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Strategic planning is about choosing a course of action designed to achieve a particular objective.
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Learning Objectives • Understand what makes a decision strategic • Understand the interrelationships between financing decisions and other aspects of new venture strategy • Be able to explain how strategic decisions are related to the entrepreneur’s objective of value- maximization • Recognize the real options reflected in strategic alternatives • Understand how to use decision trees to identify and evaluate real options • Understand how to use game trees when strategic choices depend on rival reactions • Understand how the business plan is related to strategic planning and strategy implementation
Strategic Planning • Strategic planning is about choosing a course of action designed to achieve a particular objective • Strategic plans offer the opportunity to change course (real options) • The ability to pursue a strategy may depend on the availability of financing
Framework of Strategic Planning • Describe real options as decision trees (or game trees) • Identify the objective and the strategic alternative for achieving it • Use investment valuation to compare alternative strategies
Product-Market, Financial, and Organizational Strategy • Financial strategy: defines the type and timing of financing. • Product-market strategy: involves targeted sales growth rate, product price, product quality. • Organizational strategy: concerns the horizontal and vertical boundaries of the firm • Product-market, organizational, and financial decisions need to be viewed simultaneously.
What Makes a Plan or Decision Strategic? • Strategic decisions are consequential • Strategic decisions are both active and reactive • Strategic decisions are not costless to reverse
Financial Strategy • Financial strategic choices have the same three characteristics: • consequential • active and reactive • costly to reverse • Competitive interdependencies also are present • The scope of financial strategy is quite broad • type of financing • amount of financing • financial contracting
Deciding on the Objective • Assumed objective in this text is to maximize the entrepreneur’s return • A three-step process: • Estimate the entrepreneur’s NPV for each alternative • Adjust the NPV by assigning values to qualitative considerations important to the entrepreneur • Select the strategy that yields the highest adjusted NPV to the entrepreneur • Decision will be rational, i.e., the expected right choice given the information known at the time
Strategic Planning for New Ventures • Plans of new ventures are unconstrained by prior decisions • In contrast to plans of established businesses • Strategic planning for new ventures should simultaneously consider • product-market strategy • organizational strategy • financial strategy
Strategic Planning for New Ventures Example: calorie-free ice cream technology • Product market strategy • high-margin/slow growth or low-margin/high growth • Organizational strategy • manufacture only (one-level) or manufacture and market (integrated) • Both have implications for financial strategy
Recognizing Real Options • Strategic planning is not a one-shot exercise • Passage of time brings deviation from forecasts and new information • Opportunities to abandon, expand, or redirect the venture (real options) • Select the strategy that offers the highest expected value in light of the venture’s real options
Option Basics • An option is the right, but not the obligation, to make a decision and take an action in the future • The value of an option depends on • market price of the underlying asset • volatility of the price of the underlying asset • time to option expiration • time value of money • The cost to acquire an option is called the “premium”
Call Option on a Share of Amazon Stock • Gives the holder the right to buy the underlying stock at a predetermined (exercise) price Figure 4-3
Put Option on a Share of Amazon Stock • Gives the holder the right to sell the underlying stock at a predetermined (exercise) price Figure 4-3
Comparisons Between Real and Financial Options • Real options are similar to financial options • Yet differ in important ways • real option markets are not complete • real options often are interdependent • The real option premium • may bear little relation to the value of the option • for example, the value of an abandonment option depends on the next highest alternative use of the asset
Some Common Types of Real Options • Wait/Learn • Expand or contract • Switch inputs or outputs • Abandon
The Real Option Premium • May bear little relation to the value of the option • For example, the value of an abandonment option depends on the next highest alternative use of the asset
Strategic Planning and Decision Trees • Decision trees • are a good way to conceptualize strategic alternatives that involve real options • impose discipline on the evaluation process • are used to evaluate connections between decisions today and the future value of the venture • incorporate both decisions and uncertain events • use probabilities to estimate conditional NPVs
Decision Tree Techniques Focus on the most important choices Reason forward to construct the tree Keep track of what is known and unknown at each node Evaluate choices recursively, starting at the last decision point Prune the tree Select the branch of the tree with the highest expected NPV
An Illustration • Entrepreneur is considering investing in a new restaurant • Uncertain demand can be high, moderate, or low • The decision: • build a large restaurant ($750,000) • build a small restaurant ($600,000) • don’t build • Entrepreneur invests $400,000 • Outside investor provides the balance and gets one percent of the equity for each $10,000 invested • large restaurant investor gets 35% equity • small restaurant investor gets 20% equity • entrepreneur retains balance of the equity
An Illustration (cont’d.) Total restaurant PV conditional on size and demand:
Evaluating the Venture As an Accept-Reject Decision • Consider the project as a simple accept-reject decision with mutually exclusive alternatives • Invest in large restaurant • Invest in small restaurant • Don’t invest • Decision tree notation: • Squares represent decision points • Circles represent uncertainty • Each state has an associated probability • Triangles in the figure are terminal nodes
Entrepreneur’s NPV – Large Restaurant Conditional PVs of entrepreneur PVEntrep. (Large/High) = 65% X $1,500,000 = $975,000 PVEntrep. (Large/Moderate) = 65% X $800,000 = $520,000 PVEntrep. (Large/Low) = 65% X $300,000 = $195,000 Expected PV of entrepreneur E(PVEntrep. |Large) = = 30% X $975,000 + 50% X $520,000 + 20% X $195,000 = $591,500 Expected NPV of entrepreneur E(NPVEntrep. |Large) = -$400,000 + $591,500 = $191,500
Entrepreneur’s NPV – Small Restaurant Conditional PVs of entrepreneur PVEntrep. (Small/High) = 80% X $800,000 = $640,000 PVEntrep. (Small/Moderate) = 80% X $800,000 = $640,000 PVEntrep. (Small/Low) = 80% X $400,000 = $320,000 Expected PV of entrepreneur E(PVEntrep. |Small) = = 30% X $640,000 + 50% X $640,000 + 20% X $320,000 = $576,000 Expected NPV of entrepreneur E(NPVEntrep. |Small) = -$400,000 + $576,00 = $176,000
Base Case Decision E(NPVEntrep. |Build Large) = $191,500 E(NPVEntrep. |Build Small) = $176,000 E(NPVEntrep. |Don’t Built) = $0 Build Large
The Wait/Learn Option • Suppose the entrepreneur can wait to learn more about demand • Waiting is a call option on building the optimal size restaurant • BUT waiting increases likelihood of competitor entry • reduces large restaurant PV to $1,300,000 • reduces small restaurant PV to $700,000
Wait/Learn Option • Conditional NPV of entrepreneur with waiting • NPVEntrep. (Wait/High/Build Large) = $445,000 • NPVEntrep. (Wait/Moderate/Build Small) = $160,000 • NPVEntrep. (Wait/Low/Don’t Build) = $0 • Expected NPV of entrepreneur with waiting • E(NPVEntrep. |Wait) = • = 30% X $445,000 + 50% X $160,000 + 20% X $0 • = $213,500 • Compare to base case (accept/reject) NPV = $191,500 • Option value = $213,500 - $191,500 = $22,000
Expansion Option • Entrepreneur can build small now, learn about demand, and then decide whether to expand • PV of large restaurant is $1.4 million if demand is high • Expansion costs $200,000 (total cost is $800,000) • $200,000 for expansion comes from investor • less uncertainty means better terms for entrepreneur • one percent equity for each $20,000 invested (10%) for expansion • total investor share is 30% with expansion
Expansion Option • NPVEntrep. (Small/High/Expand) = $580,000 • NPVEntrep. (Small/Moderate/Don’t Expand) = $240,000 • NPVEntrep. (Small/Low/Don’t Expand) = -$80,000 • E(NPVEntrep. |Small) = 30% X $580,000 + 50% X $240,000 + 20% X -$80,000 • E(NPVEntrep. |Small/Expansion Option) = $278,000 • Base case NPV = $191,500 • Value of expansion option = $278,000 - $191,500 • = $86,500 • Expansion vs. Wait/Learn = $278,000 - $213,500 • = $64,500
Abandonment Option • Restaurant can be converted to office space • PV of large restaurant as office $600,000 • PV of small restaurant as office $300,000 • No value for small restaurant • lowest PV as restaurant is $400,000 • NPVEntrep. (Large/Low/Abandon) = -$400,000 + (65% X $600,000) • = -$10,000 • E(NPVEntrep. |Large/Abandon Option) = • = 30% X $575,000 + 50% X $120,000 + 20% X -$10,000 = $230,500
Abandonment Option • Value of the abandonment option if we build the large restaurant • NPVEntrep. (Large/Low/Abandon) = -$400,000 + (65% X $600,000) • = -$10,000 • E(NPVEntrep. |Large/Abandon Option) = • 30% X $575,000 + 50% X $120,000 + 20% X -$10,000 = $230,500 • E(NPVEntrep. |Small/Expansion Option) = $278,000 • Best choice: build small with expansion option
Rival Reactions and Game Trees • Decision-trees do not explicitly incorporate the reactions of rivals • Not an issue if a venture offers a unique product or service • Not an issue in markets with many competitors because other firms will not react specifically to the entry of a new rival
Game Theory • A game consists of • a set of players, • an order of play, • the information set available to the players, • the set of actions available to each player, • the payoff schedule that results from the outcome of the actions of the players. • A sequential-move game can be analyzed with a game tree
Nash Equilibrium • In a non-cooperative game, the players cannot enter into binding, enforceable agreements with each other • A Nash equilibrium is a set of strategies, one for each player, such that each player’s strategy is optimal given the strategy of the other player(s)
Game Tree Illustration • Kelly is considering opening a bar • Three options • enter with a large bar • enter with a small bar • wait to see if the economy warrants another bar • Erin’s Pub, a national chain, is considering entering the market • Kelly has the first mover advantage, but she needs to consider how Erin might respond to her choice of options
Game Tree Illustration – Nash Equilibrium • If Kelly enters with a large bar, Erin’s best option is don’t enter • If Kelly enters with a small bar, Erin’s best option is to also enter • If Kelly waits, Erin’s will enter since all payoffs are > $0 • if Kelly then enters with large bar, Kelly’s payoff = $300,000 • if Kelly then enters with small bar, Kelly’s payoff = $190,000 • both are positive, but are also less than Kelly’s payoff s from immediately entering with a large bar ($425,000/no Erin; $380,000/Erin enters) • Nash Equilibrium: Kelly enters with a large bar and Erin does not enter
Games Entrepreneurs Play • Strategic games commonly played by entrepreneurs include the following: • the business plan • strategic partnering • control • information disclosure
Strategic Flexibility vs. Strategic Commitment • Decision trees and game trees are useful for assessing tradeoffs between the value of maintaining flexibility (real options) and the value of committing to a more limited course of action • Maintaining flexibility can create value if valuable information will be revealed with time (Figure 4.5) • Early commitment can create value by precluding competitive entry (Figure 4.6) • Important to consider the values of the various types of imbedded real options in any venture
Strategic Planning and the Business Plan • Entrepreneur may default into a course of action less valuable than a foregone alternative • A well-structured plan enables the entrepreneur to identify and react to problems • Not a one-shot exercise • Projections have to be modified in light of actual experience, and to reassess overall strategy
New Venture Strategy and Real Options - Summary • Product-market, organizational, and financial strategies need to be considered simultaneously • New ventures can be viewed as portfolios of real options • Real options can enhance value by adding flexibility • Decision trees and game trees are useful tools for analyzing real options and new venture strategy