Competition and Strategy Lenos Trigeorgis Executive Training & Conferences © 2016 Real Options Group

Stages in Evolution of Valuation Models Static DCF models Projects completely described by a specified stream of cash flows with given characteristics   Option models Projects managed actively in response to resolution of exogenous uncertainties about price and other variables Game-theory or industry equilibrium models Projects managed actively to also account for (re)actions of outside agents/competitors

OPTIONS & GAMES/STRATEGY 1 OPTIONS & GAMES/STRATEGY 1. High-tech firm with 1-yr license to wait for commercial production 2. Impact of exogenous competitive entry (“dividends”) 3. Early investment to preempt (two-stage investment) 4. Should it invest in R&D to acquire proprietry option to invest in more cost-effective commercial production in stage 2? 5. Impact of endogenous competition in production (stage 2) What difference if proprietary vs. shared benefits, contrarian vs. reciprocating competitive reaction? 6. What if compete in R&D (stage 1) sequentially (innovation race with first-mover advantage?). What if both invest simultaneously and get hurt? 7. Benefits of cooperating in R&D?

OPTIONS & GAMES/STRATEGY Passive NPV Invest Now (based on expected) V+=180 q=0.5 V=100 1-q=0.5 V-=60 I=80 Invest now (commitment value) = NPV = V – I = 100 – 80 = 20 (>0) Investment cost: I = 80 Risk neutral prob.: Discount rate: k = 0.20 (Gross)Project value: Risk-free rate: r =0 .08 Actual probability: q = 0.5

Proprietary Opportunity (License) Wait to invest under uncertainty C+= Max(V+-I, 0) (Invest) V+=180 q=0.5 =180 – 80 = 100 V=100 C 1-q=0.5 V-=60 C-=0 (Do not invest) t =0 t =1 I=80 Opportunity to invest provided by license (call option = 37)

Shared Opportunity A. Impact of exogenous competitive entry: reduced option value (50% cash-flow “dividends”) V+=180 p=0.4 (C+)’=90-40=50 (V+)’=90 V=100 1-p V-=60 (C-)’=Max(30-40,0)=0 (V-)’=30 Wait (call option with “dividends”): (18.5 or half of 37)

Shared opportunity Invest now if can preempt competition B. Invest now/ exercise early (e.g., build excess plant capacity) to preempt competitive erosion or capture cash-flow “dividends” V+=180 V=100 V-=60 Invest now: V - I = 100 - 80 = 20 (> 18.5)

Simultaneous Investment Timing Game Compete/invest early (prisoners’ dilemma) Firm B Invest Extensive form Wait Invest (10,10)* (18.5,18.5) (0,20) B (share NPV=20) Wait Invest (20,0) Wait A Firm A Invest (0, 20) Wait (20,0) (10,10)* B Invest (18.5,18.5) Wait (share 37) A: Invest regardless of B (dominant) B: Invest regardless of A (dominant) But better if wait!

Two-stage (Growth) Investment R&D/ infrastructure/ growth option II = 30 III = 80 V-- = 36 Stage I Stage II t = 0 t = 1 t = 2

Competitive Strategies (Dog) Depend on type of investment (proprietary vs. shared) and competitive reaction (contrarian vs. reciprocating)

Proprietary (2/3) / Contrarian (1) Invest in R&D (offensive strategy to preempt ) High Demand (V+=180) Low Demand (V-=60) Firm B Invest Wait Invest Wait (81, 25) 1 (0,100) 2 (10,0)* 1 (0,-20) 2 Wait Wait Firm A (100,0) 3 (80,20)* 4 (-20,0) 3 (0,-20) 4 Invest Invest Nash (A invest, B invest) ; IIA = 30; IIIA = 40; III = IIIA + IIIB = 80 (if preemption IIIA = IIIB = 80)

Proprietary (2/3) / Reciprocating (-1/4) Do not invest in R&D (avoid rivalry and price war) High Demand (V+=180) Low Demand (V-=60) B Invest Wait Invest Wait (61,15) 1 (0, 100) 2 (10,0)* 1 (0,-20) 2 Wait Wait A (100,0) 3 (50,5)* 4 (-20,0) 3 (-10,-25) 4 Invest Invest

Shared (1/2) / Reciprocating (+1/4) Invest in R&D (expanded pie from coordination) High Demand (V+=180) Low Demand (V-=60) B Invest Wait Invest Wait (75,75) 1 (0, 100) 2 (10,10)* 1 (0,-20) 2 Wait Wait A (100,0) 3 (73,73)* 4 (-20,0) 3 (-3,-3) 4 Invest Invest Nash (A invest, B invest) Shared (coordination): wait

Shared (1/2) /Contrarian (1) Do not invest (avoid subsidizing aggressive rival) High Demand (V+=180) Low Demand (V-=60) Invest B Wait Invest Wait (53,53) 1 (0, 100) 2 (5,5)* 1 (0,-20) 2 Wait Wait A (100,0) 3 (50,50)* 4 (-20,0) 3 (-10,-10) 4 Invest Invest (< 0);

Sequential R&D Investment Race Invest to preempt (first mover 2/3 or time-to-market) Firm B Invest Invest Wait (22,-17) 4 B (16,16) 1 (0, 35) 2 Invest (35,0) Wait Wait 3 A Invest (0, 35) Firm A Wait 2 (35,0)* 3 (22,-17) 4 B (16,16) Invest 1 Wait A invests; given that, B waits Winner takes all

both get hurt (worse than wait) Simultaneous R&D Investment Battle Invest prematurely (prisoners’ dilemma) Firm B Invest Wait (16, 16) 1 (0, 35) 2 Wait Firm A (35, 0) 3 (2, 2)* 4 Invest Invest prematurely; both get hurt (worse than wait)

Cooperate in Technology Investment Joint R&D Ventures Firm B Invest Wait (22,22)* 1 Wait Firm A (17,17) 4 Invest Save (share) costs; better appropriate (jointly) option value of waiting