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Competing For Advantage Part IV Monitoring and Creating Entrepreneurial Opportunities Chapter 13 Strategic Flexibility and Real Options Analysis Slide 2 The Strategic Management Process Slide 3 International Strategy Key Terms Strategic Flexibility condition existing when a strategy allows the firm to react to changing uncertainties by quickly changing course or, better still, allows the firm to position itself to take advantage of the resolution of uncertainty Slide 4 Sources of Enhanced Strategic Flexibility Organizational structures, systems, or other internal resources Design of investments and operations With staging opportunities With switching opportunities With follow-on opportunities Entrepreneurial activities Slide 5 Real Options Analysis Key Terms Real Option a strategic alternative, with an underlying (real) asset, that provides the firm with the right, but not the obligation, to take some future specified actions which will enable the firm to reduce its downside risk while assessing upside opportunities (a preferential claim to follow up on an investment opportunity) Slide 6 Real Option Criteria A right Not an obligation Future specified action Enabling reduction of downside risk Assessing upside opportunities Slide 7 Types of Real Options Key Terms Growth Options investments that enable the firm to expand the investment in the future, if that action turns out to be valuable Abandonment Options investments that provide the firm flexibility by allowing it to reverse course and exit deteriorating competitive situations Slide 8 Types of Real Options Key Terms Switching Options investments that combine the features of growth and abandonment options by allowing firms to change the mix of outputs or inputs Options to Defer investments that recognize a value in waiting Compound Options investments that confer multiple options that are built upon one another Slide 9 Types of Real Options Slide 10 Reasons for Positive Effect of Real Options Analysis on Strategic Decision Making It challenges a conventional perspective on strategic investment based on asset valuation Shifts attention from possible gains from efficiencies to changes in value chain activities Moves central focus to operational flexibility rather than operational control Joint ventures and minority investments have come to be seen as stepping stones (transitional investments) rather than permanent, inflexible investments Slide 11 Reasons for Positive Effect of Real Options Analysis on Strategic Decision Making It unites strategic analysis and capital budgeting Employs the use of tangible cash flows as explicit decision criterion for corporate investment (capital budgeting) Introduces the flexibility of active management and follow-on opportunities to make resource allocation decisions (strategic analysis) Slide 12 Reasons for Positive Effect of Real Options Analysis on Strategic Decision Making It changes go/no-go thresholds for investment decisions by considering embedded growth options It takes into account the potential for future opportunities that evolve from the project at hand However, an argument can be made for retaining assets and operations despite expected gains from divestiture Slide 13 Reasons for Positive Effect of Real Options Analysis on Strategic Decision Making It becomes a source of value for firms The present value of a firms growth opportunities is its value of growth options because growth in economic profits reflects discretionary future investments by the firm Despite general tendencies across industries, the degree to which growth options matter within industries varies greatly Slide 14 Drivers of Call Option Value Slide 15 Option Value Determinants Net Present Value (NPV) the value of the underlying asset divided by the present value of the exercise price Cumulative Volatility the time to invest divided by the volatility Slide 16 Criticisms of Real Options Analysis It is overly technical It is beyond the mathematical competence of many managers It is too complex to implement Slide 17 Transitional Steps Conduct one or more experimental pilot projects Get support from top managers and those involved in the project Codify the real options technique through expert groups and training materials Institutionalize real options analysis as a way of thinking as well as an analytical tool Slide 18 Ethical Questions What are the ethical implications of making an investment that appears to be a money loser in the short term because of money-making opportunities that may be provided in the longer term? For instance, as a shareholder, would you be comfortable with a firm that routinely supports these types of decisions? Slide 19 Ethical Questions How can a firm include human issues (such as the well-being of employees or human risk factors) in a real options analysis? Slide 20 Ethical Questions Can real options analysis be used to justify poor decisions? If so, what are the agency implications? What are the legal implications? Slide 21 Ethical Questions How can a board of directors ensure that real options analysis does not result in management decisions that hurt shareholders and other important stakeholders?