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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


  • 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?