Young Li, Barclay James, Ravi Madhavan, & Joseph Mahoney 2007 Advances in Strategic Management REAL OPTIONS: TAKING STOCK AND LOOKING AHEAD

 A concentrated report on developments in ‘real options theory’ and how ‘real options’ ideas can effectively be used  A discussion on the past, present, and potential future of Real Options Theory research and literature  Real Options Defined –  A Real Option is the right to undertake some action or decision in the future (i.e. the option to ‘make’, ‘abandon’, or ‘contract’, etc.) ARTICLE OVERVIEW

 Investment Decisions  Implications of common real options on investment strategies  Investment Mode Choices  The effects of real options on governance and organization  Performance Implications  How real options analysis and understanding affects valuation and performance REVIEW OF CURRENT REAL OPTIONS LITERATURE

APPLICATIONS OF REAL OPTIONS THEORY

 Wait-to-invest  In cases of uncertainty and high irreversibility of investment, a firm may choose to invest later rather than immediately  Allows firm to wait for favorable conditions  Abandon and switch  Real Options theory proposes that the value of a put option increases with salvage value and future uncertainty  Adds divestment considerations to NPV analysis  Corporate growth  Decisions made not necessarily for immediate cash flows, but for value derived from potential future benefits and returns INVESTMENT AND DIVESTMENT

 Option Interactions  Additional options increase the value of investment projects  Substitutable options add flexibility to investments, increasing value  ‘Dueling’ options take place of each other but have differing value  Options Portfolios  Strategic decisions can be viewed as bundles of real options  R&D project portfolios can be viewed as a portfolio of options  Alliances can be viewed as ‘exploratory investments in real options’ INVESTMENT AND DIVESTMENT

 Competitive Dynamics  Investments are made with the industry as a whole in mind  Options are weighed with first-mover advantage, competitive entry, sector monopoly/dominance, etc.  Uncertainty and Learning  In general, uncertainty increases the value of real options  Two types:  Exogenous – resolved with time, encourages waiting prior to investing  Endogenous – reduced by strategic investments, reveals learning opportunities and can encourage investing  Investments can be made by a firm to influence uncertainty to their advantage INVESTMENT AND DIVESTMENT

 Choice of Investment Modes  Real options can affect a firm’s choice in investment modes  Real options weigh heavily on the ‘make or buy’ decision  Example - Exogenous technological uncertainty leads to a preference for equity collaboration over acquisition  Collaborative Ventures  Trading of real options between partners can create joint gains  Optimal equity shares of a joint venture can be determined by the real options each partner holds ORGANIZATION AND GOVERNANCE

 Valuation  Risk-neutral probabilities of success are smaller for early-stage ventures & positively related to the number of prior financing rounds  Implied volatility is larger for early-stage ventures and are negatively related to the number of prior financing rounds  Performance Implications  Option pricing models may not readily apply to real investments (because of differences between real and financial options)  Businesses that link small options with large strikes will perform better than those who stay small or large  Firms with greater exit value and less specialized assets are worth more to investors VALUATION AND PERFORMANCE

 Investment  Real options/learning and resources and capabilities  Investment decisions from a real options perspective  Exit/abandonment decisions  Interactions between real options and option-like projects  Investment Mode Choices  Governance choice and contractual issues  Performance Implications  Real options theory and organizational performance  Cost of real options creation and exercise  Firm and industry-level influences on investment performance THE FUTURE OF REAL OPTIONS RESEARCH