real options: teaching strategy for uncertain...
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Real Options: Teaching Strategy
for Uncertain Environments
Michael Leiblein
Fisher College of Business
The Ohio State University
Three Points: How I incorporate real options concepts
Disequilibrium
Quips, simple examples, humor to create some discomfort
with standard assumptions
An alternative means of thinking
Opinion, model, simulation to illustrate option principles
in a structured, data driven manner
Generate insights
(Case) examples, simulation, & discussion to tie options
to other theories of resource allocation & organization
Disequilibrium An Alternative Insights
Disequilibrium:
Standard Quips & Quotes
―The route to success is to put more money at
risk, not less.‖
J. Lewent, CFO, Merck & Co.
―… the larger the uncertainty, the greater the
opportunity for value creation‖
T.W. Faulkner, Director of Strategic Planning,
Eastman Kodak
Why is that?
Disequilibrium An Alternative Insights
Disequilibrium:
Simple stories and examples
Consider a cross-country drive
MapQuest provides a pre-determined route from Boston
to LA, but …
… many value the ―flexibility‖ to change course given
new information. Why?
Consider a Poker Game …
You know the rules and the potential payoffs, but …
… often you don‘t place your final bet before the first (or
even last) card has been dealt? Why?
Disequilibrium An Alternative Insights
An alternative means of thinking:
Expert Opinion
―Discounted cash flow is going to look at an average
scenario," comments Triantis. "But if you talk to any
manager, that's not how they think. They think about
contingencies — what's going to happen, how would
we react. And even if they don't think that way, once
it's presented to them that way, they say, 'Yeah, that's
the way we should be thinking.'"
CFO Magazine – ―Will Real Options take roots?‖, July 2003
InsightsDisequilibrium An Alternative
An alternative means of thinking:
(A quick look at financial options)
―A call option gives its owner the right to buy
stock at a specified exercise or strike price‖
(Brealey & Myers, 1988: 471).
The Black-Scholes option pricing model:
G = f {S, X,, T, r}
The value of a call option increases with project
value (S), uncertainty (), time (T), and the cost
of capital (r).
Disequilibrium An Alternative Insights
An alternative means of thinking:
Simple Example
It is 1982 and you are evaluating entry into the PC business. Entry is now or never. Delay will concede the market to competitors.
The Project NPV for the ‗Mark I‘ appears to be negative … approximately $100 million.
A colleague asks about the importance of ―strategic motives‖ If you enter today, you will have an option to introduce a ‗Mark II‘
micro in a few years as the technology evolves and the market grows.
Your best current information indicates that the Mark II is simply a bigger and riskier project than the Mark I.
Given the tremendous uncertainties in predicting the PC market, you feel the NPV of the Mark II is anyone‘s guess … your point estimate is negative $ 200 Million
Adapted from Brealey, Myers, & Allen (2008).
Disequilibrium An Alternative Insights
An alternative means of thinking:
Simple Example
Absolutely. In three years you have the option to pursue or walk away from the Mark II
The conditional NPV for the Mark II is: $0 if the market flops
$0 if the market is mildly successful
$500 million if the market takes off
With equal probabilities, the Mark II represents a ―lottery ticket‖ on the PC industry with an expected payoff of $167 million.
Adapted from Brealey, Myers, & Allen (2008).
Disequilibrium An Alternative Insights
An alternative means of thinking:
Simple Example
Suppose a riskier set of market forecasts: ($1 billion) if the market flops,
($200 million) if the market is mildly successful,
$600 million if the market takes off
Expected NPV is still - $200 million.
Conditional on your go-ahead in three years, NPV for the Mark II will be: 0 if the market flops, 0 if the market is mildly successful, $600
million if the market takes off
The expected payoff of your lottery ticket is now $200 M.
The more uncertain the prospects, the more you should be willing to pursue the investment
Adapted from Brealey, Myers, & Allen (2008).
Disequilibrium An Alternative Insights
An alternative mean of thinking: Toy growth example with staged decision making
Case literature
Nucor at a Crossroads, Nucleon, Polaris Energy, …
WSJ examples
Cost of developing a new drug increases to about $1.7 billion (Dec. 8, 2003)
Pfizer ‗Youth Pill‘ Ate Up $71 Million Before It Flopped (May 2, 2002)
Staged Invention
Pharmaceuticals (e.g., Discovery, Preclinical, Clinical trial- phase I, Clinical
trial- phase II, Clinical trial- phase III, FDA filing and review
Sequential Innovation
Industrial Products (e.g., Aircraft and Automobile Frames); Consumer
Products (e.g., Software versions; golf clubs); Manufacturing Processes (e.g.,
semiconductor lithography)
Organization
Equity stakes as options on acquisition
An alternative means of thinking:
Simulation
Black-Scholes Option Calculator
Calculator inputs Option Analog Black Scholes Calculations
PV of Current Opportunity (S) $6,000,000 PV of StockPresent Value
-$8,000,000
Dividend Yield (q) 0.0% Call Option Value $1,237,684
Required Investment (X) $14,000,000 Strike / Exercise Price d1 -0.1273
Risk-free rate (Rf) 5.50% d2 -1.1273
Time to expiration (T) 4.00 N'(d1) 0.3957
Volatility (Sigma) 50.0%
Some initial (relatively small) investment on a clearly defined underlying asset
whose value changes over time …
Provide payoffs contingent on a specific observable event …
That create advantage due to some restriction on competition in the event of the
contingency (e.g., preferential access)
Disequilibrium An Alternative Insights
Generate insights
If real option logic provides a means to consider the evolution
of competitive advantage …
Then it may provide insight into fundamental strategy
questions
How does (sustainable) competitive advantage arise?
How do manager‘s affect the formation of (sustainable)
competitive advantage?
When might resource allocation and organization
decisions facilitate adaptation?
Disequilibrium An Alternative Insights
Example: Linking growth & deferal options
logic w/ early and late mover advantages
Early Mover Advantages
Technological leadership
Leaning, Patent, R&D races
Pre-emption of scarce
assets
Key Inputs, Product /
Geographic niches
Switching costs and
Quality risks
Late Mover Advantages
Free Rider effects
Spillovers, educated
consumers
Resolution of technical /
market uncertainty
Industry standards are
established
Incumbent inertia
Pioneer may get bogged
down in bureaucracy
See Lieberman & Montgomery (1988, 1998)
Disequilibrium An Alternative Insights
Example: Linking deferral & growth options
logic w/ early and late mover advantages
A simple model of technology
adoption considers two decision
points
Whether and when to adopt a
current technology.
Whether to adopt a future
technology.
Compulsive
Buy & Hold
LaggardInvest in initial opportunity
Time Period 1 Time Period 2
Leapfrog
Investment Strategy
Invest in follow-on
opportunity
Bystander
See Leiblein & Ziedonis (2007);
Grenadier & Weiss (1997)
Generate insights: Deferral & growth
options differ on object of uncertainty
Deferral Option opportunity cost of irreversibly
investing in current project.
Growth Option value of future (linked) projects
Discuss factors that might affect the value of an
embedded deferral or growth option opportunity cost is a function of attractiveness of alternative projects
if under a budget constraint.
Value of future project implies mechanisms are in place (proprietary
learning, contractual agreements) that insure any advantage vis-à-vis
the follow-on opportunity are not competed away when uncertainty is
favorably resolved.
Disequilibrium An Alternative Insights
Using Simulation to Generate Insight
Deferral & Growth Option Calculator
Calculator inputs Adjust Values Black Scholes Calculations
PV of Current
Opportunity
(SCurr) $6,000,000
PV of Current
-$4,000,000 d1 0.2092
Required
Investment
(XCurr) $10,000,000
Deferral Option
Value $1,775,477 d2 -0.7908
Risk-free rate
(RfCurr) 5.50% N'(d1) 0.3903
Time to expiration
(TCurr) 4.00
Volatility
(SigmaCurr) 50.0%
Opportunity cost sim (u, sigma, normal)
Model as a random draw of a project w/ NPV x= sigma = . Firms in more
munificent environments get more or better draws; firms with fewer
resources and more constraints.
Preemption
(Kulatilak & Perotti)sim (0,1, uniform)
Number of Rivals (and weaker appropriability regime) diminish SCurr {e.g.,
SCurrAdj=SCurr*(1-Preemption)
Disequilibrium An Alternative Insights
Using Simulation to Generate Insight
Deferral & Growth Option Calculator
Calculator inputs Adjust Values Black Scholes Calculations
PV of Future
Opportunity (SFut) $8,000,000PV of Future
-$4,000,000 d1 0.3145
Required
Investment (XFut) $12,000,000
Growth Option
Value $2,613,447 d2 -0.6855
Risk-free rate
(RfFut) 5.50% N'(d1) 0.3797
Time to expiration
(TFut) 4.00
<-- raise to see greater "volatility"
effect
Volatility
(SigmaFut) 50.0%
Claim on Future
Technology sim (0,1, uniform)
Strength of claim (proprietary learning; explicit claim, appropriability
regime) directly affects SFut {e.g., SFutAdj=SFut*Regime)
Holding Costs sim (0,1, uniform)Holding Costs raise XFut (e.g., XFutAdj=XFut*HoldingCost)
Standard Setting Externality (Lin &
Kulatilaka)
Positive externalities may encourage early investment by increasing Sf and
decreasing Sd
Disequilibrium An Alternative Insights
Using Simulation to Generate InsightDeferral & Growth Option Calculator
Calculator inputs Adjust Values Black Scholes Calculations
PV of Current
Opportunity
(SCurrComb) $6,000,000
PV of Future
Opportunity
(SFutComb) $8,000,000
Required
Investment …
Risk Free Rate
(RfComb) 5.50%
Sum (Defer,
Growth) $4,388,924
Time to expiration
(TComb) 4.00Max Min(Defer,
Growth) OV $2,102,196 d1comb 1.1214
Corr(SigmaCurr,
SigmaFut) -0.10 Setup Max(Min(Vdef, Vgrowth)-F,0) d2comb -0.9762
Volatility
(SigmaComb) 110.00%Max Max(Defer,
Growth) OV $2,286,728 N(d1comb) 0.8689
Setup Max(Max(Vdef, Vgrowth)-F,0) N(d2comb) 0.1645Covariance Current
& Future
Opportunity sim (-1,0,1, uniform)
Disequilibrium An Alternative Insights
A Few Big Picture Points
Disequilibrium & Discomfort to open students
to possibility of different thinking.
Humor to suggest concept & simulation to
illustrate principles
Case examples and illustrations to consider
how joining options with other theory may
generate insight
Disequilibrium An Alternative Insights
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