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Real Options: Taking Stock and Looking Ahead

Real Options: Taking Stock and Looking Ahead. Yong Li; Barclay E. James; Ravi Madhavan ; Joseph T. Mahoney Advances in Strategic Management, 2007. BADM545, Fall 3012; Prepared by: Hyunsun Kim. Introduction.

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Real Options: Taking Stock and Looking Ahead

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  1. Real Options: Taking Stock and Looking Ahead Yong Li; Barclay E. James; Ravi Madhavan; Joseph T. Mahoney Advances in Strategic Management, 2007 BADM545, Fall 3012; Prepared by: Hyunsun Kim

  2. Introduction • For firms operating under uncertainty, real options theory implies the economic value of managerial flexibility to adjust actions upon arrival of new information • Two relevant strategy topics to real option theory • Investment decisions • Investment and divestment • Investment mode choices • Organizational performance implications • Contribution of real option theory: • “a theoretical explanation for why firms may make investment decisions that differ from what the net present value (NPV) approach would prescribe (p.32)”

  3. Taking Stock: Applications of Real Options Theory

  4. Investment and Divestment • Decision to make: whether and when to invest or exit? Type of options • Option to wait-to-invest • Provides strategic flexibility to defer the investment until additional information is received • => option is more valuable with high exogenous uncertainty • Options to abandon and switch • Put options: the right to abandon an investment if market condition gets worse • Growth options • Call options: multi-stage investment opportunities • (first stage: create -> second stage: exercise, e.g., patenting) Value of an option could be affected by: • ‘substitute’ options v. ‘complementary’ options

  5. Investment and Divestment (cont’) • Portfolio of options • Firm decisions as “bundles of resource-investment alternatives”; R&D as “creating real options” • Competition and investment • Anticipation of rivals’ investment matters • “first-mover advantage” need to be considered • Endogenous uncertainty and learning • Cost uncertainty (technical and input cost uncertainty) • Endogenous uncertainty can be reduced • Exit decisions and hysteresis • Exit delays under uncertainty: justifies continuation currently non-profitable projects; valuable when restarting cost is high

  6. Organization and Governance • Decision to make: how should organize or govern activities? • Preferred investment modes under uncertainty • Joint venture (collaboration) > acquisition or internal development • Market-like mechanism > integration • In collaborative ventures • Option value of acquiring or selling the venture: • symmetry ex ante; diverge ex post • Antecedents of divergence • Complementary assets; learning capabilities

  7. Valuation and Performance Implications • Valuation • Real option theory is fundamentally a theory of valuation • Takes the value of managerial flexibility into account: • Could use discrete binomial and continuous Black-Scholes-Merton option pricing models • Even a simple binomial model could outperform the risk-adjusted NPV model • Performance Implications • Technological competence (holding patents) –(+)-> market value • IJV have positive impacts on growth option values • Multinationals have greater flexibility in shifting value chains, compared to domestic-only firms • Downside risk also exists

  8. Looking Ahead: The Future of Real Options

  9. Real Option Theory of Investment • Firm-level heterogeneity in resources and capabilities -> different investment patters in option creation and exercise • As real options are often shared by firms, their competition -> sequential investment as uncertainty changes • Game-theoretic perspective • Decisions on exit/abandonment • Implications on uncertainty and irreversibility • Escalation of commitment • Organizational portfolio of projects and businesses • Effects of uncertainty • Ambiguity in the sources of uncertainty

  10. Investment Mode Choicesand Performance Implications • Collaboration under uncertainty • Real option theory: strategic flexibility and learning benefits • Transaction cost economics: misappropriation and hold-up • Governance choices and contractual issues • Performance implications • Mixed results • Cost of obtaining options • Firm- or industry-level contingencies

  11. Issues in Implementation • Quantitative option pricing models • Problem of finding right model; measurement; complexity • Research questions related to organizational processes (Kulatilaka,1999) • Who controls the decision rights to the option? • What changes in the firm’s processes are needed to manage real options? • What changes in the organization are needed to capture the option value?

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