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1 Chapter 13 Strategic Flexibility and Real Options Analysis PART IV MONITORING AND CREATING ENTREPRENEURIAL OPPORTUNITIES

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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

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

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Environmental analysis Analysis of competitive rivalry and competitive dynamics Real options analysis

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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

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Organizational structures, systems, or other internal resources Design of investments and operations Incorporating staging opportunities Switching opportunities Articulating the follow-on opportunities Entrepreneurial activities

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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

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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

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Is a right Is not an obligation Specifies a future action Reduces downside risk Accesses upside opportunities

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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

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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

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Addresses motives for strategic investments Reconciles strategic and financial analyses Shifts investment thresholds Drives actual firm value

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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

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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

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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

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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

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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

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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

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Overly technical Beyond the mathematical competence of many managers Too complex to implement Assumed correlations with overvalued Internet stocks and corporate scandals Mental barriers

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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.

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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

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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

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1. Calculate the value of the underlying asset and the present value of the exercise price, PV( X ). 2. Determine d 1 and d 2 using these two values as well as σ and t. 3. Use the normal distribution table to find N ( d 1 ) and N ( d 2 ). 4. Use the Black-Scholes formula to compute the option value.

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1. Calculate NPV q. 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.

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1. 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.

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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?

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How can a firm include human issues (such as the well-being of employees or human risk factors) in a real options analysis?

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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?

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How can a board of directors ensure that real options analysis does not result in management decisions that hurt shareholders and other important stakeholders?

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