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Joint Ventures and the Option to Expand and Acquire

Foundations of Strategy Research (Fall 2013). Joint Ventures and the Option to Expand and Acquire. Undergrad: U.C. Berkeley (Political Science) Masters: Columbia University (International Affairs) Ph.D.: M.I.T. Sloan Assistant, Associate, Chaired Professor at Wharton

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Joint Ventures and the Option to Expand and Acquire

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  1. Foundations of Strategy Research (Fall 2013) Joint Ventures and the Option to Expand and Acquire • Undergrad: U.C. Berkeley (Political Science) • Masters: Columbia University (International Affairs) • Ph.D.: M.I.T. Sloan • Assistant, Associate, Chaired Professor at Wharton • Currently Chaired Professor at Columbia University Bruce Kogut (1991) Management Science, 37(1): 19-33. Jae Kyun Yoo

  2. Introduction • The task of building a market position and competitive capabilities requires lumpy and non-trivial investments. • It is beyond the resources of a single firm to buy the right to expand in all potential market opportunities. • A partner, especially one which brings the requisite skills, may be sought to share the costs of placing the bet that the opportunity will be realized. Joint Ventures • Due to its benefits of sharing risk and of reducing overall investment costs, joint ventures serve as an attractive mechanism to invest in an option to expand in risky markets. • To exercise the option to expand requires further commitment of capital, thus requiring renegotiation among the partners. • One possible outcome is that the party placing a higher value on this new capital commitment buys out the other. Focus - The exploration of the link in the timing of the acquisition of joint ventures and of the exercise of the option to expand. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  3. Real Option Perspective • Firms engage in cooperative ventures as buffers against uncertainty (Pfeffer & Nowak, 1976) and that managerial discretion is severely limited by environmental volatility (Hannan & Freeman, 1977; McKelvey & Aldrich, 1983). • Joint ventures are designed as mechanisms to exploit, as well as buffer, uncertainty. • Joint ventures are investments providing firms with the discretion to expand in favorable environments, but avoid some of the losses from downside risk. Real Options Theory Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  4. Real Options • An alternative or choice that becomes available with a business investment opportunity. Real options can include opportunities to expand and cease projects if certain conditions arise, amongst other options. They are referred to as “real” because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments. Oftentimes, however, valuation methods, such as NPV, do not include the benefits that real options provide. - Investopedia • Joint ventures are real options… in terms of the economic opportunities to expand and grow in the future. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  5. Real Options (cont.) • The value of any investment can be broken into the cash flows stemming from assets as currently in place and those stemming from their redeployment or future expansion (Myers, 1977). Value of the venture as estimated by the jth firm Value of the assets in their current use Valuation of the future growth opportunities Pindyck (1988) K: investment : current value of an uncertain state variable Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  6. Joint Ventures as Real Options • Two options why joint ventures can be viewed as analogues. • Waiting to invest – It pays to wait before committing resources. • Joint ventures resolves partly the tradeoff between buying flexibility now and waiting to invest and focus later (Wernerfelt & Karnani, 1987). • Expanding production – Investment commitment is necessary in order to have the right to expand in the future. • When the market for the technology or new product is proven, the option to acquire is likely to be exercised. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  7. Timing of Exercise • The acquisition is justified only when the perceived value to the buyer is greater than the exercise price. Value of the jth firm of purchasing the remaining shares in the venture Price of purchasing the remaining shares Value of the option to acquire and <1 and is the current share owned by firm j Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  8. Timing of Exercise (cont.) • The timing of the exercise of the option to terminate the venture by acquisition is influenced by two considerations: the initial base rate forecast underlying the valuation of the business and the value of the venture to each party as realized over time. The venture will be acquired when its valuation exceeds the base rate forecast. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  9. Selection Cues and Market Valuation • Two time-varying specifications of the market cues relevant to the acquisition decision is considered. • Short-term annual growth rate • Annual residual error from a long-term trend • These two variables are proxies for changes in the unobserved state variable that determines the value of the joint venture. • The likelihood of an acquisition should increase with positive movements of the proxy variable. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  10. Statistical Results Managers are sensitive to a long-term intra-industry base rate which serves as a standard by which to evaluate annual changes. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  11. Termination by Dissolution If joint ventures are designed as options, then as long as the investment is sunk and the operating costs are moderate, downward movements should not lead to dissolution. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

  12. Conclusion • Joint ventures are designed as options. • Factors that increase the likelihood of an acquisition. • Unexpected increases in the value of the venture. • The degree of concentration in the industry. • Firms may profit from uncertainty. • A more flexible production process or organizational design (Piore& Sabel, 1984). • Investments in joint ventures which serve as platforms for possible future development. Bruce Kogut (1991) Joint Ventures and the Option to Expand and Acquire Management Science, 37(1): 19-33.

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