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©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Learning Objectives Understand what makes a decision strategic. Understand the interrelationships between financing decisions and other aspects of new venture strategy. Relate strategic decisions to the entrepreneur’s objective of value maximization. Describe strategic alternatives in terms of real options. Use decision trees to identify and evaluate real options. Use game trees when strategic choices depend on rival reactions.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 What Makes a Plan or Decision Strategic? Strategic decisions are consequential Strategic decisions are both active and reactive Strategic decisions limit the range of possible future actions

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Interactive Financial Strategy

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Financial Implications of Product-Market and Organizational Strategic Choices

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 An Introduction to Options Option - A right to make a decision in the future Elements of an option –An underlying asset –Exercise price (strike price) –Expiration date –European or American form Basic options: Calls, Puts Financial options Real options Complex options –Contingent options - created by earlier action –Options with interdependent values

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 The Structure of a Call Option

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Realized Returns on Options

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Valuing Options Put-Call Parity –Option Pricing Models based on no-arbitrage –Stock + Put = Call + PV(Exercise Price) –Role of complete markets Financial Options –Complete markets –Incomplete markets Real Options –Complete markets –Incomplete markets Complex Real Options (Rainbow Options) –Discrete scenarios –Simulation

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Real Options - Some Examples Defer - Investing now eliminates the option to defer (learning) Expand - An option to defer part of the scale of investment Contract - The flexibility to reduce the rate of output Abandon - Stop investing, and liquidate existing assets Staging - Substitute a series of small investments for one large Switching - Re-deploy resources or change inputs

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Examples of Real Options

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Techniques for Reasoning Through Decision Trees 1.Focus on the most important decisions. 2.Reason forward to construct the tree. 3.Track certainties and uncertainties at each decision point. 4.Calculate backward to evaluate choices. 5.Select the tree branch with the highest expected value.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Decision Tree Example - Assumptions Demand may be high (30%), medium (50%), low (20%). Cost of large restaurant is $750,000. Cost of small restaurant is $600,000. Entrepreneur will invest $400,000, outside investor provides the rest. Investor requires 1% of equity for each $10,000 invested. If demand is high - PV large is $1,500,000, PV small is $800,000. If demand is medium - PV large is $800,000, PV small is $800,000. If demand is low - PV large is $300,000, PV small is $400,000.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Accept/reject Decision to Invest in Restaurant Business

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Accept/Reject Alternatives Large-scale entry: NPV conditional on high demand = $575,000 NPV conditional on intermediate demand = $120,000 NPV conditional on low demand = ($205,000) NPV =.3 x $575, x $120,000 –.2 x $205,000 = $191,500

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Accept/Reject Alternatives (Cont’d) Small-scale entry: NPV conditional on high demand = $240,000 NPV conditional on intermediate demand = $240,000 NPV conditional on low demand = ($ 80,000) NPV =.3 x $240, x $240, x $80,000 = $176,000 Do not enter: NPV = $0

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Restaurant Business Investment With an Option to Delay Investing

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Option to Delay Large-scale entry strategy: NPV = $191,500 Delay until uncertainty is resolved: –High demand Build large restaurant NPV conditional on high demand = $445,000 –Intermediate demand Build small restaurant NPV conditional on intermediate demand = $160,000 –Low demand Do not enter NPV conditional on low demand = $0

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Option to Delay (Cont’d) NPV of delay strategy: –=.3 x $445, x $160, x $0 –= $213,500 Value of Option to Delay = $213, ,500 –= $22,000

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Restaurant Business Investment With an Option to Expand Initial Investment

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Option to Expand Large-scale entry strategy: NPV = $191,500 Delay until uncertainty is resolved: NPV = $213,500 Build small, with Option to Expand: –Conditional on High demand: NPV if Expand = $580,000 NPV if Remain Small = $240,000 Conclusion: Expand if demand is high –Conditional on Intermediate demand: NPV of Remaining Small = $240,000 –Conditional on Low demand: NPV of Remaining Small = ($80,000)

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Option to Expand (Cont’d) NPV of Small-scale entry with Option to Expand –=.3 x $580, x $240, x $80,000 –= $278,000 Value of Expansion Option = $86,500 Incremental value over Delay Option = $64,500 –The Options are Mutually Exclusive

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Option to Abandon Large-scale entry strategy: NPV = $191,500 Large-scale entry with Abandonment option: –Convert to office with $600,000 value –NPV of converting for entrepreneur = ($10,000) –NPV with Abandonment Option: =.3 x $575, x $120, x $10,000 = $230,500 –Would pay up to $39,000 extra for location that is convertible

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluation of Option to Abandon (Cont’d) Small-scale entry with Expansion and Abandonment Options: –Convert to office with $300,000 value –NPV of converting for entrepreneur = ($160,000) –NPV with Abandonment Option: =.3 x $580, x $240, x $160,000 = $262,000 –Abandonment has negative value for the small restaurant –A result of discreteness of the analysis Conclusion: Build small with Expansion Option –NPV = $278,000

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Game Trees The Basics –Players –Order of play –Information set –Available actions –Payoff schedules Strategic interaction –Cooperative and Non-cooperative games –Sequential-move game - Game tree –Simultaneous-move game - Payoff matrix Nash equilibrium Sub-game perfection

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Evaluating Strategic Games Specify assumptions about rival actions and reactions. Develop the tree. Prune branches involving dominated strategies.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 4 Entry Decision Game Tree