FDI and New Venture Strategy: Real Option / Strategic Decision Trees Analysis Compiled by Ted Fu July 1, 2002 Adapted from Luenberger: Investment Science Smith: Entrepreneurial Finance Click: International Financial Management

Opportunities to alter input and output prices fluctuate with exchange rate changes. Opportunities to alter input sourcing, change output mix, or redirect exports to new markets are omnipresent in a setting of multiple markets with fluctuating currency values. Indeed, with the devaluation of Southeast Asian currencies in 1997, Japanese automakers shifted the output mix of their subsidiaries in Thailand and Indonesia from production of autos for the local markets to production of parts for developed country markets. This flexibility is often given as a major reason for corporate multinationality and for value creation through multinationals.

Strategic decisions are consequential. Strategic decisions are both active and reactive. Strategic decisions limit the range of possible future actions. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 What Makes a Plan or Decision Strategic?

Figure 4-1 Rapid growth requires a larger organization. Economies-of-scope imply more product lines. Financial Strategy Product Market Strategy Organizational Strategy The more vertical and horizontal integration, the greater the financial needs. Outside investment is more likely the larger the firm. Rapid growth reduces financial flexibility and requires sacrificing control to attract outside financing.  Outside v. entrepreneur  Debt v. equity  Loan covenants  Options  Staging Type of financing Financial contracts  Price  Margin  Quality  Differentiation Product Targeted sales growth  Scale and scope Vertical boundaries Horizontal boundaries ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Interactive Financial Strategy

Figure 4-2 ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Financial Implications of Product-Market and Organizational Strategic Choices

An Introduction to Options Option - A right to make a decision in the future Elements of an option –An underlying asset –Exercise price (strike price) –Expiration date –European or American form Basic options –Call option –Put option Financial options Real options Complex options –Contingencies - Option created by some earlier action –Interdependencies - Options with interdependent values ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Value of Asset Value of Underlying Asset Underlying Asset E Expiration Value Call before Expiration ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 The Structure of a Call Option

Buy a Call Write a Call Loss Gain Loss ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Realized Returns on Options

Put-Call Parity –Option Pricing Models based on no-arbitrage –Stock + Put = Call + PV(Exercise Price) –Role of complete markets Financial Options –Complete markets –Incomplete markets Real Options –Complete markets –Incomplete markets Complex Real Options (Rainbow Options) –Discrete scenarios –Simulation ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Valuing Options

Defer - Investing now eliminates the option to defer (learning). Expand - An option to defer part of the scale of investment. Contract - The flexibility to reduce the rate of output. Abandon - Stop investing, and liquidate existing assets. Staging - Substitute a series of small investments for one large. Switching - Re-deploy resources or change inputs (terminate). Change Scope - Expand or contract scope. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Real Options - Some Examples

Techniques for Reasoning Through Decision Trees Focus on the most important decisions. Reason forward to construct the tree. Track certainties and uncertainties at each decision point. Calculate backwards to evaluate choices. Select the tree branch with the highest expected value. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Extending brand names to new products or marketing through existing distribution channels Defer Expand or contract Abandon Switch inputs or outputs Grow To wait before taking an action until more is known or timing is expected to be more favorable To increase or decrease the scale of a operation in response to demand To discontinue an operation and liquidate the assets To commit investment in stages giving rise to a series of valuations and abandonment options To alter the mix of inputs or outputs of a production process in response to market prices Stage investment To expand the scope of activities to capitalize on new perceived opportunities ExamplesDescriptionOption Adding or subtracting to the daily flights on an airline route or adding memory to a computer When to harvest a stand of trees, introduce a new product, or replace an existing piece of equipment Discontinuing a research project, closing a store, or resigning from current employment Staging of research and development projects or financial commitments to a new venture The output mix of refined crude oil products or substituting coal for natural gas to produce electricity Examples of Real Options