Option to Delay• Large-scale entry strategy: NPV = $191,500• Delay until uncertainty is resolved:

– High demand• Build large restaurant• NPV conditional on high demand = $445,000

– Intermediate demand • Build small restaurant• NPV conditional on intermediate demand • = $160,000

– Low demand• Do not enter• NPV conditional on low demand = $0


Evaluation of Option to Delay (Cont’d)

• NPV of delay strategy:– = .3 x $445,000 + .5 x $160,000 + .2 x $0 – = $213,500

• Value of Option to Delay = $213,500 - 191,500 – = $22,000


The option to Add to the initial Investment i.e. Expansion Option

• Suppose initial Investment for small Restaurant is $600,000 ($400,000 from Entrepreneur+ $200,000 from Outsider).

• Outsider will to provide with 20% i.e. 1% on every 20,000. so the total return on $600,000 would be @30% due to expansion.

• Expanding, NPV $580,000• Not-Exapnding, NPV $240,000


Restaurant Business Investment With an Option to Expand Initial Investment


Evaluation of Option to Expand• Large-scale entry strategy: NPV = $191,500• Delay until uncertainty is resolved: NPV = $213,500• Build small, with Option to Expand:

– Conditional on High demand:• NPV if Expand = $580,000• NPV if Remain Small = $240,000• Conclusion: Expand if demand is high

– Conditional on Intermediate demand:• NPV of Remaining Small = $240,000

– Conditional on Low demand:• NPV of Remaining Small = ($80,000)


Evaluation of Option to Expand (Cont’d)

• NPV of Small-scale entry with Option to Expand– = .3 x $580,000 + .5 x $240,000 - .2 x $80,000 – = $278,000

• Value of Expansion Option = $86,500• Incremental value over Delay Option = $64,500

– The Options are Mutually Exclusive


Evaluation of Option to Abandon

• Suppose the Restaurant Facility, large or small, Has alternative use as office space.

• If converted the Value of Large Rest. Would be $600,000 and of small would be $300,000.

• Here the option to abandon the small restaurant is worthless i.e. being at low-demand state the PV ($300,000)< $400,000.

• So by converting Large Restaurant into Office space i.e. $600,000, the realized value would be $390,000 (600,000*0.65)

• NPV=-400,000+0.3*975,000+0.5*520,000+0.2*390,000=$230,500• This value is less than the value of strategy of initially investing in the

small restaurant (240,000) but higher than other alternatives.


Evaluation of Option to Abandon (Cont’d)

• Small-scale entry with Expansion and Abandonment Options:– Abandonment has negative value for the small

restaurant– A result of discreteness of the analysis

• Conclusion: Build small with Expansion Option– NPV = $278,000


Game Trees• The Basics

– Players– Order of play– Information set– Available actions– Payoff schedules

• Strategic interaction– Cooperative and Non-cooperative games– Sequential-move game - Game tree– Simultaneous-move game - Payoff matrix

• Nash equilibrium• Sub-game perfection


Evaluating Strategic Games• Specify assumptions about rival actions and

reactions.• Develop the tree.• Prune branches involving dominated strategies.


Entry Decision Game Tree


End of Chapter Questions


Question 4-1• What is an abandonment option?• In what ways might an entrepreneur benefit by giving an outside

investor an option to abandon a project?• How might the entrepreneur be harmed?



Question 4-2You can acquire an existing business for $2 million. Future demand is uncertain:

– High demand: p = 40%, PV = $3.0 million– Moderate demand: p = 25%, PV = $1.5 million– Low demand: p = 35%, PV = $1.0 million• What is the NPV of the business?• Should you invest or not? Explain



Question 4-3Suppose that if you buy the business described in question 2, you can expand by investing $500,000Future demand is uncertain:

– High demand: p = 40%, PV = $4.0 million.– Moderate demand: p = 25%, PV = $2.5 million.– Low demand: p = 35%, PV = $1.0 million.• Draw the decision tree.• Evaluate the alternatives.• What is the NPV of the business with the option?• What is the NPV of the option?



Question 4-4Now, assume in the previous problem that the market value of the business assets is $1,800,000 in liquidation.

• Draw the decision tree for the abandonment option.• Evaluate the alternatives.• Find the NPV of the business with the abandonment option.• How valuable is the option?



Question 4-5Re-evaluate the previous problem considering both expansion and abandonment options.

• Draw the decision tree incorporating both.• Are the values additive?• Why or why not?



Question 4-6By committing to invest $3 million today, you can acquire a project with a 30% chance of success at the end of year 1. If not successful in year 1, the probability of success in year 2 is 40%. If not successful in year 2, the probability of success in year 3 is 20%. In the event of success at any point, the project cash flows are worth $4 million. If the project fails, it is worth zero.

• Find the cumulative probability of success.• Find the NPV of the project.



Question 4-7Continuing Problem 4-6: If you can spend $1 million on the project today, the probability of success by year 1 is 30%. If you spend another $1 million at year 1, the probability of success by year 2 is 40%. If you spend another million at year 2, the probability of success by year 3 is 20%. Conditional on success at any stage, the project PV is $4 million.

• Draw the decision tree• Evaluate the tree

• Is the project worth pursuing?• Which is the best course of action for the decision

maker?• Compare the values in problems 4-6 and 4-7

• How valuable is the staging option?• How is staging related to abandonment?• Are the series of abandonment options additive? Explain.



Question 4-8 Having accumulated 7000 points at a casino night fund-raiser for your school, you are in lead. The closest contender has accumulated only 4000 points. The grand prize is a two-day yacht trip with Michael Bloomberg and other prizes are trivial and there is time for one more bet. Assume that both would like win the trip. Support your reasoning with game trees.

• Suppose you hold on to 5000 points and bet 2000 on black. What should your rival do?

• Suppose your rival goes first and bets everything on red. What should you do?

• Suppose your rival offers to split the prize evenly with you if you both agree not to bet. What should you do? How does your answer depend on whether you would bet first, your opponent would bet first, or you both would have to bet at the same time?

• All things considered, would you rather be the first mover, the second mover, or both at the same time?



Question 4-9 Which of the following decisions are “strategic”? Explain your

reasoning.a) An owner of a nursery decides to buy an option on a parcel

of land that is contiguous to his nursery.b) The nursery owner exercises the option and buys the land.c) The nursery owner decides to carry palm trees.d) The nursery owner expands his staff by 10 employees.e) The nursery owner builds a greenhouse on the plot of land

he purchased.



Question 4-10 Explain how trade credit can be used to shift part of financing burden to others.



Question 4-11 From the perspective of the entrepreneur explain, in general terms:

– the strategic considerations that would tend to favor small-scale entry over large scale entry;

– the strategic considerations that would tend to favor rapid growth;

– the strategic considerations that would tend to favor vertical integration into manufacturing as well as distribution;

– the strategic considerations that would tend to favor outside equity financing instead of debt.

In each case, be sure to focus on the value of the entrepreneur’s interest in the venture rather than the entire venture, taking into considerations the interdependencies among product-market, organization, and financial strategic choices. Support your reasoning with some specific examples.



Question 4-12 Redo the real option analysis of the restaurant model in Section 4.8

assuming that the probability of high demand is 40% and the probability of low demand is 30%. All other assumptions are unchanged.a) Calculate or examine how this change affects the values of

the accept-reject decision and the various alternatives involving the real options to wait, expand and abandon.

b) What are the approximate values of the various options?c) What is the best strategy to pursue? Assume that the

option to abandon the small restaurant can be acquired at no cost, but the option to abandon the large restaurant would cost $17,000 (the incremental values computed in Section 4.8).

d) Why do you think increases in the probabilities of the high and low demand states change the values in the way that they do?

e) What can you say about how the values of real options depend on risk levels?



Question 4-13 Suppose, as the restaurant entrepreneur in Section 4.8, you

believe the outside investor should be willing to accept a lower fraction of equity in the case that the option to wait before investing is exercised. Specifically, because the investor will know the true state of nature, you believe the investor should be willing to accept one percent of the equity for each $20,000 he invests (just like with the expansion option,but for the investor’s entire investment). All other assumptions are unchangeda) Re-evaluate the waiting option.b) How, if at all, does this change the conclusions about the

best strategy for you to follow?



Question 4-14 Consider the game-tree analysis in Section 4.9

a) Suppose Kelly is uncertain of how Erin will react to her decisions. Kelly believes that, conditional on Kelly’s decisions, there is a 70% probability that Erin will make the right choice, based on the assumptions in Fig 4-6, and a 30% that Erin will make the wrong choice. How does this affect the expected values of Kelly’s strategies to enter with a large bar, a small bar, or wait? How, if at all, does this affect Kelly’s optimal strategy? (Ignore the possible effects of this risk change on the conditional present values shown in Fig 4-6).

b) Suppose Kelly believes Erin will ignore Kelly’s initial decision. Rather, there is a 70% chance that Erin will enter no matter what Kelly does. What is the best strategic course of action for Kelly to follow? Comment on how game trees and decision trees differ from each other. (Ignore the possible effects of this risk change on the conditional present values shown in Fig 4-6).


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