Real Options: Taking Stock and Looking Ahead

Yong Li; Barclay E. James; Ravi Madhavan; Joseph T. Mahoney Advances in Strategic Management, 2007

BADM545

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)”

Taking Stock: Applications of Real Options Theory

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 • 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• 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• 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

Looking Ahead: The Future of Real Options

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 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

• 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?