1. Real Options: Taking Stock and Looking Ahead Yong Li; Barclay E. James; Ravi Madhavan; Joseph T. Mahoney Advances in Strategic Management, 2007 BADM545, Fall 3012; Prepared by: Hyunsun Kim

2. Introduction For firms operating under uncertainty, real options theory implies the economic value of managerial flexibility to adjust actions upon arrival of new information Two relevant strategy topics to real option theory Investment decisions Investment and divestment Investment mode choices Organizational performance implications Contribution of real option theory: “a theoretical explanation for why firms may make investment decisions that differ from what the net present value (NPV) approach would prescribe (p.32)”

4. Taking Stock: Applications of Real Options Theory

5. Investment and Divestment Decision to make: whether and when to invest or exit? Type of options Option to wait-to-invest Provides strategic flexibility to defer the investment until additional information is received => option is more valuable with high exogenous uncertainty Options to abandon and switch Put options: the right to abandon an investment if market condition gets worse Growth options Call options: multi-stage investment opportunities (first stage: create -> second stage: exercise, e.g., patenting) Value of an option could be affected by: ‘substitute’ options v. ‘complementary’ options

6. Investment and Divestment (cont’) Portfolio of options Firm decisions as “bundles of resource-investment alternatives”; R&D as “creating real options” Competition and investment Anticipation of rivals’ investment matters “first-mover advantage” need to be considered Endogenous uncertainty and learning Cost uncertainty (technical and input cost uncertainty) Endogenous uncertainty can be reduced Exit decisions and hysteresis Exit delays under uncertainty: justifies continuation currently non-profitable projects; valuable when restarting cost is high

7. Organization and Governance Decision to make: how should organize or govern activities? Preferred investment modes under uncertainty Joint venture (collaboration) > acquisition or internal development Market-like mechanism > integration In collaborative ventures Option value of acquiring or selling the venture: symmetry ex ante; diverge ex post Antecedents of divergence Complementary assets; learning capabilities

8. Valuation and Performance Implications Valuation 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 (holding patents) –(+)-> market value IJV have positive impacts on growth option values Multinationals have greater flexibility in shifting value chains, compared to domestic-only firms Downside risk also exists

9. Looking Ahead: The Future of Real Options

10. Real Option Theory of Investment Firm-level heterogeneity in resources and capabilities -> different investment patters in option creation and exercise As real options are often shared by firms, their competition -> sequential investment as uncertainty changes Game-theoretic perspective 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 Mixed results Cost of obtaining 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?