Real Options: Taking Stock and Looking Ahead Yong Li; Barclay E. James; Ravi Madhavan; Joseph T. Mahoney Advances in Strategic Management, 2007 BADM545

Introduction Real options Contributions of real option theory: A set of opportunities or rights but not obligations Take some actions in the future Confers managers the flexibility when facing uncertainty In the absence of sufficient information Bearing economic value Contributions of real option theory: It explains why firms may make investment decisions that differ from what the net present value (NPV) approach would indicate It proposes that under certain conditions, real options value comprise a substantial portion of the economic value

Taking Stock: Applications of Real Options Theory

Investment and Divestment The real option creates economic value by generating future decision rights. Common types of real options: Option to wait-to-invest Provides strategic flexibility to defer the investment until additional information is received with the passage of time => Value increases with high exogenous uncertainty Option to abandon and switch (put option) grants firms the capability to abandon or switch when future conditions are believed to be sufficiently adverse => Value increases with the salvage value and future uncertainty Growth option (call option) Allows firms to make additional investment subsequently Multi-stage projects: (1st stage: create -> 2nd stage: exercise) Interaction of options: project value Attenuated by “substitute” but enhanced by “complementary”

Investment and Divestment Extensions of Real Options theory of Investment Portfolio of options Multiple projects and firms decisions as “bundles of real options” greater strategic flexibility than holding options separately Competition and investment Integration of game theory and real options theory Should consider its market position, the industry structure, and competitive dynamics when making investment decisions Endogenous uncertainty can be reduced through investment implies opportunities for learning Exit decisions and hysteresis Delay exist may be a rational reaction to uncertainty and irreversibility Valuable when restarting cost is high Exogenous Uncertainty Endogenous Uncertainty Reduced with time passage Reduced with investment Wait to invest Invest to learn

Organization and Governance Decision to make: how should firm invest or organize activities? Preferred investment modes under uncertainty Joint venture (collaboration) > acquisition or internal development greater flexibility and learning opportunity Market-like mechanism > integration greater flexibility In collaborative ventures Option value of acquiring or selling the venture depends on whether: have divergent economic valuations of the venture ex ante anticipate a divergence of their ex post valuations Complementary assets; learning capabilities of asymmetric information

Valuation and Performance Implications 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 in uncertainty => higher market value IJV have positive impacts on growth option values Multinationals have greater flexibility in shifting value chains, compared to domestic-only firms

Looking Ahead: The Future of Real Options

Real Option Theory of Investment Firm-level heterogeneity in resources and capabilities Different investment patterns in option creation and exercise Integrating real options with game theory Interactions between real options Dilemma between commitment and flexibility 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 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 Inconsistent empirical results Cost of creating 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?

Discussion When facing uncertainty, real options theory suggests that market contracting gives more leverage(flexibility) than integration, and therefore the firm is better off. Whereas, property rights theory suggests that internalizing externalities could give the firm more control over uncertainties. Do these arguments contradict with each other?