1. Chapter 4 New Venture Strategy
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2. 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.

3. What Makes a Plan or Decision Strategic?
Strategic decisions are consequential
Strategic decisions are both active and reactive
Strategic decisions limit the range of possible future actions

4. Interactive Financial Strategy

5. Financial Implications of Product-Market and Organizational Strategic Choices

6. 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: Calls, Puts
Financial options
Real options
Complex options
Contingent options - created by earlier action
Options with interdependent values

7. The Structure of a Call Option

8. Realized Returns on Options

9. Valuing 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
Complex Real Options (Rainbow Options)
Discrete scenarios
Simulation

10. Real Options - Some Examples
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

11. Examples of Real Options

12. 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 backward to evaluate choices.
Select the tree branch with the highest expected value.

13. 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.

14. Accept/reject Decision to Invest in Restaurant Business

15. Evaluation of Accept/Reject Alternatives
Large-scale entry:
NPV conditional on high demand
= $575,000
NPV conditional on intermediate demand
= $120,000
NPV conditional on low demand
= ($205,000)
NPV = .3 x $575, x $120,000 – .2 x $205,000
= $191,500

16. Evaluation of Accept/Reject Alternatives (Cont’d)
Small-scale entry:
NPV conditional on high demand
= $240,000
NPV conditional on intermediate demand
NPV conditional on low demand
= ($ 80,000)
NPV = .3 x $240, x $240, x $80,000
= $176,000
Do not enter:
NPV = $0

17. Restaurant Business Investment With an Option to Delay Investing

18. 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

19. Evaluation of Option to Delay (Cont’d)
NPV of delay strategy:
= .3 x $445, x $160, x $0
= $213,500
Value of Option to Delay = $213, ,500
= $22,000

20. Restaurant Business Investment With an Option to Expand Initial Investment

21. 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)

22. Evaluation of Option to Expand (Cont’d)
NPV of Small-scale entry with Option to Expand
= .3 x $580, x $240, x $80,000
= $278,000
Value of Expansion Option = $86,500
Incremental value over Delay Option = $64,500
The Options are Mutually Exclusive

23. Evaluation of Option to Abandon
Large-scale entry strategy: NPV = $191,500
Large-scale entry with Abandonment option:
Convert to office with $600,000 value
NPV of converting for entrepreneur = ($10,000)
NPV with Abandonment Option:
= .3 x $575, x $120, x $10,000 = $230,500
Would pay up to $39,000 extra for location that is convertible

24. Evaluation of Option to Abandon (Cont’d)
Small-scale entry with Expansion and Abandonment Options:
Convert to office with $300,000 value
NPV of converting for entrepreneur = ($160,000)
NPV with Abandonment Option:
= .3 x $580, x $240, x $160,000 = $262,000
Abandonment has negative value for the small restaurant
A result of discreteness of the analysis
Conclusion: Build small with Expansion Option
NPV = $278,000

25. 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

26. Evaluating Strategic Games
Specify assumptions about rival actions and reactions.
Develop the tree.
Prune branches involving dominated strategies.

27. Entry Decision Game Tree

28. End of Chapter Questions

29. 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?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

30. Question 4-2
You 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
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

31. Question 4-3
Suppose that if you buy the business described in question 2, you can expand by investing $500,000
Future 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?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

32. Question 4-4
Now, 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?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

33. Question 4-5
Re-evaluate the previous problem considering both expansion and abandonment options.
Draw the decision tree incorporating both.
Are the values additive?
Why or why not?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

34. Question 4-6
By 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.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

35. Question 4-7
Continuing 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.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

36. 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?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

37. Question 4-9
Which of the following decisions are “strategic”? Explain your reasoning.
An owner of a nursery decides to buy an option on a parcel of land that is contiguous to his nursery.
The nursery owner exercises the option and buys the land.
The nursery owner decides to carry palm trees.
The nursery owner expands his staff by 10 employees.
The nursery owner builds a greenhouse on the plot of land he purchased.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

38. Question 4-10
Explain how trade credit can be used to shift part of financing burden to others.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

39. 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.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

40. 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.
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.
What are the approximate values of the various options?
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).
Why do you think increases in the probabilities of the high and low demand states change the values in the way that they do?
What can you say about how the values of real options depend on risk levels?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

41. 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 unchanged
Re-evaluate the waiting option.
How, if at all, does this change the conclusions about the best strategy for you to follow?
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4

42. Question 4-14 Consider the game-tree analysis in Section 4.9
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).
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).
©2003, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4