© 2005 Kevin J. Laverty Real options and organizational capabilities Kevin Laverty May 2005

© 2005 Kevin J. Laverty Background Decision  DE - CIDE, literally; “cut off” Uncertainty and time are fundamental elements of strategic decisions Imperfect knowledge of consequences Costs and benefits occur at different times Discounted cash flow analysis developed as aid to making investment decisions

© 2005 Kevin J. Laverty Development of concepts Financial options Real options: extension of options logic to tangible assets The logic of options Real options on organizational capabilities: challenges and seminal ideas

© 2005 Kevin J. Laverty Financial options Black-Scholes formula 1997 Nobel Price in Economics to Merton and Scholes Scholes#The_formulahttp://en.wikipedia.org/wiki/Black- Scholes#The_formula Scholes#The_formula

© 2005 Kevin J. Laverty Financial options An option involves an opportunity, but not an obligation Example: “an option on” a share of stock The owner of the option can “exercise the option” or “let the option expire” Mathematical formulations for a variety of financial instruments – derivatives Logic and intuitive application

© 2005 Kevin J. Laverty Real options Real options: extension of options logic to tangible assets Examples: oil leases, real estate, minerals Application is “closest to” financial options for assets that have well-established markets

© 2005 Kevin J. Laverty The logic of options: basics Purchasing an option is an alternative to purchasing the asset. For example, purchasing an option to buy a house is an alternative to purchasing the house. An option has value because it provides time to gain more information before having to make a full commitment Favorable information  exercise the option Unfavorable information  let it expire

© 2005 Kevin J. Laverty The logic of options: example I am interested in purchasing a house as an investment. Information Purchase price$350,000 Estimated price in 1 year$375,000 Required rate of return10% Analysis using DCF (Discounted Cash Flow) Present value$340,909 Net Present Value-$9,091 Therefore, DCF analysis argues against purchase

© 2005 Kevin J. Laverty (example continued) But... under uncertainly, the there is not a single possible outcome (that is, the estimated price does not capture all relevant information) Information 50% probability$450,000 50% probability$300,000 Estimated price in 1 year$375,000 Required rate of return10% If price in 1 year = $450,000 Present value$409,091 If price in 1 year = $300,000 Present value$272,727 If price in 1 year = $375,000 Present value$340,909

© 2005 Kevin J. Laverty (example continued) Example of an option: for $10,000, I can purchase an option to buy the house in 1 year for $375,000 Rule for using options: exercise the option if the value of the asset is greater than the option price; if not, let the option expire If 1 year from now, the house is worth $450,000, I exercise the option (because $450,000 > $375,000). My profit is $450,000 - $375,000 - $10,000 = $65,000 Value - option price - cost of purchasing option If 1 year from now, the house is worth $300,000, I let the option expire (because $300,000 < $375,000). My loss is -$10,000 (cost of purchasing option only) Therefore, the option value is $27,500 [(50% * 65,000) + (50% * -10,000)] Remember that the Net Present Value is -$9,091

© 2005 Kevin J. Laverty The logic of options: essence Purchasing an option can be a “third alternative” to what appears to be a “yes-no” decision. For example, purchasing an option to buy a house is an alternative to purchasing the house or declining to purchase the house. The value of an option often is greater than the NPV. In other words, projects that would be rejected using DCF may be acceptable if the choice can be framed as an option. This is because some losses can be avoided. Other things equal, the value of an option increases with the amount of uncertainty There is a cost to eliminating an option

© 2005 Kevin J. Laverty Real options on capabilities Challenges Organizational capabilities are intangible assets – complex combinations of resources An option on a capability involves activity; it is not a passive investment Management theory and practice are criticized for ignoring and undervaluing intangibles (DCF is a case in point) Real options mathematics are not necessarily useful for strategic decisions Therefore … apply the logic, not the formal technique

© 2005 Kevin J. Laverty Capabilities and strategy The concept of capabilities is central to contemporary ideas about strategy and is consistent with the resource- based view and the notion of core competence Capabilities are relevant to all business functions Production and operations Marketing and understanding customers Distribution; supply chain relationships; alliances Developing products and services; reaching customers Planning and environmental scanning Capabilities are maintained and enhanced through investment and experience

© 2005 Kevin J. Laverty Capabilities, learning, and options Organizational learning is inherent in capabilities – creating, maintaining, enhancing Learning makes options on capabilities fundamentally different from financial options and real options on tangible assets The only way to create on option on a capability is to act – it is not a passive investment (e.g., a pilot project might be considered to be an option on a full-scale investment) Ideally, any organizational action is the source of learning Learning changes the configuration of capabilities Therefore, the act of creating an option will change an organization’s capabilities – and what it knows about them

© 2005 Kevin J. Laverty Capabilities, learning, and options – 2 Unlike options on other types of assets, an option on a capability is valuable per se because of the nature of organizational learning Expands the set of future opportunities (by developing capabilities) Improves the information available about customers, suppliers, production, distribution, etc. – and about the organization’s capacity to carry out various activities Enhances the ability to detect opportunities For this reason, options analysis undervalues an option on a capability. For example, if an option on a capability had the same “pro forma” as the option on the house presented earlier, the option on the capability would be worth more.

© 2005 Kevin J. Laverty Conclusion Starting point: uncertainty and time are fundamental – DCF and rules such as payback period may undervalue the future, and tend to be difficult to apply to intangible assets The most important assets that will form the basis of CA in the future require learning – changes to capabilities and reconfiguration of resources Real Options is a way to deal with these problems, but standard Real Options analysis undervalues the value of options on capabilities – because it ignores learning Organizations will benefit from analysis and planning that incorporate the full value of options on knowledge assets

© 2005 Kevin J. Laverty