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

2. 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

4. Taking Stock: Applications of Real Options Theory

5. 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”

6. 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

7. 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

8. 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

9. Looking Ahead: The Future of Real Options

10. 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

11. 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

12. 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?

13. 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?