Competing For Advantage Part IV – Monitoring and Creating Entrepreneurial Opportunities Chapter 13 – Strategic Flexibility and Real Options Analysis

The Strategic Management Process The Strategic Management Process - A logical approach for responding to 21st century competitive challenges. Provides an outline of the content of the textbook by each chapter. Chapter 2, Strategic Leadership Strategic leaders are the engines driving the development and use of the strategic management process. Strategic direction is reflected in the firm's vision, mission, purpose, and long-term goals. Part II, Strategic Analysis The two key sources of information-based inputs to the strategic management process are derived from an analysis of the firm's external environment (Ch. 3) and its internal organization (Ch. 4). This analysis identifies opportunities, threats, resources, capabilities, and core competencies that are used collectively to establish strategic direction and strategies to create a competitive advantage. Part III, Creating Competitive Advantage An examination of business-level strategies (Ch. 5) illustrates how firms determine the competitive advantages the firm will use to effectively compete in specific product markets. Competitive rivalry and dynamics, the interactive play between rivals in the marketplace, is taken into consideration when firms select and use strategies (Ch. 6). The trend toward cooperation reflects the increasing importance of forming partnerships between firms to share and develop competitive resources (Ch. 7). Corporate level strategies are employed by diversified organizations to determine the businesses in which they plan to compete and how they will allocate resources (Ch. 8). Merger and acquisition strategies are the primary means diversified firms use to create corporate-level competitive advantages (Ch. 9). International strategies can be used to create value and above-average returns for an organization (Ch. 10). Each type of strategy commands the type of organizational structure that an organization should use to effectively support its strategic efforts. Part IV, Monitoring and Creating Entrepreneurial Opportunities Corporate governance serves to monitor organizational actions to assess their success, make sure they reflect the firm's values, and ensure that they are aligned with stakeholder interests (Ch. 11). To compete in today's competitive environment, firms must continuously seek entrepreneurial opportunities (Ch. 12). Real options analysis is a tool that is useful for evaluating new ventures and increasing strategic flexibility (Ch. 13).

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 Strategic Flexibility – Strategic decisions face by firms are complex and ambiguous, demanding a tool that will help firms deal with uncertainty and increase strategic flexibility.

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 Sources of enhanced strategic flexibility: By organizational structures, systems, or other internal resources that augment the responsiveness of an organization By the particular design of investments and operations Incorporating staging opportunities (i.e., investing sequentially in a project as milestones are reached) Switching opportunities (i.e., shifting inputs or outputs across machines, geographic markets) Articulating the follow-on opportunities embedded in strategic choices (i.e., other prospective investments opened up by initial resource commitments) By entrepreneurial activities that open up future opportunities when decisions are made to invest in new ventures

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) Real Options Analysis - Introduce real options by defining the concept and establishing five criteria that must exist to determine if an option is embedded in a firm's investments or operational practices.

Real Option Criteria A right Not an obligation Future specified action Enabling reduction of downside risk Assessing upside opportunities Real Options Analysis - Introduce real options by defining the concept and establishing five criteria that must exist to determine if an option is embedded in a firm's investments or operational practices. Five criteria must be met for an option to exist: A right Not an obligation Future specified action Enabling reduction of downside risk Assessing upside opportunities

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 Types of Real Options - A wide range of real option types can be found in firms' investments and operations. They are relevant in different contexts.

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 Types of Real Options - A wide range of real option types can be found in firms' investments and operations. They are relevant in different contexts.

Types of Real Options Typical contexts for each type of real option: Growth Infrastructure investments Investments in products with multiple generations Abandonment New product introductions Capital-intensive industries Switching Consumer goods susceptible to volatile demand Tapered vertical integration Defer Natural-resource extraction industries Real estate development Compound Investments Any of the above

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 Purpose and Importance of Real Options Analysis - Real options analysis plays a role in recasting the motives for a variety of strategic decisions, opening up new opportunities to bridge strategic and financial analyses, and altering investment thresholds.

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) Purpose and Importance of Real Options Analysis - Real options analysis plays a role in recasting the motives for a variety of strategic decisions, opening up new opportunities to bridge strategic and financial analyses, and altering investment thresholds.

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 Purpose and Importance of Real Options Analysis - Real options analysis plays a role in recasting the motives for a variety of strategic decisions, opening up new opportunities to bridge strategic and financial analyses, and altering investment thresholds.

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 firm’s 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 Purpose and Importance of Real Options Analysis - Real options analysis plays a role in recasting the motives for a variety of strategic decisions, opening up new opportunities to bridge strategic and financial analyses, and altering investment thresholds.

Drivers of Call Option Value The value of real options is driven by five factors: Value of the underlying asset Cost of exercising the option Risk-free rate of return Time to invest Volatility (uncertainty dimension) Once a particular type of option has been identified as being embedded in a strategic investment decision, the next task for decision makers is to determine how particular aspects of the investment correspond to the value drivers for real options. The value of real options is driven by five factors, as shown in Table 13.2. For simplicity, this material focuses on call options, though the value of put options can also be described in terms of the same five variables. Furthermore, each of these factors is analogous to the individual value drivers for financial calls. First, the current value of the underlying asset (S) is akin to the current price of a stock. For real options, the current value of the underlying asset is equivalent to the present value of the estimated cash flows associated with the underlying asset, or second-stage investment. This value sets the starting point for potential variations in the value of the second stage investment in the future. For example, if a firm builds a scaleable plant in Stage I, the value of the underlying asset is equal to the present value of the cash flow attributable to expansion of the plant in Stage II, say, three years in the future. The higher this present value, the greater the likelihood that it will ultimately finish higher than the cost of exercising the option, X. The exercise price is therefore equal to the amount that must be paid three years in the future to expand the plant. In this particular example, X amounts to capital expenditures that the firm must make to expand the facility. As such, option value increases in S and decreases in X, just as the NPV of any investment increases in the cash flows generated in the future and decreases in the initial investment required. However, in the case of an option, the commitment is made in the future rather than at time zero. This future commitment, or exercise price, is therefore discounted at the risk-free rate of return (rf) because it is assumed to be fixed and known with certainty at the time the option is purchased. Increases in the risk-free rate therefore discount the exercise price more substantially, which implies that the option value increases. It is also the case that the ability to delay this decision for a longer period of time enhances the firm’s discretion and flexibility, so with everything else held constant, the value of the option also increases in the time to investment (t). In the simple example just discussed, the option value of building a second-stage plant after four years will be greater than for a similar project after three years, with everything else held constant. Finally, whereas uncertainty is considered a liability for typical investment projects, in the case of call options, uncertainty relates positively to option value. This is because of the inherent properties of options: the firm has the right but not the obligation to take some future specified action. In the presence of uncertainty, this means that the firm is able to limit its downside risk and access upside opportunities. Given these two asymmetries between right versus obligation and upside opportunities versus downside risk, this implies that increases in uncertainty enhance, rather than detract from, option value. In the worst-case scenario, the firm is compelled to do nothing, but if uncertainty leads to very favorable outcomes, the firm is positioned to act on them. In other words, with options the firm is more exposed to positive developments and not exposed to negative developments.45 The uncertainty dimension is represented by the parameter volatility (s) in Table 13.2.

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 Two values summarize the five parameters to determine option value.

Criticisms of Real Options Analysis It is overly technical It is beyond the mathematical competence of many managers It is too complex to implement Implementation Requirements of Real Options - More development is needed to define implementation requirements for real options to be used in an organizational and systematic framework that will enable flexible strategies to be implemented effectively. Real options analysis has received some criticisms. Some transitional steps are suggested to facilitate the process for firms adopting real options analysis.

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 Some suggestions for transitional steps from financial valuation approaches into the adoption of real options analysis: Conduct one or more experimental pilot projects Get support from top managers and those involved in the project Codify the real options technique through an expert group and training materials Institutionalizing real options analysis as a way of thinking as well as an analytical tool

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?

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?

Ethical Questions Can real options analysis be used to justify poor decisions? If so, what are the agency implications? What are the legal implications?

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?