Strategic Investment: Real Options and Games
Abstract
Corporate finance and corporate strategy have long been seen as different sides of the same coin. Though both focus on the same broad problem, investment decision-making, the gap between the two sides--and between theory and practice--remains embarrassingly large. This book synthesizes cutting-edge developments in corporate finance and related fields--in particular, real options and game theory--to help bridge this gap. In clear, straightforward exposition and through numerous examples and applications from various industries, Han Smit and Lenos Trigeorgis set forth an extended valuation framework for competitive strategies. The book follows a problem-solving approach that synthesizes ideas from game theory, real options, and strategy. Thinking in terms of options-games can help managers address questions such as: When is it best to invest early to preempt competitive entry, and when to wait? Should a firm compete in R & D or adopt an accommodating stance? How does one value growth options or infrastructure investments? The authors provide a wide range of valuation examples, such as acquisition strategies, R & D investment in high-tech sectors, joint research ventures, product introductions in consumer electronics, infrastructure, and oil exploration investment. Representing a major step beyond standard real options or strategy analysis, and extending the power of real options and strategic thinking in a rigorous fashion, Strategic Investment will be an indispensable guide and resource for corporate managers, MBA students, and academics alike. © 2004 by Han T. J. Smit and Lenos Trigeorgis. All rights reserved.
... As a first step toward mitigating the limitations of extant patenting research on both the dependent-and independent-variable sides of the equation, we develop a theory that integrates dynamic demand-side factors and allows for coopetition in patent deployment choices as well as for shifting among competition and cooperation modes over time to better capture the interplay between competition and cooperation in the patent deployment context. Recognizing that both the strategic interaction among competitors and the flexibility to respond to demand volatility affect rival firms' patent deployment choices, we use a real-options game framework (Smit & Trigeorgis, 2004, 2017 as the basis of our theory. Our analysis further considers that both competition and cooperation can be implemented in multiple ways. ...
... Our baseline numerical analysis focuses on the Nash equilibrium deployment choices made by each firm in period 2 based on option games analysis (Chevalier-Roignant & Trigeorgis, 2011;Smit & Trigeorgis, 2004, 2017. We assume that both firms' technologies are publicly known and that patent rights are perfectly enforced. ...
... We assume that both firms' technologies are publicly known and that patent rights are perfectly enforced. Expected cash flows are discounted across periods to determine current market value (the underlying "asset" for the options) by using the risk-adjusted cost of capital r while expected option values in the option games are based on risk-adjusted (or risk-neutral) probabilities and discounted at the risk-free interest rate r (Chevalier-Roignant & Trigeorgis, 2011; Smit & Trigeorgis, 2004, 2017. Table 2 lists the parameters and parameter values used in our baseline numerical analysis. ...
... A wide range of examples of evaluating acquisition and investment strategies in R&D are considered in practical science. However, quite often only the business level can be analyzed, and the regional aspect is ignored [20]. ...
... Depending on the state of the investment climate, the inflow of investment into the region may increase or decrease, and regional investment attractiveness can be used to assess the effectiveness of the region's government apparatus. With regard to Russia, it should be noted that the regulation of investment processes at the regional level is inefficient, which leads to the need of finding new ways to increase regional investment attractiveness and identifying problems in existing management schemes [10], [20], [31]. ...
This paper aims to develop a multifactor model of the impact of attracting investment in the fixed capital of a region. To this end, the authors conducted a factor analysis of regional investment attractiveness. Correlation and regression analysis served as the methodological basis for determining the qualitative dependencies of regional fixed capital investments. Testing of the examined model allowed the authors to identify dependencies between controlled variables (factors that can be influenced at the regional level) and the resulting indicator (investment in the fixed capital of a region) for the Russian federal subjects. The significance of the model lies in the possibility of developing practical measures (focused on specific conditions of territorial functioning) to improve regional investment policies.
... By being first in acquiring a license to operate in a location rich in scarce assets, the MNE preempts rival firms from accessing these assets (Lieberman & Montgomery, 1988), significantly affecting its profits. Smit and Trigeorgis (2004) show that if by investing a firm can obtain strategic advantages over its rivals, investing is the optimal action even when uncertainty is high. Natural resource MNEs are particularly dependent upon specific scarce assets; thus, they are geographically constrained in their location. ...
... Natural resource MNEs are particularly dependent upon specific scarce assets; thus, they are geographically constrained in their location. These firms might invest in a location despite the presence of political conflict to secure access and acquire the rents associated with a first-mover advantage (Mason & Weeds, 2010;Smit & Trigeorgis, 2004). As a result, MNEs active in the resource sector should be less sensitive to political conflict than MNEs in sectors in which location choice is less restricted. ...
... The second strand of the real options literature relates to compound options and opines that conducting investments not only sacrifices the value of waiting options but also results in the acquisition of future investment options. (See, e.g., Kulatilaka and Perotti (1998) and Smit and Trigeorgis (2004)). ...
... whose value increases with uncertainty. (See, e.g., Kulatilaka and Perotti, 1998;Smit and Trigeorgis, 2004). By focusing solely on the oil and gas sector, we overcome omitted variable bias problems. ...
This study examines the impact of uncertainty on mergers and acquisition (M&A) activity. We focus on product market uncertainty in the oil and gas sector. Analysing this industry enables us to construct a natural forward-looking measure of product market uncertainty, namely the implied crude oil volatility. Using a sample of U.S. firms in the oil and gas sector from 1994-2018 and 4,323 announced transactions, we document that product market uncertainty is negatively related to future M&A activity. Uncertainty is mainly a driver of horizontal and vertical M&A, while output price uncertainty of upstream firms is a more important driver of M&A activity than the input price uncertainty of downstream firms. Our results lend support to a real options explanation of investment under uncertainty where firms choose to defer investments as a response to increased uncertainty.
... Traditional NPV analysis designates an investment opportunity as a "now-or-never" action, thus implicitly assuming an immediate commitment to future plans [28]. In other words, it does not take into account managerial flexibility to adopt a "wait-and see" strategy until conditions are less uncertain. ...
... In other words, it does not take into account managerial flexibility to adopt a "wait-and see" strategy until conditions are less uncertain. Conversely, according to Smit and Trigeorgis [28], investment decisions should be made on an Expanded NPV model that extends the passive NPV and incorporates such flexibility. That is, Expanded NPV = Passive NPV + Flexibility value (option premium) For what it regards a project, the passive NPV implies that there is no value attributed to flexibility. ...
Business sustainability and real options are closely connected, as real options are managerial flexibility that allows organizations to adapt to changes in their environment, thus making the organization more robust and economically sustainable. Studies in real options theory abound, yet there is still a lack of evidence on whether people make decisions consistently with the predictions made by real options models. We run a laboratory experiment to study the role of option value and the laboratory time required to resolve uncertainty in individuals’ decision to price and adopt an option to wait. Specifically, we compare decision makers’ choices in two investment scenarios: One with a short time to maturity (implying a low option value), and another with a longer time to maturity (implying a high option value). In the lab, both scenarios are implemented with the waiting time of twenty and sixty minutes. Our results show that decision makers deviate from the theoretical predictions, recognizing the benefit of waiting, when the value of the option is higher, or when the waiting time is shorter. Our study does not only bring more insights into real options adoption at the individual level, but also emphasizes the great potential of behavioral and experimental approach to bridge the gap between theory and practice in the real options literature.
... The NPV rule defines an investment decision as a "now or never" proposition. To capture the full value of an investment opportunity, economists use real options and incorporate a "wait-and-see" strategy into the decision-making process (Smit, Trigeorgis 2004). However, in the standard real options analysis (ROA), a firm formulates its investment decision in isolation, taking no notice of interactive competition. ...
... Investment decisionmaking has been described as a game between two players, while the real options approach is used to find the value of the investment project. Hence, this paper falls in the category of real options games (ROG) (Smit, Ankum 1993, Brandenburger, Nalebuff 1995, Grenadier 2000, Smit, Trigeorgis 2004, Chevalier-Roignant, Trigeoris 2011, Trigeorgis, Baldi 2013, Rychłowska-Musiał 2017b. We will examine the impact of risk (measured by volatility) on the firm's investment strategy in competitive and co-opetitive relationships. ...
... En el mundo actual de los negocios, las empresas se enfrentan a múltiples fuentes de incertidumbre cuando toman decisiones sobre futuras oportunidades de inversión. En este sentido, realizar una valoración correcta de estas oportunidades es más complejo de lo que el modelo tradicional de valoración (el flujo de caja descontado -FCD) puede sugerir (Dixit y Pindyck, 1994;Smit y Trigeorgis, 2004), dadas las limitaciones que este presenta por su carácter estático 1 . Sin embargo, un análisis de valoración adecuado requiere que la empresa pueda revisar o adaptar sus decisiones de inversión en respuesta a los acontecimientos futuros que presenta el mercado. ...
... Además, Dixit y Pindyck (1994) y Trigeorgis (1996) reconocen que el modelo FCD presenta una deficiencia notable, producto del abandono total de la naturaleza incierta de los flujos de caja, y de las respuestas estratégicas de la gerencia para su gestión. Una ventaja adicional del ROA es que permite reducir las complejas estructuras corporativas y de los proyectos de inversión a simples estructuras analíticas conformadas por diferentes tipos de opciones reales simples con fácil aplicación (Smit y Trigeorgis, 2004). ...
El modelo binomial presenta un conjunto de propiedades que lo convierten en el enfoque adecuado para resolver el problema de valoración en el campo de las opciones reales, mediante una aplicación fácil y práctica. Cabe resaltar que esto solo es posible en el contexto donde se presenta una única fuente subyacente de incertidumbre. Sin embargo, su adopción puede ser limitada para aquellas inversiones que cuentan con múltiples incertidumbres, dado que su interacción debería incorporarse al proceso de valoración. Como respuesta, la teoría ha propuesto enfoques de valoración que permiten representar las diferentes fuentes de incertidumbre mediante una estimación consolidada de la volatilidad, tal es el caso del enfoque Marketed Asset Disclaimer (MAD) desarrollado por Copeland y Antikarov (2001). Como alternativa, se puede dar un tratamiento individual a cada incertidumbre. En este contexto, se encuentran diferentes propuestas que extienden el modelo binomial a un contexto k-dimensional, donde se incorpora la dinámica propia de cada incertidumbre, así como sus correlaciones. Para lograr esta aplicación, se requiere una aproximación al proceso estocástico k-dimensional. Este trabajo presenta una revisión sucinta de los diferentes métodos propuestos en este contexto, así como sus bondades, limitaciones y algunos enfoques alternativos.
... It is important to mention that DCF methodology may be valid, for example, in cases such as replacement analysis when valuing bonds or determining asset value in a stable environment. Still, it is an all or nothing decision-making criterion that has big limitations when trying to introduce uncertainty and flexibility in the process (Boyle & Guthrie, 2003;Smit & Trigeorgis, 2004). ...
... Real options and Games ". H.Smit & L. Trigeorgis, 2004, p. 111. © 2004 ...
In this dissertation it was described in detail the multiplicative quadrinomial tree numerical method with nonconstant volatility, based on a basis a proposal system of stochastic differential equations. The methodology allowed to estimate first, the value of the parameters based on an estimate conditional volatility process for a WTI oil commodity prices quoted in the Bloomberg platform, then they were derived and found their equivalent parameters in the proposed stochastic differential equations system, and finally the appropriate numerical method was constructed to include the volatility that was estimated. For the above, the first two moments of the proposed equations were derived to estimate the respective recombination between discrete and continuous processes and, as a result, a numerical methodological proposal was formally presented to value, with relative ease, both real and financial options, when the volatility was stochastic. The main findings showed that when in the proposed method the volatility approached to zero, the multiplicative binomial traditional method was a particular case, and that the results were comparable between these methodologies, as well as with the exact solution offered by the Black-Scholes model; Finally, the originality of the methodological proposal was that it allowed for the emulation in a simple way the presence of a nonconstant volatility in the price of the underlying asset, and it could be used to value all kinds of options both for a real world and in risk-neutral situations.
... Para embasamento teórico do assunto, realizou-se busca nas bases Jstor, Scielo, Science Direct, Scopus e Willey Online Library, além de em revistas es- pecializadas sobre o tema, admitindo fundamentar o estudo com pesquisas relevantes publicadas em periódicos de alto impacto. valor de mercado que se aproxime do valor de realização dos investimentos diante do ambiente altamente competitivo e incerto (SMIT;TRIGEORGIS, 2004). ...
... Para embasamento teórico do assunto, realizou-se busca nas bases Jstor, Scielo, Science Direct, Scopus e Willey Online Library, além de em revistas es- pecializadas sobre o tema, admitindo fundamentar o estudo com pesquisas relevantes publicadas em periódicos de alto impacto. valor de mercado que se aproxime do valor de realização dos investimentos diante do ambiente altamente competitivo e incerto (SMIT;TRIGEORGIS, 2004). ...
Resumo: O objetivo com o estudo foi verificar a atratividade nos retornos dos investimentos de empresas brasileiras do agronegócio com o uso do modelo Capital Asset Pricing Model (CAPM). Para isso, realizou-se pesquisa descritiva, análise documental e utilizou-se abordagem quantitativa. A amostra é composta por ações de 13 empresas do agronegócio brasileiro negociadas na BM&FBovespa e o período de análise compreende os anos de 2010 a 2014. Os achados apontaram que o CAPM identifica maior atratividade para as empresas do agronegócio brasileiro quando comparado com a média do mercado dado pelo IBovespa. Contudo, o CAPM foi eficiente para dimensionar os retornos esperados apenas nos anos 2010, 2011 e 2014, sendo que, em 2012 e 2013, a atratividade apontada pelo CAPM foi significativamente menor do que o retorno real, fato que pode ser entendido por meio de aspectos econômicos, pois o setor do agronegócio cresceu nesse período em oposição ao baixo desempenho geral do mercado. Por fim, salienta-se que o retorno real médio foi constatado superior para as empresas do agronegócio brasileiro em relação ao retorno do mercado em geral. Por vezes, apresentaram retornos reais maiores do que o esperado e, assim, foram consideradas atrativas para investimentos pela maximização dos ganhos no mercado acionário brasileiro.
Palavras-chave: Atratividade dos investimentos. CAPM. Empresas do agronegócio.
Return of investments of brazilian agribusiness companies
Abstract: The aim of the study is to assess the attractiveness of the investment returns of Brazilian agribusiness companies using the Capital Asset Pricing Model (CAPM). For this, was achieved descriptive research, document analysis and quantitative approach. The sample is composed of 13 Brazilian agribusiness companies listed on the BM&FBovespa and the analysis period comprises the years between 2010 to 2014. The findings indicated that the CAPM identifies more attractiveness for companies in the agribusiness compared to the market average given by IBovespa. However, the CAPM was efficient to scale the expected returns only in the years 2010, 2011 and 2014, occurring in 2012 and 2013, that the attractiveness appointed by CAPM was significantly lower than the actual return, which can be understood through economic aspects, because the agribusiness sector grown in this period in opposition to the low overall market performance. Finally, it should be noted that the average real return was found to be higher for the brazilian agribusiness companies in relation to the market return in general. At times, they had higher-than-expected real returns and thus were considered attractive for investments by maximizing earnings in the Brazilian stock market.
Keywords: Attraction of investments. CAPM. Agribusiness companies.
... El análisis del comportamiento estratégico es un problema difícil de abordar. A través de la teoría de juegos se trata de explicar el comportamiento económico, mediante análisis de las estrategias que los jugadores en el mercado usan para maximizar sus utilidades, donde termina siendo una mezcla entre matemática y psicología (Smit y Trigeorgis, 2004;Paenza, 2016). Establece métodos analíticos que concilian los intereses de los actores sociales interconectados, examinando las decisiones entre dos o más agentes que compiten y cuyas decisiones los afectan a todos. ...
El presente trabajo trata de presentar las claves fundamentales de la utilidad de la teoría de juegos en la gestión de la incertidumbre aplicado a la situación actual que vive el mundo. Para la toma de decisiones es necesario entender la articulación con su contexto, donde la incertidumbre juega un papel preponderante al momento de decidir. Para gestionar la incertidumbre sobre el comportamiento contextual se debe obtener un diagnóstico preciso y situado sobre el mismo. La teoría de juegos permite establecer criterios de asignación óptima y decisión en un marco de incertidumbre, modelando posibles resultados en base a comportamientos de actores sociales del entorno y las decisiones internas.
... Moreover, the multiple theoretical strands on the nexus between domestic investment and uncertainty do not give credence to a specific assent. 4 Under different maintained assumptions, including irreversibility of investment, one strand supports a negative association (e.g., Bernanke, 1983;Pindyck, 1991;Dixit & Pindyck, 1994;Bloom, 2009;Nakamura, 2002), whereas others support the antithesis of this negative link (e.g., Oi, 1961;Hartman, 1972;Abel, 1983;Kulatilaka & Perotti, 1998;Sarkar, 2000;Smit & Trigeorgis, 2004) Indeed, estimating the causal IT effect on aggregate domestic investment using cross-country data is likely fraught with several identification issues. We tackle the endogeneity associated with IT adoption due to selection on unobservables. ...
Some countries have adopted an Inflation Targeting (IT) regime to reduce inflation and inflation uncertainty: two factors the literature suggests firms put positive weight on when making outlay decisions that may affect aggregate domestic investment. This observation naturally leads to the question of whether domestic investment responds to IT. We apply the synthetic control method to developed and developing IT and non-IT countries to estimate the IT regime's causal effect on the domestic investment over time while addressing country heterogeneity. Adopting an IT regime had no short or long-run effect, at conventional levels of significance, on domestic investment in 21 out of 29 treated countries; this dominant pattern appears consistent with recent works on rational inattentive behaviour of firms. However, IT induced mainly long-run heterogeneous changes in domestic investment prices in 9 targeters, suggesting that supply constraints external to firms can also weaken the link between IT and domestic investment.
... Competition has been consistently identied as an important force in rms' capacity strategies (Spence, 1977;Porter, 1989;Bashyam, 1996;Smit and Trigeorgis, 2012). Due to the existence of time-to-build, rms usually build their capacity before the demand is known and enter a capacity constrained price competition once the demand is revealed (Bashyam, 1996;Anupindi and Jiang, 2008). ...
This book studies the impact of uncertainty and competition on a firm’s decision-making in the field of operations management. First, I investigate the dynamics of a firm’s decision. Second, I investigate how competition between supply chain players changes the dynamics of a firm’s decisions. I focus on three specific decision areas: (1) capacity planning at the strategic and tactic levels (2) anti-counterfeiting strategies at the tactic level; and (3) risk management for long field-life systems at the operational level. Our main generic research questions are as follows: (a) how should a firm make its capacity investment decisions in a competitive market, considering the changing demand? (b) how can a firm compete against counterfeiters in a global supply chain? (c) how should a firm that purchases parts manage end-of-supply risk of these parts, considering the changing supply and demand?
... The use of game theory in economics traces back to the major work «Theory of Games and Economic Behavior», written by J. Von Neumann & O. Morgenstern [13]. Many researchers investigated in detail the game theory method in economics, for instance: A. Dixit & B. Nalebuff [4], W.P. Fox & R. Burks [7], J. Newton [10], H.T. Smit & L. Trigeorgis [12]. These studies contain a sufficient amount of theoretical knowledge and many practical ways concerning the adaptation of the game theory method to making economic decisions. ...
This work is aimed at developing the behavior strategy of an economic entity involved in investment activities using the game-theoretic method. To build a qualitative model, the authors considered the economic aspects of game theory and developed an algorithm for adopting the game-theoretic criteria to investment planning. The authors analyzed the investment portfolios available for business entities on the Russian market to test the model. The outcome of the article is the formation of the authors’ approach to rationalizing the behavior of an economic entity in the course of investment activities. A practical example is given in which the suggested method is used when various investment portfolios are available. The approach was tested to prove that it can be practically applied and further used in the construction of investment strategies.
... Thus, the leader can increase capacity upon receiving a positive signal or shut down production upon receiving a negative signal. The value of this option also declines with the level of competition as competition mitigates the leader's discretion (Smit and Trigeorgis, 2004). It is also shifted lower by contemporaneous uncertainty as this form of uncertainty engenders decision-making errors. ...
The existence of a learning curve in which a firm’s costs decline with cumulative experience suggests that early entry provides learning opportunities that create advantage by reducing future costs relative to later entrants. While prior strategy research often assumes that learning curves are deterministic and known ex ante to firms, a substantial body of evidence suggests that learning curves are inherently uncertain. If there is uncertainty in the learning curve, then the taken-for-granted wisdom regarding the strategic implications of learning curves may over- or under-emphasize the value of early entry. We consider two forms of uncertainty prospective (future costs) and contemporaneous (current costs). We demonstrate computationally that while prospective uncertainty in the learning curve enhances the benefits of early entry, contemporaneous uncertainty reduces these benefits. Further, we examine the implications of these findings for competition and learning curve spillovers between leader and laggard firms. Recognizing learning curve uncertainty highlights a novel form of spillovers that don’t affect expected cost, but rather affect uncertainty about cost. Our core insight is that when learning curve uncertainty is large relative to the expected learning rate, it is uncertainty, rather than expectations about this rate, that determines the extent of early mover advantage
... As opposed to simultaneous games where players make their decisions at the same time, consecutive games characterize conditions where a first-mover advantage exists (Gans, 2005). Sequential games have been the focus of several works over recent years as these games have a wide array of applications in various fields such as political science, evolutionary biology, philosophy, economics, and even supply chain management (Smit & Trigeorgis, 2012). Qin (2012) modeled a basic cooperative two-stage supply chain game with a manufacturer (follower) and a distributor (leader) as a Stackelberg game to compute the optimal combination of the decision variables such as product price and customization time. ...
This paper presents an actual case application of a newly developed game-theoretic model in analyzing a single manufacturer-many supplier, multi-period, make-to-order supply chain with fuzzy parameters. The supply chain under consideration comprises an exclusive supplier for every component required by the manufacturer in producing its product. In certain instances, some supply chains enable the manufacturer to opt for a third-party subcontractor to produce a portion of its demand. We assume that the supply chain faces a price and lead-time-sensitive demand, which is relevant in a make-to-order environment. The vertical interaction within the supply chain is played as a Stackelberg game, where the manufacturer is considered the leader and the suppliers as the followers. Results show some important managerial insights in supply chain planning under a make-to-order condition.
... The ROM could be useful to assess startup value because it considers the strategic flexibility contained in investment decisions (Smit & Trigeorgis, 2012). ...
The aim of this conceptual article is to present a systematic literature review about the most used and innovative startup valuation methods to define the state of art and future trends on this important topic. Because of the particular features of early-stage companies, it is not easy to find an adequate method to assess their value. Traditional valuation methods are unsuitable for startups. Therefore, over time, academic literature and experienced investors created alternative and innovative valuation models. We analysed the main models, outlining the advantages and limits for each one. The results of our analysis show that there is currently no "perfect" method to assess a startup’s value. Each model discussed has significant limits, and the possibilities for improvement are many. We are witnessing a gradual withdrawal from more arbitrary valuation models, and consciousness is growing towards the idea that to better assess startup’s value, it is necessary to consider three aspects: attention to future forecasts instead of past data, using probability to consider different scenarios, and understanding of and attention to the specific business model of the startup rather than data on comparable companies in the market. Currently, none of the discussed methods integrates these three features harmoniously. We expect that in the near future, the academic literature will develop new valuation methods (or will perfect existing ones) that should consider the three characteristics mentioned previously. In this way, it would be possible to create a more suitable method to assess a startup's value, i.e., a method to reduce uncertainty and that better represents the startup’s value and makes startup company valuation more reliable.
... Thus, the leader can increase capacity upon receiving a positive signal or shut down production upon receiving a negative signal. The value of this option also declines with the level of competition as competition mitigates the leader's discretion (Smit and Trigeorgis, 2004). It is also shifted lower by contemporaneous uncertainty as this form of uncertainty engenders decision-making errors. ...
... необходим учет возможного риска проекта. Для этого можно использовать реальный пут-опцион на отказ от реализации проекта в будущем [13,14,15]. Здесь под моментом отказа от проекта имеется в виду любой момент времени срока реализации проекта, кроме последнего года. ...
... Empirical evidence of the negative impact of oil price uncertainty on corporate investments has been provided not only for Chinese listed companies but also for a global dataset of 54 countries (Phan et al., 2019b). However, following Smit and Trigeorgis, (2004), Henriques and Sadorsky (2011) believe that the impact of oil price uncertainty on corporate investments could be nonlinear and show a U-shape. Increasing uncertainty causes firms to reduce their investments, but firm investments will increase if the level of uncertainty keeps increasing to a certain point. ...
This study investigates the impact of oil price uncertainty on the cash holdings of firms. Using a sample of the Chinese stock market for the period from 2007 to 2016, our empirical results show that the impact of oil price uncertainty on cash holdings exhibits an inverted U-shape. Cash holdings increase with oil price uncertainty, but after a point, this impact becomes negative. Moreover, we find that the effect of oil price uncertainty is mitigated as the market value of firms increases. Meanwhile, state-owned companies are less impacted by oil price uncertainty. The results are robust to various tests and alternative explanations. Our findings are consistent with real options theory and pecking order theory.
... Leviäkangas and Lähesmaa (2002) also argued that even though NPV analysis is combined with Monte Carlo simulation, the uncertainties in a transport infrastructure project cannot be fully reflected. The sum of NPV and real option value equals the value of expanded NPV (ENPV), which can reflect the value of a project's flexibility (Smit and Trigeorgis 2012). Thus, to better reflect the flexible value of a project, the value of real options need to be calculated first. ...
... The project requires an investment outlay I , I > 0 (this may be both financial as well as non-financial contribution). The two competitors share the same investment opportunity, it is a shared option (Smit and Trigeorgis 2004). We assume that the lifetime of the investment project is infinite. ...
Cooperation between competing firms called coopetition has increasing relevance to business practice. However, firms and their managers who want to enjoy the benefits of coopetition are also aware of the risks that it entails. The key questions need to be answered: under which circumstances firms are willing to coopete and to keep the arrangement, what factors are decisive, and when benefits are most significant. In the paper, we are looking for answers to these questions on the basis of coopetitive real options games. We consider the case of two firms that can establish a coopetition arrangement to implement an investment project (each firm possesses a shared investment option). In the paper, we point out conditions under which coopetition between companies is easy, tough or impossible. The key factors are the project risk and the size of market shares. In particular, it is worth noting that for high-risk projects, the area of tough coopetition is larger than for low-risk projects. A large disproportion in market shares makes coopetition rather impossible.
... The three examples are inspired from the decision analysis literature (see French 1988, Keeney 1992and Smit and Trigeorgis 2004. Indeed there already exist suggestions on how to handle such decision situations expanding appropriately the set of alternatives. ...
... En la actualidad, una de las metodologías más utilizadas para valuar todo tipo de activos es el DCF, método que ofrece un enfoque determinístico y de corto plazo y en el que el valor de la empresa o del proyecto se establece a través de la estimación del valor presente (present value o PV) de los flujos futuros de dinero descontados a una tasa ajustada por riesgo que se deriva de ellos (Mun, 2002;Vidarte, 2009;Pareja Vasseur & Cadavid Pérez, 2016). Esta metodología, a pesar de su importante acogida entre la comunidad académica y los practicantes, presenta evidentes deficiencias entre las que se cuentan: (a) no contempla el valor de la flexibilidad y el riesgo en los programas de inversión, (b) subestima el valor de los activos cuando existen opciones y (c) no considera la naturaleza variable de la tasa de descuento a través del tiempo, que corresponde por lo común al costo promedio ponderado de capital (weighted average cost of capital o WACC), lo que puede generar la subestimación o la sobreestimación de un proyecto de inversión en particular (Mun 2002;Boyle & Guthrie, 2003;Schwartz & Trigeorgis, 2004;Smit & Trigeorgis, 2004;Hinojosa, 2012). ...
The aim of this paper is to summarize exhaustively and concisely, the different methodologies for estimating the volatility that has been proposed for the real options approach (ROA), and also provide a theoretical and practical explanation for estimating an unbiased volatility and unconditional for this methodology. The results of the research suggest that the use of the current methods generates a marked overestimation of the volatility, which is ultimately transmitted in the overvaluation of the real option. In this way, the application of the unbiased estimation method is used to determine its impact on decision-making for a real project in the oil and gas sector in Colombia, in which its strategic value was estimated through the use of real options, and it was compared with the static result obtained by the method of discounted cash flows (DCF); as a result it was found that, it is generated an additional value not perceived by the traditional methodology, that is consistent with the respective volatility that was generated by the commodity. It is proposed that for future research, unbiasedness condition is maintained, but that the estimate is conditional through econometric models, in order to emulate the irregularities and empirical characteristics presented in the financial series using, for example, an appropriate system of stochastic differential equations, as required condition for the performance of price, and the volatility of the underlying asset.
... Re-positioning in white spaces could be seen as exercising a real option to test a product extension with new or existing customers. Real option theory (ROT, Smit & Trigeorgis, 2012) could help us to understand the effectiveness of these various transition paths. ROT values the uncertainty around investments in product extensions. ...
Blue Ocean Strategy (BOS) has attracted a resurgence of interest following various market discontinuities, including digital disruption, the growth of the sharing economy and the development of ecosystems. BOS is a combination of value innovation and new markets, driving sustained higher performance through specific marketing activities, but it is difficult to conceive and implement.
We outline five cases that use various transition paths to BOS through white spaces - with product extensions in the existing market. An important part of this transition are ‘blue ocean droplets’ which drive profitable growth through the transition and then onto a successful deployment of a blue ocean strategy. Blue ocean droplets drive profitable growth - simultaneously increasing volume sales, maintaining/increasing prices and maintaining/decreasing costs.
We then use an inductive qualitative approach in a multi-team gaming simulation to examine drivers of firm performance. Higher than average performance is driven by repositioning in white spaces and execution of the three blue ocean droplets.
Finally, we discuss implications for firms: execute a number of real options to follow one of several transition paths to a full BOS. This approach involves less downside risk than a full BOS approach, but can still be sustainably profitable, while also breaking the traditional value/cost trade-off.
... In the limited instances where there is interaction between the firms, it does not appear to rise to the "act-and-see" concerns of A&L(a). Certainly, the involvement with the portfolio firms when pursuing a wait-and-see strategy through CVC is far less than with a joint venture (Reuer & Tong, 2005;Tong, Reuer, & Peng, 2008) or an R&D-focused strategic alliance (Kogut, 1991;Smit & Trigeorgis, 2004;Vassolo et al., 2004). In these latter two cases, the resolution of uncertainty would be endogenous, as it would depend on the actions of the corporate investor. ...
We apply real options (RO) theory to understand the role of corporate venture capital (CVC) investments and its relationship with internal R&D capabilities in supporting the acquisition of external technologies. We formulate hypotheses about key drivers of the option value of CVC and the decision to exercise the RO using a dyadic dataset of global pharmaceutical firms and their biotech partners. Our findings suggest that the option value of CVC is higher for investors with weaker scientific capabilities; engaging the markets for technology in distant technological fields; and, when their innovation pipeline is tilted towards the late‐stage development process. Finally, the licensing of high‐value technologies is the most likely form of option exercise when technological uncertainty is reduced post‐CVC.
Managerial summary
Despite the fact that one of the main goals of corporate venture capital (CVC) investments in high‐tech industries is to gain a window on future technologies, the relationship between CVC and other strategies used to acquire external technologies, such as licensing, has not been adequately explored. To address this gap, we formulate hypotheses about key drivers of the decision to make CVC investments as a wait‐and‐see strategy in the markets for technology (MFT) using a longitudinal dataset of global pharmaceutical firms and their biotech partners. We find that investors’ scientific capabilities, technological domains, and research pipelines impact investors’ decisions to make CVC investments prior to other MFT transactions. In our research setting, investors typically acquire high‐value technologies via licensing when technological uncertainty is reduced post‐CVC.
... Cost-Benefit Analysis (see Dasgupta & Pearce, 1972;Nas, 1996 ) is widely used and, perhaps, the best known method for evaluating public policies among both practitioners and researchers (e.g. the Cost-Benefit Analysis manual of the European Union 1 and the World Bank manuals about CBA 2 ). However, Cost-Benefit Analysis is not without contemporary critics (for example, Ackermann, 2010;Adler & Posner, 2006 ) and many other ap-proaches have been developed such as, for instance, Real Options Analysis (see Smit & Trigeorgis, 2004;Trigeorgis, 1990 ). Economists have developed mechanism design theory (e.g. Hurwicz, 1960;Hurwicz, 1972;Maskin, 1985;Myerson, 1981;Myerson & Satterthwaite, 1983 ) to support policy making processes by first identifying the desired outcome or social goal to be achieved, then checking whether or not an appropriate institution (mechanism) could be designed to attain that goal and finally exploring what form that mechanism might take (e.g. ...
The design of alternatives is an essential part of decision making that has been less studied in theory and practice compared to alternatives’ evaluation. This topic is particularly relevant in the context of public policy making, where policy design represents a crucial step of the policy cycle since it determines the quality of the alternative policies being considered. This paper attempts to formalise the decision aiding process in two real interventions dealing with alternatives’ generation for territorial policy making in Italy. The aim of this research is to understand what generates novelty within the alternatives’ design phase of a decision aiding process, i.e. what allows to expand the solution space and discover new alternatives to solve the problem under consideration. It demonstrates ways in which novelty in decision processes can be supported by Operational Research/Multicriteria Decision Aiding tools. The two case studies are used to answer the following questions: (i) Why have new alternatives arose during the policy making process? (ii) How have they been generated? (iii) Which consequences did they lead to? and (iv) What generated novelty in the process? The results highlight two main reasons that can expand the solution space within a decision aiding process: (i) dissatisfaction (of the client, of the analyst or of the relevant stakeholders, especially when dealing with public policies) with respect to the solutions currently proposed to the decision making problem and (ii) opportunity for a change in one of the variables/constraints.
... The three examples are inspired from the decision analysis literature (see French 1988, Keeney 1992and Smit and Trigeorgis 2004. Indeed there already exist suggestions on how to handle such decision situations expanding appropriately the set of alternatives. ...
This paper presents a general framework for the design of alternatives in decision problems. The paper addresses both the issue of how to design alternatives within “known decision spaces” and on how to perform the same action within “partially known or unknown decision spaces”. The paper aims at providing archetypes for the design of algorithms supporting the generation of alternatives.
... In our setting, we explicitly consider the joint competition for capacity considering each player's investment cost, as well as the bidding strategy to sell generated energy. This problem is neither studied in traditional capacity investment games (randomness is not considered) [24,25] 1 nor in competition of renewable resources (investment strategy is considered) [17,19]. To characterize the Nash equilibria in the two level capacity-pricing game, we consider two performance metrics. ...
Renewable resources are starting to constitute a growing portion of the total generation mix of the power system. A key difference between renewables and traditional generators is that many renewable resources are managed by individuals, especially in the distribution system. In this paper, we study the capacity investment and pricing problem, where multiple renewable producers compete in a decentralized market. It is known that most deterministic capacity games tend to result in very inefficient equilibria, even when there are a large number of similar players. In contrast, we show that due to the inherent randomness of renewable resources, the equilibria in our capacity game becomes efficient as the number of players grows and coincides with the centralized decision from the social planner's problem. This result provides a new perspective on how to look at the positive influence of randomness in a game framework as well as its contribution to resource planning, scheduling, and bidding. We validate our results by simulation studies using real world data.
... In a turbulent economic environment, innovation is considered as a strategic driver to gain competitive advantage, also it increases the sustainability, productivity, economic growth and business competitiveness (Smit, Trigeorgis 2012). Innovation becomes an ongoing process of learning, searching and exploring that result in new products, new techniques, new forms of organizations and eventually new markets (Eveleens 2010). ...
The main objective of this study was to examine the direct and indirect effects of organizational culture, knowledge management and organizational learning on innovation. The study combined knowledge-based view theory (KBV), competitive value framework to develop a new original theoretical framework for investigation of factors that affect innovation. Data was gathered from a survey of 279 companies supplying automobile parts to Iran Khodro Company, an Iranian leading automobile manufacturer. Study discovered that organizational culture and knowledge management influenced organizational innovation. Besides that, organizational learning played a significant role as a mediator in that relationship. However, knowledge management was not considered as a mediator in the relationship between organizational culture and organizational innovation. As a practical contribution, the findings of the study serve as a guideline for policy makers and managers in the formulation of policies and strategies for sustainable innovation. Knowing the effectiveness of the innovation can help the government to make decisions about the continuation of this policy. Moreover, study contributes to firm management in formulation of policies and strategies for sustainability in innovation context. Innovation assists organizations supplying the product or service in the automotive sector to operate innovatively, competitively and profitably
... In our setting, we explicitly consider the joint competition for capacity considering each player's investment cost, as well as the bidding strategy to sell generated energy. This problem is neither studied in traditional capacity investment games (randomness is not considered) [24,25] 1 nor in competition of renewable resources (investment strategy is considered) [17,19]. To characterize the Nash equilibria in the two level capacity-pricing game, we consider two performance metrics. ...
Renewable resources are starting to constitute a growing portion of the total generation mix of the power system. A key difference between renewables and traditional generators is that many renewable resources are managed by individuals, especially in the distribution system. In this paper, we study the capacity investment and pricing problem, where multiple renewable producers compete in a decentralized market. It is known that most deterministic capacity games tend to result in very inefficient equilibria, even when there are a large number of similar players. In contrast, we show that due to the inherent randomness of renewable resources, the equilibria in our capacity game becomes efficient as the number of players grows and coincides with the centralized decision from the social planner's problem. This result provides a new perspective on how to look at the positive influence of randomness in a game framework as well as its contribution to resource planning, scheduling, and bidding. We validate our results by simulation studies using real world data.
This study investigated the effect of green marketing strategy on firm performance. To this end, the study involved 380 manufacturing firms and obtained data from marketing/production managers through structured questionnaire. Structural equation modeling was used to test the hypotheses of the research. The findings revealed that the green marketing strategy positively affects firm performance through competitive advantage. Moreover, green marketing strategy has a direct positive influence on firm performance indicating a partial mediation and lastly, the indirect effect of green marketing strategy on firm performance through competitive advantage is moderated by competitive intensity.
Startups play a substantial role in the economic growth of a nation, by introducing new technologies, ground-breaking innovation, creating jobs, etc. A couple of decades back, it was extremely difficult to start a business, but today new businesses pop up every day, all around the world. Recognizing the importance of a startup, governments across the globe are doing their best to provide an atmosphere where startups can bloom. Despite its importance and all the support, the startup failure rate is at 90%; about 10% of startups fail in the first year and 70% fail in two to five years. The startup boom saw the emergence of alternative sources of funding like Venture Capitalist, Angel Investors, etc. These investors (Venture Capitalist, Angel Investors, etc.) played a crucial role in startup success by providing easy access to funds which is a critical and scarce resource for any founder. Traditionally business success is linked with sustainable profitability but in the startup world most used method to define success is valuation. Based on CB Insights research, as of January 2022, there are more than 900 unicorns (startup with a valuation of over $1 billion) around the world and of these unicorns less than 10% are profitable. It’s difficult to explain/comprehend how startups’ which are neither profitable nor foresee profitability in near future are valued higher than traditional business with stable profitability. Current valuation methods have impacted the startup ecosystem. Today, founders start their business with exit in mind, the focus of founders is on growth/scale rather than profitability. There is a school of thought that believes that such valuations will soon result in the bursting of the startup bubble just like the dotcom bubble seen in late 1990s. The focus of this paper is to investigate the techniques used by investors for startup valuation and how these techniques are impacting the startup ecosystem and its founders. The paper looks at all stages of the investment cycle, from seed to IPO or takeover and understands the process of valuation at each stage and how it impacts all stakeholders in the ecosystem.
Industrial energy audit is one of the main strategies to improve energy efficiency. Usually, as an energy audit output, several improvement alternatives are provided. Choosing the best alternative has been detected as one of the main barriers in adopting energy efficiency projects. This work contributes to this decision-making process with a case study from an Argentine industrial plant. The project includes the installation of a micro-turbine within the steam system to generate electricity. To address the decision-making process, the historical records of steam system flows associated with energy consumption and costs were analysed. The project allows to reduce the annual energy consumption of the whole industrial plant by 6%. Furthermore, the investment needed for the project is recovered in around 4 years, and after a 10-year period, the project will refund more than 240,000$ plus the discount rate. The project reduces CO2 emissions by over 1000 tons per year.
This paper empirically explores the impact of oil price uncertainty on the strategic investment of China's renewable energy enterprises from the perspective of certain substitution relationships between renewable energy enterprises and traditional energy enterprises by using the systematic GMM method. In addition, we propose three specific influence mechanisms for the renewable energy industry. The results of our mechanism analysis show that the uncertainty of oil price will increase the market's expectation of renewable energy enterprises and thus stimulate their investment. While the uncertainty of oil price will restrain the investment expenditure of renewable energy enterprises through risk transmission. The scale of enterprises will affect the above two influencing mechanisms. However, the uncertainty of oil price can hardly influence the strategic investment decision through the stimulation of the renewable energy industry by the consumer market. Our results are helpful to the strategy makers of renewable energy enterprises and the macro policy‐makers of the government.
This paper studies the role of ambiguity and managerial ability in firm growth options from the perspective of behavioural theory. We argue that managerial ability increases both the identification and exploitation of growth options opportunities, but ambiguity reduces strategic growth options value as a result of information incompleteness and non-Bayesian behaviour. Using a dataset of all US-listed firms, we test the joint effects of ambiguity and managerial ability on growth options value after controlling for standard determinants and endogeneity. The results indicate that ambiguity has a negative effect on growth options value, while ability has a positive effect. We also find that the negative association between ambiguity and growth options is less pronounced with higher managerial ability. These findings underscore the importance of firm heterogeneity in the identification, exercise, and management of strategic and innovative real options opportunities. The paper's contribution provides relevant management insights into the behavioural antecedents of real options at the firm level as well as highlights that managerial and behavioural characteristics are important determinants of growth options value.
Competition and concentration effects in the banking sector are still highly object questioned in the public policy. Problems of asymmetric information and high interest rates prompt the discussion on whether bank competition is good or bad for efficiency, or more generally, for social welfare. In recent years, a lot of research work has been carried out investigating the nature of competition in the banking industry. Since the 2008 financial crisis, competition in the banking industry has been characterized by low interest rates, low credit growth, increased regulation and compliance requirements. The objective of this study is to analyze the national credit market by calculating and analyzing concentration and competition indicators, between 2010 and 2020. To compare and estimate indexes of concentration, such as the Herfindahl-Hirschman index and competition through the Lerner index. The results suggest that the concentration has decreased in the period considered so as competitiveness, suggesting that there is less competition in the market. Despite the limitations pointed out, the results suggest that bank concentration in the Brazilian financial market has been decreasing over the last few years due to an increased position and importance of new players such as Digital Banks, Fintechs and High-Techs firms, which caused a decrease in the market share of large banks. Although, competition levels are not improving, showing that the market share is being absorbed by Financial Institutions of considerable size and perhaps not by new entrants in the market.
In this Chapter, several efforts that the SIM Research Group, from the University of Seville, accomplished during the Covid-19 pandemic lockdown in March-June 2020, are introduced. These efforts had an important impact on media and were mainly concern with the pandemic recovery phase. When confinement ends, recovery phase must be accurate planned at a local level. Health System (HS) capacity, specially ICUs and plants capacity and availability, would remain the key stone in this pandemic life cycle phase. This Chapter describes: First the important of the action plans design by local level, while a unique decision-making center is considered by country; Second, a management tool based on a ICUs and plants capacity model to estimate ICUs and plants saturation, and with these results, set new local and temporal confinement measures. The tool allows a dynamic analysis to estimate maximum Ro saturation scenarios; Third, a practical management tools to tackle the deconfinement strategy design problem. A proper control system to follow the course of action, especially in a scenario with unprecedent uncertainty, is developed. In all cases, it is remarked the importance of R (the pandemic basic and effective reproductive number), first as a variable to monitor and control the pandemic, to ensure its decline; second as a target to score risks associated to start certain activities over, after confinement. Reducing the potential increase in the value of R, when any type of activity is re-opening, guides the strategy. One common objective in these initiatives: Applying asset management principles to accelerate as much as possible socioeconomic normalization with a strict control over HS relapses risk.
Empirical research reports various behaviors exhibited by investors, including voluntary concurrent investments, which are called bandwagon investments. However, the current theoretical understanding is still limited in explaining under which condition the investment bandwagon effect occurs. We investigate the closed-loop subgame perfect equilibrium of an investment timing game that describes voluntary simultaneous investments. We show that investors are on the investment bandwagon when (1) they expand their current capacities and (2) the second mover’s additional profit rate exceeds a threshold value. Otherwise, investors invest sequentially. This result explains the frequently observed investment herd effect.
In this paper, we analyse the effects that the number and outcomes of R&D experiments have on the strategic equilibria between two firms that can both compete and cooperate in a context of uncertainty. As is well known, R&D projects are characterised by the sequentiality of investments and by the outcomes obtained from the success or failure of their experiments. Furthermore, the positive results and the number of tests carried out in R&D increase the market value of the innovative product. The Real Option Approach evaluates the flexibility of R&D investments and the strategic scenarios. According to Nash equilibria, we show how the market value threshold, for which the investment policy is optimal, depends on the number of experiments and on the information revelation.
Prior studies on capital investments, including mergers and acquisitions, point to investment irreversibility as the primary factor behind diminished investments during periods of increased policy uncertainty. We show that increased relational risk, due to the potential for counterparty misbehavior or shirking and higher contracting costs, appears to be the primary driver behind the diminished propensity to undertake strategic alliances during enhanced policy uncertainty regimes. Alliances are even less likely during such times when they (a) involve more than two firms, (b) are in industries with greater counterparty risk, and (c) involve partners that require intense contracts.
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Generating alternatives for decision problems is a critical activity regularly underestimated and underdeveloped in the decision analysis literature. We present a survey showing how little this topic has been studied in the last 50 years. We then introduce a general framework under which formalize the design of alternatives. Two examples help to understand our point of view: alternatives are generated through separation of attributes describing the value space of the client/decision maker.
Previous research on third party funding for academic institutions has demonstrated that it entails positive and negative outcomes. This manuscript deals with this idea from a reputational perspective, using the options theory as the framework for the analysis. The reasoning is based on the definition of a reputational income that is supposed to follow a stochastic behavior. It is modelled as a mean reverting type process, which is modified to introduce a correction factor with the aim of capturing the special reputational sensitivity of academic institutions regarding funding issues. We develop a stochastic partial differential equation, and we use its solution to deploy a sensitivity analysis to identify how the value of reputation reacts to changes in certain key variables. We find that the value of reputation increases if the academic institution becomes more sensitive to reputation related issues, or if there is an increase in the reputational reward that the market offers to a continued commitment to third-party funding. Also, the value of reputation gets higher as the ability to recover from reputational pitfalls strengths, but it decreases in a framework with high uncertainty and risk. So, this research proposes a mathematical formalization for the reputational dimension of third party funding in academic institutions, with the aim of identifying the critical variables that are likely to affect their reputational value and, thus, assist managers in their decision-making processes.
Las empresas de la nueva economía como start up, empresas de base tecnólogicas, intangibles en I&D, e inversiones en estrategias innovadoras, entre otras, se caracteriza por su dinamismo y flexibilidad. Para su valoración se deben emplear modelos de opciones reales. La principal debilidad de los modelos reside en suponer mercados completos, condición difícil de cumplir en mercados emergentes. Por tal motivo, se desarrolla un modelo que combina la transformación de Edgeworth y funciones isoelásticas de utilidad (CRRA - relative risk aversión coefficient), incorporando grados de aversión al riesgo del agente. Se utiliza el análisis de casos, sobre un proyecto biofarmacéutico con opciones secuenciales; se aplica análisis de sensibilidad sobre el coeficiente de aversión y el valor de la opción. Se concluye sobre las ventajas del modelo, en particular, se incorpora la probabilidad extrema de éxitos y fracasos mediante momentos estocásticos de orden superior y actitudes frente al riesgo.
This paper presents a model to calculate the value of the real option to defer an investment project within one, two, and in general n periods. The methodology used to deduce the mathematical expression of this option is based on the binomial model by constructing all possible future scenarios as well as their associated probabilities. Consequently, this manuscript provides the expression to assess the operative flexibility of a project when its deferment is possible. Indeed, this is an easy‐to‐handle and reliable tool that allows more accurate forecasts to reduce the uncertainty around a project then facilitating the managerial decision‐making processes.
Flexibility is a central element for the successful development and operation of infrastructure. In particular, it is important regarding the possibilities of modifying investment decisions through time as both the project’s internal and external conditions evolve. Therefore, flexibility opens new opportunities and allows stakeholders taking risks that may enhance the benefits derived from the operation of the system. Risky investment decisions may include, for example, the possibility of delaying the execution of a task; the possibility of abandoning the project before or after completion; or the possibility of an expansion. This paper discusses the importance of flexibility in infrastructure management and presents a model, based on a single redesign, that can be used for evaluating and implementing a mayor project expansion. At the end, two illustrative examples show the advantages of the proposed approach and the potential for the future management of large infrastructure systems.
The main goal and the original contribution of this paper are to find and describe optimal investment strategies for asymmetric firms acting on a competitive market. Investment decision-making process is described as a game between two players, and the real options approach is used to find a value of an investment project; therefore, the paper falls in the area of the real options games (ROG). We also study the effect of a project risk level (measured by volatility) on a firm’s investment strategy and examine a case of symmetric firms as well. It is no surprise that the advantage is mostly on the side of a dominant company, but under some circumstances, a weaker party has a very strong bargaining chip. Firms may cooperate, and their negotiations could be supported by a payoff transfer computed as the coco value. It also turned out that the cooperation between competitors gains in significance when a project risk is high regardless of whether firms are asymmetric or symmetric.
Justifying new manufacturing technology is usually very difficult since the most important benefits are often strategic and difficult to quantify. Traditional capital budgeting procedures that rely on return measures based on direct cost savings and incremental future cash flows do not normally capture the strategic benefits of higher quality, faster responses to wider ranges of customer needs, and the options for future growth made available by flexible manufacturing technology. Adding to these limitations is the difficulty of using traditional cost accounting systems to generate the information necessary for justifying new manufacturing investments. This paper reviews these problems and recommends procedures useful for assessing investments in flexible manufacturing technology.
We present a simple analysis of the generic flexibility to switch between alternative technologies or operating "modes." The firm can select between alternative projects based on inflexible (rigid) technologies, or a flexible project that allows for switching the operating mode, possibly at some cost. Without switching costs, the value of the flexible project can be seen as the value of a rigid project plus the sum of the values of the options to switch in future periods. The presence of switching costs, however, creates a compoundness effect that may make option value additivity break down. The resulting decision rule reflects a persistence or hysteresis effect where, even though immediate switching may seem attractive, it may be long-term optimal to wait. This general framework subsumes as special cases most other known real options. The option to defer investments, expand or contract production, temporarily shut down and restart operations, abandon for salvage, and default during construction are revisited. The framework also finds applications in flexible manufacturing systems and other capital investments.
OVERVIEW:
Real options reasoning is a logic for funding projects that maximizes learning and access to upside opportunities while containing costs and downside risk. Although it has considerable advantages over conventional approaches, the tools for using it remain scarce. This article describes a method for assessing uncertain projects that approximates option value through scoring a series of statements. Variables are the size and sustainability of potential revenue streams, speed or delay in market adoption, development costs, commercialization and market access costs, company strengths, likely competitive responses, dependence on standards, and the degree of uncertainty. Each variable is measured by asking questions that, in turn, can be used to assess the risks confronting a proposed project and to suggest remedies, even if they demand abandoning or reconfiguring the project. A major advantage of this approach is that it integrates both technological and strategic considerations.
In this model, the effects of advertising are infinitely durable, fixed (and sunk) costs give rise to economies of scale, post-entry behavior is noncooperative, and pre-entry expectations are rational. Despite the obvious resemblance to work on the use of investment in production capacity to deter entry, here the incumbent monopolist never finds it optimal to advertise more if entry is possible than if it is not. This result and other features of this model indicate the dangers of analyzing advertising with analogies to other sorts of investments. The results make clear the need for more theoretical work on advertising and entry deterrence.
We study the optimal pattern of outlays for a single firm pursuing an R&D program over time. In the deterministic case (a) the amount of progress required to complete the project is known and (b) the relationship between outlays and progress is known. In this case it is optimal to increase effort over time as the project nears completion. The value of a research project is convex in its payoff on completion and in the difficulty of the project. Relaxing (a) we find in general a simple, positive relationship between the optimal expenditure rate at any point in time and the (expected) value at the time of the research program. We also show that, for a given level of expected difficulty, a riskier project is always preferred to a safe project. Relaxing (b), we find again that research outlays increase as further progress is made.
This paper provides an overview of game theory, in particular its applications in finance. Traditional models in which the uninformed agent moves first are examined initially, and this is followed by an examination of models in which the informed agent moves first. Some of the equilibrium concepts which are discussed are: Nash equilibrium, subgame perfection, sequential equilibrium, the Cho-Kreps intuitive criterion and the Banks-Sobel divinity and universal divinity refinements. Applications to corporate control, capital structure, dividends and stock repurchases, external financing, and financial intermediation are reviewed.
This article unbundles the relation between commitment and flexibility by distinguishing between firm-specific and usage-specific resources. This distinction turns out to be valuable because firm-specificity does not always imply (nor is it always implied by) usage-specificity. Firm-specific resources are more strategic than usagespecific resources. More broadly, the distinction between these two kinds of specificity helps explain why the tension between commitment and flexibility can easily be overdone: the two aren't always negative measures of each other.
Presents a real options and game-theoretic approach to corporate investment strategy under competition. Analysis of aspects of competition in a microeconomic framework; Forecasting of operating cash inflows based on economic rents or excess profits; Implications of results obtained.
This paper develops a model for assessing options in joint ventures. The model is used specifically to examine the option to acquire or divest a joint venture, both in the case where the acquisition/divestiture price is specified ex ante in the initial contract and in the case where the price is to be negotiated ex post. The results derived from the model show how the value of the option and each partner's pay-off from the venture vary with the structure of the option and how the presence of the option may affect the structuring of the joint venture. The main theoretical insights are stated in 12 potentially testable propositions, and possible ways to operationalize some of the propositions for empirical testing are also explored. Copyright © 2000 John Wiley & Sons, Ltd.
This paper examines dynamic R&D investment policies and the valuation of R&D programs in a contingent claims framework. We incorporate the following characteristics of R&D programs into our model: learning-by-doing, collateral learning between different projects in the program, interaction between project cash flows, periodic reevaluations of the program, different intensities of investment, capital rationing constraints, and competition. We show that a firm may invest in multiple projects even if only one can be implemented after development is complete. Furthermore, the firm may significantly alter its funding policy over time. For example, it may simultaneously develop multiple projects for a period of time, then focus on a lead project, and potentially resume funding of a "backup" project if the lead project fails to deliver on its early promise. We show how a firm can forecast expected R&D spending through time for an optimally executed R&D program. While project volatility plays an important role in determining R&D program value, we find that for high volatility projects the optimal investment policy is not very sensitive to changes in (or misestimation of) volatility. In considering whether to accelerate development of a project, a firm should balance the adverse effects of increased costs and the loss of investment flexibility against the positive effects of rapid uncertainty resolution and accelerated cash flows. In the presence of a budget constraint that prevents the firm from simultaneously accelerating projects and developing projects in parallel, we find that, if one project significantly dominates another early in the development stage, the option to accelerate the lead project is likely to be more valuable than the option to exchange projects. Thus, the backup project would be shelved in order to commit extra resources to development of the lead project. Finally, competition from other firms leads to more parallel investment in the early development stages of projects, less parallel investment in the latter stages of development, and lower overall investment.
This paper analyzes a utility power plant construction project using an option pricing model of the value of the capital investment. It includes descriptive factors frequently ignored in the valuation of capital investments by regulated firms, including lead time, lumpy and sequential cost outlays, irreversibility of expenditures, and uncertainty about regulatory outcomes for completed projects. The analysis shows the value of shorter lead time technologies, the value of flexibility to delay or abandon construction, the incentive to delay construction under uncertain regulation, and how cost recovery policies, such as possible disallowance of Allow for Funds Used During Construction (AFUDC), create incentives to invest less, but to complete construction quickly. The analysis may also apply in unregulated contexts, where the value of a completed project is affected by taxation, the possibility of nationalization, or possible competitors' actions that create uncertain restrictions on potential profits.
This paper presents a numerical method for valuing complex investments with multiple interacting options. The method is a log-transformed variation of binomial option pricing designed to overcome problems of consistency, stability, and efficiency encountered in the Cox, Ross, and Rubinstein (1979) and other numerical methods. This method handles well options with a series of exercise prices (compound options), nonproportional dividends, and interactions among a variety of real options. Comparisons with several existing numerical methods regarding accuracy, consistency, stability, and efficiency are given.
In 1996, HAL Investments, a European private equity investor, agreed to buy Pearle Benelux, a leading optical chain in Belgium and the Netherlands. HAL subsequently made further acquisitions in Belgium and the Netherlands and also in Germany, Austria, and Italy, all within the same industry. These transactions were part of an acquisition strategy known as "buy-and-build," in which an equity investor initially undertakes a "platform" acquisition in an industry and then leverages core competencies or efficiencies onto follow-on acquisitions in a broad-ended geographical base. The goal of such a strategy is targeted industry consolidation. This paper develops a framework for assessing the value generated by both the option-like and competitive characteristics of an acquisition strategy.
A contingent claims approach to capital budgeting may be preferable to traditional methods where uncertainty and managers' strategic reactions to changing conditions are important. As an example of such a case, we solve the classical problem of the duration of an investment in forestry resources (i.e., when to cut down the trees) in the general case of stochastic output prices and stochastic natural growth rate and timber inventories. A contingent claims approach is used to value the forestry resources as a function of: (1) stochastic prices and inventories, and (2) an asymmetric, optimal production policy that incorporates the option to halt timber production temporarily.
We study entry into a new market in a model where firms choose when to enter the market. An early entry is profitable because it yields a strategic advantage in the market; however, costs will also be larger owing to interest on the capital cost. It is shown that rent equalization need not occur, and that social welfare may be lower under competition than under pure monopoly. Furthermore, under some circumstances there is a strictly positive probability that the firms enter simultaneously, even in the limit when the period length converges to zero.
The types of investments a firm undertakes will depend in part on what it expects the outcome of those investments to reveal about its skills, capabilities, and assets (i.e., its resources). We predict that a firm will specialize when young, then experiment in a new line of business for some time, and then either expand into a large, multisegment business or focus and scale up its specialized business. We derive several empirical implications for firm valuations and the reaction of stock prices to news about firm prospects. We also offer a novel explanation for the well-documented “diversification” discount.
This article deals with the optimal timing of project initiation in a preemptive competitive environment. Specifically, it illustrates how option pricing can be used to determined whether and when management should exercise a deferrable investment opportunity by making an early investment commitment to preempt anticipated entry by competitors, or whether to wait despite the risk of competitive damage. It is shown that the impact of anticipated competitive arrivals on the value of an investment opportunity in such preemptive situations can be analyzed in a way analogous to known dividends on American call options. An extension to random competitive arrivals is also presented.
This paper considers several related strategic duopoly settings in which uncertainty creates an ‘option value’ from retaining flexibility by delaying investment or output decisions until after uncertainty is resolved. This value of flexibility must be weighed against the strategic value of pre-commitment, yielding a trade-off between flexibility and pre-commitment. We obtain a simple characterization of the timing of output decisions as a consequence of the degree of uncertainty. Particular attention is paid to the implications for entry-deterrence by an incumbent firm and to the possible flexibility-enhancing effects of investment in capital.
In an oligopoly context the present technological choice of a firm which expects to receive private revelant information just prior to the uncertain market stage has both a flexibility value and a strategic commitment value. In contrast to some common wisdom ideas we provide a natural two-stage competition framework in which an increase in uncertainty always raises the commitment value of the technological choice of the firm and may decrease its flexibility value when the increased uncertainty takes the form of more variable beliefs. The first result tends to reinforce therefore the findings of the strategic commitment literature under certainty.
The paper deals with the numerical valuation of leasing contracts with a variety of embedded operating options. Unlike earlier work which either ignores such options or focuses on only one type of operating option in isolation, this paper recognizes that leasing is a context in which complex options typically occur as well as the importance of using computational methods to quantify the interactions among several options present in combination. It describes a Contingent Claims Analysis (CCA) of operating lease options, and suggests a CCA-based numerical analysis method for valuing leasing contracts with multiple such options. A numerical leasing example with the options to cancel the lease early, extend its life, and purchase the leased asset is presented for illustration.
Game theory has not been applied much to business strategy. I review some criticism of the game-theoretic approach which inhibits its application, and mention some others. The common criticism that game-theoretic models assume too much rationality is often wrong because (i) some games require little rationality to compute equilibria; and (ii) players may reach an equilibrium by communicating, adapting, or evolving to it rather than by calculating it. However, other criticisms can be forceful: Game theory is hard to use and test, it threatens to explain anything, it generates customized models of local settings rather than general regularities, and it offers only part of the advice a manager needs. Nonetheless, game theory could be a fruitful source of ideas and testable implications for strategy, requiring more fine-grained, longitudinal studies sensitive to interactions between structural variables.
The theoretical literature on innovation has been concerned with a single innovation produced by a number of identical agents.
By contrast, we consider a market in which one firm is the current incumbent, while the remaining firms are challengers. Moreover,
we consider a sequence of innovations, so that success does not imply that the successful firm reaps monopoly profits forever
after, but only until the next, better innovation is developed. We begin with a fully optimizing behavioral model and derive
the equivalent of the Schumpeterian “process of creative destruction.” That is, a firm enjoys temporary monopoly power but
is soon overthrown by a more inventive challenger.
The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process…The fundamental
impulse that sets and keeps the capitalist engine in motion comes from the new consumers' goods, the new methods of production
or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates [Schumpeter,
1942, pp. 82–83].
In this article we examine the effect of private information and information externalties on the ex post efficiency of investment in oil exploration. We show that too much drilling tends to occur if firms believe that the area is likely to contain a sizeable pool of oil, and too little drilling occurs if the opposite is true. Bargaining with well-defined property rights to the information externality can eliminate underinvestment, but overinvestment remains a problem because firms have an incentive not to disclose their private information.
We examine a model in which all firms receive common signals as to the uncertain profitability of an investment whose actual payoffs are split only among those who develop the project earliest. The benefit from preempting rivals yields an equilibrium reduction in the amount of learning and earlier development as the number or rivals increases. The set of equilibria shrinks as the number of rivals gets large, and in the limit only the competitive outcome occurs.
This paper studies the strategic interaction among firms in a growing market. It focuses upon the investment decisions of the firms. Central to the analysis is the idea that investment and growth for the firm are constrained by physical and financial factors. Firms that enter early and/or firms that can grow rapidly can make preemptive investments. The paper studies the optimal levels of preemptive investment and the implications for the long-run structure of the market. The analysis of optimal preemption is similar in spirit to the von Stackelberg equilibrium concept in oligopoly theory.
In aggregate, options on real and financial assets can have very different properties. Typically, the good or service produced
by a real asset has a finite elasticity of demand, and developers have finite capacities. Also, the supply of options can
be limited, and developers can be less than perfectly competitive. In a subgame, perfect Nash equilibrium with these properties,
the optimal exercise policy, and resulting values of developed and undeveloped assets are calculated explicitly. The novel
comparative statics are discussed in detail.
This article investigates the interaction between market entry, company foreclosure, and capital structure in a duopoly. We
find that the order in which firms foreclose is determined not only by differences in firm-specific factors, but also by common
economic factors, such as the interest rate and the market profit volatility. We extend the exit model by allowing financially
distressed firms to renegotiate their debt contracts through a one-off debt exchange offer. We find that firms with high bankruptcy
costs or with prospects of profit improvement can get bigger reductions on their debt repayments. Investigating market entry,
we find that financial vulnerability of the incumbent induces earlier entry.
In many real-world situations, agents must formulate option exercise strategies with imperfect information. In such a setting,
agents may infer the private signals of other agents through their observed exercise strategies. The building of an office
building, the drilling of an exploratory oil well, and the commitment of a pharmaceutical company toward the research of a
new drug all convey private information to other market participants. This article develops an equilibrium framework for option
exercise games with asymmetric private information. Many interesting aspects of the patterns of equilibrium exercise are analyzed.
In particular, informational cascades, where agents ignore their private information and jump on the exercise bandwagon, may
arise endogenously.
The authors introduce competition over entry time into a sequential output choice model to show how profit differences will be dissipated. This resolves a problem in the standard Stackelberg model that the order of moves is exogenously specified yet an earlier position in the order is usually preferred to a later one. If capacity costs are not too low, the authors' solution applies even if firms cannot commit to sell their entire output. Introducing positive capacity costs slightly modifies the static Stackelberg results since endogenous cost asymmetries arise. The framework, therefore, partially rehabilitates the Stackelberg model. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.
This article analyzes the optional and strategic features of infrastructure investment. Infrastructure investments generate other investment opportunities, and in so doing change the strategic position of the enterprise. A combination of real options theory and game theory can capture the elusive value of a strategic modification of a firm’s position in its industry. My model focuses in particular on an analysis of European airport expansion. Airports with infrastructures that are less constrained by growth regulations capture more value, because they are in a better position to exercise growth options available in the airport industry.
Discounted cash flow analysis is the most common method for evaluation of investment projects, yet practitioners worry about its shortcomings. In particular, there is concern that standard DCF comparisons may introduce bias against long-term investments. Here, we explore a possible source of such bias in the structure of the uncertainty underlying project cash flows, and the way it is incorporated into project discounting.