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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

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
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)”
investment and divestment
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
investment and divestment cont
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
organization and governance
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
valuation and performance implications
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
real option theory of investment
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
investment mode choices and performance implications
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
issues in implementation
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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