Strategic Investment – Real Options and Games - Hardcover

Smit, Han T. J.; Trigeorgis, Lenos

Hardcover

ISBN 10: 0691010390 ISBN 13: 9780691010397

Publisher: Princeton University Press, 2004

Synopsis

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.

About this title

About the Author

Han T. J. Smit is HAL Professor of Private Equity at Erasmus University in Rotterdam. Lenos Trigeorgis has been the Bank of Cyprus Chair Professor of Finance at the University of Cyprus and Visiting Professor of Finance at the University of Chicago. His book "Real Options" is a classic in the field.

From the Back Cover

"Strategic Investment: Real Options and Games provides a powerful synthesis of modern corporate finance and corporate strategy. Its arrival could not be more timely for the practice of strategic management. Cumulative developments in finance science and innovations in financial technology over the past three decades have had a profound impact on financial markets and financial institutions globally. However, their influence on the practice of strategic corporate finance has been far more limited. That is changing and as a consequence one can anticipate significant opportunities for innovation in strategic advice and its implementation in the impending future. Who better to prepare us for it than Han Smit and Lenos Trigeorgis, with their combined experiences as serious academic researchers, skilled consultants, and seasoned teachers? Their carefully constructed text uses actual case settings and hypothetical situations to exemplify the power of combining real options and game theory to clarify and quantify strategic analysis of the firm. Whether MBA student or seasoned professional, the reader is in for a treat: Bon Appetit!"--Robert C. Merton, Harvard Business School and Nobel Laureate in Economic Sciences

"This excellent book builds bridges across two dimensions. First, it synthesizes the real options approach to capital investment and game-theoretic analysis of strategic interactions. Second, it spans sophisticated theory and business practice. Academics as well as business managers can learn from it and enjoy its wonderfully clear exposition."---Avinash Dixit, author of Lawlessness and Economics

"A tour de force. This book unifies two major strands of economic theory--real options and games--into a single, coherent framework, and then shows how these ideas can be applied to the formulation of corporate strategy. With deep knowledge, enlivened by zest and humor, the authors take the reader to the forefront of current thinking."--Carliss Y. Baldwin, William L. White Professor of Business Administration, Harvard Business School, coauthor of Design Rules: The Power of Modularity

"In the study of investment decisions, it has been common to focus on either the financial or the strategic aspects of an investment. This admirable book combines the two perspectives, using the tools of real options and game theory. With its wide-ranging and eclectic assortment of theoretical models and case studies, the book will prove useful to students, practitioners, and researchers."--Robert L. McDonald, Erwin P. Nemmers Distinguished Professor of Finance, Kellogg School of Management, Northwestern University, author of Derivatives Markets

"This book promises to have a very significant impact on the field of strategic management. For years, the field has struggled to find a way of reconciling two contradictory views: flexibility is good vs. commitment is good. Smit and Trigeorgis provide the framework and tools to evaluate when each strategy will create shareholder value. Very well written, the book provides a wealth of interesting examples. It will certainly be of interest to the strategy/investment analyst and MBA student."--Karel Cool, BP Chaired Professor of European Competitiveness, INSEAD

"This timely pioneering book by preeminent authorities in the field provides a powerful introduction to the combination of two important modern tools for investment decisions--real options and game theory. These tools are being increasingly used by consultants and firms. Smit and Trigeorgis show that it is possible to be straightforward and clear when analyzing real investments and framing business plans using sophisticated tools like real options and games. They bypass complexity and focus on intuition and applicability, providing a rich practical framework allowing the reader to analyze investment strategy with eagle-eyed wisdom. Even the most rigorous reader will recognize the power of simplicity in analyzing complex business problems and the richness of the case applications. It is the ideal text not only for undergraduate and MBA students but also for consultants and managers, who will finally get the first readable book on this topic."--Marco A.G. Dias, Petrobras

Excerpt. © Reprinted by permission. All rights reserved.

Strategic Investment

Real Options and GamesBy Han T.J. Smit Lenos Trigeorgis

PRINCETON UNIVERSITY PRESS

Copyright © 2004 Han T.J. Smit and Lenos Trigeorgis
All right reserved.
ISBN: 978-0-691-01039-7

Contents

List of Figures...................................................................................................................................................xiList of Tables....................................................................................................................................................xviiList of Boxes.....................................................................................................................................................xixAcknowledgments...................................................................................................................................................xxiIntroduction: Strategic Investment as Real Options and Games......................................................................................................xxiiiI.1. Introduction: About This Book................................................................................................................................xxiiiI.2. Real Options and Games: Linking Corporate Finance and Strategy...............................................................................................xxivI.3. An Overview of the Book......................................................................................................................................xxviiiChapter 1 Corporate Finance and Strategic Planning: A Linkage....................................................................................................31.1. Introduction.................................................................................................................................................31.2. The Market Value of Growth Opportunities.....................................................................................................................51.3. From NPV to an Expanded (Strategic) NPV Criterion............................................................................................................81.4. Value Drivers of NPV, Flexibility Value, and Strategic Value.................................................................................................131.5. Value Creation in Strategic Planning.........................................................................................................................321.6. Conclusions..................................................................................................................................................33Chapter 2 Strategic Management: Competitive Advantage and Value Creation.........................................................................................352.1. Introduction.................................................................................................................................................352.2. Views of Value Creation of the Firm..........................................................................................................................382.3. Competitive Advantage and Industry Evolution.................................................................................................................532.4. Portfolio Planning of Growth Opportunities...................................................................................................................682.5. Conclusions..................................................................................................................................................90Chapter 3 Corporate Real Options.................................................................................................................................933.1. Introduction.................................................................................................................................................933.2. Options Valuation............................................................................................................................................943.3. Overview of Common Real Options..............................................................................................................................1063.4. Prototype Examples: Valuing an R & D Program and a Mining Concession.........................................................................................1233.5. An In-Depth Case Application: Valuing Offshore Oil Concessions in the Netherlands............................................................................1343.6. Summary and Conclusions......................................................................................................................................154Appendix 3.1. Binomial Option Valuation...........................................................................................................................156Chapter 4 Games and Strategic Decisions..........................................................................................................................1634.1. Introduction.................................................................................................................................................1634.2. The Rules of the Game........................................................................................................................................1714.3. A Taxonomy of Basic Games....................................................................................................................................1814.4. Competitive Reactions in Quantity versus Price Competition...................................................................................................1914.5. Two-Stage Games: Strategic Value of Early Commitment.........................................................................................................2024.6. Summary and Conclusions......................................................................................................................................208Appendix 4.1. A Chronology of Game Theory Developments............................................................................................................210Chapter 5 Simple Strategic Investment Games......................................................................................................................2175.1. Introduction.................................................................................................................................................2175.2. A Road Map for Analyzing Competitive Strategies..............................................................................................................2185.3. One-Stage Strategic Investments..............................................................................................................................2225.4. Two-Stage (Compound) Options: The Case of Proprietary R & D..................................................................................................2265.5. Two-Stage Investments with Endogenous Competition............................................................................................................2295.6. Cooperation in the First Stage: Joint R & D Ventures.........................................................................................................2475.7. Summary and Conclusions......................................................................................................................................251Chapter 6 Flexibility and Commitment.............................................................................................................................2556.1. Introduction.................................................................................................................................................2556.2. The Basic Two-Stage Game.....................................................................................................................................2586.3. Numerical Examples of Different Competitive Strategies under Contrarian versus Reciprocating Competition.....................................................2686.4. Summary and Conclusions......................................................................................................................................285Appendix 6.1. Reaction Functions, Equilibrium Actions, and Values in Different Market Structures under Quantity or Price Competition.....................289Chapter 7 Value Dynamics in Competitive R & D Strategies.........................................................................................................2957.1. Introduction.................................................................................................................................................2957.2. Literature on R & D Options..................................................................................................................................2967.3. The Basic Two-Stage R & D Game...............................................................................................................................2987.4. Critical Demand Zones/Sensitivity............................................................................................................................3007.5. Technical R & D Uncertainty, Stochastic Reaction Functions, and Asymmetric Information with Signaling........................................................3097.6. Learning Experience Cost Effects.............................................................................................................................3157.7 Competition versus Cooperation in R & D......................................................................................................................3197.8 Summary and Conclusions......................................................................................................................................322Chapter 8 Case Applications......................................................................................................................................3298.1. Introduction.................................................................................................................................................3298.2. Strategic Games in Consumer Electronics......................................................................................................................3468.3. Buy-and-Build Platform Acquisition Strategies................................................................................................................3528.4. Infrastructure Investment: The Case of European Airport Expansion............................................................................................3668.5. Conclusions and Implications.................................................................................................................................389Chapter 9 Continuous-Time Models and Applications................................................................................................................3939.1. Introduction and Overview....................................................................................................................................3939.2. Continuous-Time Version of Smit-Trigeorgis Framework.........................................................................................................3969.3. Strategic Investment Timing under Uncertainty................................................................................................................4089.4. Exercise Strategies under Incomplete Information with Applications...........................................................................................4149.5. General Equilibrium Investment Strategies under Imperfect Competition and Asymmetric Information.............................................................4199.6. Conclusions..................................................................................................................................................423Appendix 9.1. Derivation of Option-Pricing Differential Equation..................................................................................................425Appendix 9.2. Discounted Profit Flow and Value Function...........................................................................................................427Appendix 9.3. Sequential Stackelberg Leader-Follower Entry........................................................................................................428Chapter 10 Overview and Implications.............................................................................................................................42910.1. Introduction................................................................................................................................................42910.2. Implications of the Strategic Options and Games Framework...................................................................................................43910.3. Empirical Implications......................................................................................................................................445References........................................................................................................................................................447Index.............................................................................................................................................................461

Chapter One

Corporate Finance and Strategic Planning: A Linkage

Life can be understood backward, but ... it must be lived forward. - Soren Kierkegaard (1813-1855)

1.1. Introduction

This chapter takes a first step toward closing the gap between traditional corporate finance theory and strategic planning. To put issues in a broad perspective, figure 1.1 summarizes three approaches to strategic planning and their impact on the market value of the firm. This conceptual framework aligns the design of an investment strategy with the value of the firm. Consider the various sources of economic or market value a firm can create. As shown in the left-hand column, the market value of a firm is not completely captured by the expected cash flow generated by the tangible assets that are currently in place (measured by NPV). Stock market prices partly reflect a firm's strategic growth potential. This value derives from investment opportunities that the firm may undertake in the future under the right circumstances, and is sensitive to competitive moves. The strategic option value of a firm can be vulnerable not just to the actions of incumbents, but also to the unanticipated entry of new rivals with entirely new technologies that can modify the competitive landscape in which the firm operates.

Investment appraisal methods should capture the components of flexibility and strategic value, as they may contribute significantly to the firm's market value in an uncertain competitive environment. The flexibility and strategic considerations of importance to practicing managers can now be brought into a rigorous analysis in a fashion consistent with the tenets of modern finance and the maximization of shareholder value. The right-hand column in figure 1.1 shows the valuation approach based on insights from real options and game theory, which captures additional flexibility and strategic value not measured by cash flow benefits per se. This approach considers growth opportunities to be a package of corporate real options that is actively managed by the firm and may be affected by competitors actions and by new technologies. If a firm's investment decisions are contingent upon and sensitive to competitors' moves, a game-theoretic treatment can be helpful. Competitive strategies should be analyzed using a combination of option valuation and game-theoretic industrial organization principles, as the two may interact.

To link corporate strategy with the value creation of the firm, one should identify the investment opportunity's value drivers. These value drivers provide an interface between the quantitative project valuation methodology and the qualitative strategic thinking process, focusing on the sources of value creation in strategic planning. The second column in figure 1.1 suggests that to understand total strategic value creation, one must examine, not only the traditional value drivers that focus on why a particular investment is more valuable for a company than for its competitors, but also the important value drivers for capitalizing on the firm's future growth opportunities, and how strategic moves can appropriate the benefits of those growth opportunities, as well as limiting risk if unfavorable developments occur.

This broader framework provides deeper insights for competitive strategic planning. As the strategies of firms in a dynamic, high-tech environment confirm, adaptability is essential in capitalizing on future investment opportunities and in responding appropriately to competitive moves. Adapting to, or creating, changes in the industry or in technology is crucial for success in dynamic industries.

The rest of this chapter is organized as suggested by the columns of figure 1.1. Starting from the left with shareholders' (market) value, and the components of this value observed from stock prices in financial markets, we reason back to the origins of this value in the real (product) markets and to corporate strategy. The market value components are discussed in section 1.2. Section 1.3 reviews the relevant valuation approaches, and the need for an expanded NPV criterion. Games are used to capture important competitive aspects of the strategy in a competitive environment. The value drivers of NPV, flexibility value, and strategic value, are discussed in section 1.4, relating the qualitative nature of competitive advantage and corporate strategy with quantifiable value creation measures for the firm. Section 1.5 discusses the options and games approach to capturing value creation in corporate strategy.

1.2. The Market Value of Growth Opportunities

In a dynamic environment, strategic adaptability is essential in capitalizing on favorable future investment opportunities or responding appropriately to competitive moves. A firm's growth opportunities and its strategic position in the industry are eventually reflected in stock market prices. Of course, not all stocks generate the same earnings stream or have the same growth potential. Growth stocks (e.g., in biotech, pharmaceuticals, or information technology) typically yield high price-earnings and market-to-book ratios. In fact, it is precisely the intangible and strategic value of their growth opportunities that determines most of the market value of high-tech firms in a continuously changing environment. As box 1.1 suggests, a proper analysis of this strategic growth option value is more difficult than price-earnings ratios or other multiples might imply. An underlying theory that can explain this market valuation is now available if we consider the strategic option characteristics of a firm's growth opportunities. There is indeed a clear appreciation in the market for a firm's bundle of corporate real options (present value of growth opportunities, or PVGO).

Table 1.1 shows that industries with higher volatility and (market, firm-specific, or total) risk (and as we will see, more option value) - such as information technology, pharmaceuticals, and consumer electronics - tend to have more valuable growth opportunities and a higher proportion of PVGO to price on average (above 80%) than other industries - such as transportation, chemicals, and electric power (below 60%). The former industries involve more unexpected technological changes and competitive moves; as the firm's (or the industry's) dynamic path unfolds, management must be better prepared to learn, adapt, and revise future investment decisions. The market appropriately rewards with higher market valuations those firms better able to cope with change, capitalizing on the upside potential while mitigating downside risk.

Growth firms (e.g., leading firms in information technology, pharmaceuticals, and consumer electronics) tend to have a higher option value component (PVGO) than income stocks, for two reasons. First, they tend to operate in more volatile industries (characterized by more frequent technological innovations and a more intensely competitive environment), with the higher underlying volatility being translated into higher (simple) option value. Second, they tend to have a greater proportion of compound (multistage or growth) options as opposed to simple (cash-generating) options, which amplifies their option value (being options on options). This higher (growth) option value, in turn, is translated into higher market valuations, which may appear excessive from the perspective of standard DCF valuation methods.

Figure 1.2 shows competitive strategies and relative market (price) performance over a two-year period in various high-tech industries. Panel A shows Microsoft's strategic moves and superior market performance in comparison to Netscape and other computer software rivals; panel B shows superior market performance by Intel and Sun Microsystems in comparison to IBM, Hewlett-Packard, and other computer hardware rivals; panel C shows Texas Instruments and Philips' performance relative to Sony, Time Warner, Matsushita, and other rivals in consumer electronics. We later provide specific examples of intelligent strategic decisions made by some of these leading companies.

1.3. From NPV to an Expanded (Strategic) NPV Criterion

In corporate finance, value creation for the firm's shareholders is the accepted criterion for making investment decisions or selecting business alternatives. A standard assumption is that financial markets are efficient and that the prices of all traded securities adjust rapidly to reflect relevant new information. When unanticipated information about a firm's investment opportunities or profits comes out in the financial markets, investors bid prices up or down until the expected return equals the return on investments with comparable risk. Under the assumption of a perfectly competitive financial market, all investors will apply the same risk-adjusted required return to discount the expected cash flows in valuing a particular asset. Standard valuation methodologies, such as NPV, aim at selecting investments that, to create value for existing shareholders, yield an expected return in excess of the return required in financial markets from assets of comparable risk.

Consider an investment opportunity in competitive real (product) markets characterized by costless entry and exit and homogeneous products. Early investment in such a project can produce only a temporary excess return. Competitors will eventually enter the industry and catch up. In the long run, equilibrium rates of return in competitive industries should be driven down to required returns. Most real markets, however, have significant entry barriers and are less competitive. In such imperfect real markets, it is possible for a firm to consistently earn excess returns that exceed the risk-adjusted return or the opportunity cost of capital. Firms can only earn excess returns because of some competitive advantage, such as achieving lower costs (e.g., as a result of absolute cost advantage or economies of scale) or earning a premium in product prices (e.g., as a result of product differentiation or monopoly power; see Porter 1980 and Shapiro 1991). Firms may also achieve higher returns because of more creative management, adaptive strategic planning, or organizational capabilities that enable it to better adapt to changes in the environment and to competitive moves.

In a DCF valuation, the project's expected cash flows, E(C[F.sub.t]) over a prespecified life (T) are discounted at a risk-adjusted discount rate k (derived from the prices of a twin traded security in the same risk class, typically from the Captial Asset Pricing Model, or CAPM) to arrive at the project's value [V.sub.0], that is,

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. (1.1)

The net present value (NPV) is the above gross present value of discounted cash flows, [V.sub.0], minus the present value of the necessary investment cost outlay, [I.sub.0]. If positive, it represents the value creation for the shareholders undertaking this project.

With a standard NPV analysis, it is not practical to capture the full value of an investment strategy that involves real options. The NPV method implicitly assumes precommitment to future plans and defines an investment decision as a "now or never" proposition; it does not properly take into account the value of a wait-and-see strategy to make decisions as the value of the project evolves and uncertainty is revealed. Consider, for example, capacity expansion in the steel industry (see Dixit and Pindyck 1994, 8). If steel prices fall and the project turns out to be a bad investment, it may not be possible to recover the investment cost by selling the plant to another steel company (i.e., the investment may be irreversible). Such an irreversible decision should be made with caution, and flexibility in the timing of the investment becomes important. Managers should not invest immediately in such a project if they expect to earn just the opportunity cost of capital. In fact, timing flexibility in an uncertain environment gives management an incentive to wait until the project is more clearly successful, requiring a premium over the zero-NPV cutoff value, equal to the option value of deferment. This option value is analogous to an insurance premium because waiting may avoid the mistake of investing prematurely.

In fact, the opportunity to invest in a project is analogous to having a call option. Figure 1.3 illustrates this analogy. A call option gives its holder the right, by paying a specified cost within a given period, to exercise the option and acquire the underlying asset. If there are no opportunity costs of waiting or dividend-like benefits to holding the asset, the holder will postpone the decision to exercise until the expiration date (t). In the real-option case, the underlying asset is the present value of the cash flows from the completed and operating project, [V.sub.t], while the exercise price is the necessary investment outlay (at time t), [I.sub.t]. The ability to defer a project with an uncertain value, [V.sub.t], creates valuable managerial flexibility. If, during the later stage, market demand develops favorably and [V.sub.t] > [I.sub.t], the firm can make the investment and obtain the project's net present value at that time, NP[V.sub.t] = [V.sub.t] - [I.sub.t]. If, however, the project value turns out to be lower than originally expected ([V.sub.t] < [I.sub.t]), management can decide not to make the investment and its value is truncated at zero. In this case, the firm only loses what it has spent to obtain the option. The curve in figure 1.3 illustrates the current value of the option characterized by this truncated payoff. The value represented by this curve can be divided in two components, the static NPV of cash inflows and the timing flexibility component of value. The latter captures the premium over the zero-NPV threshold, representing the option value of deferment. This premium is generally lower if other options (besides the expected cash flows) may be generated from the project.

Investment decisions should thus be based on an expanded NPV criterion that incorporates, along with the direct NPV of expected cash flows from an immediate investment, the flexibility value of the combined options embedded in the project. That is,

Expanded NPV = passive NPV + flexibility (or option) value. (1.2)

An important next step in bridging the gap between traditional corporate finance theory and strategic planning is combining this real-options approach with game theory, taking into account competitive counteractions. For instance, the commercialization decision of Digital's Alpha chip was in fact greatly influenced by Intel's decisions regarding its Pentium processor; similarly, Philips' and Sony's strategy to commercialize the digital video disc was affected by competitive decisions by Toshiba and Time Warner, and vice versa. These decisions are better seen as strategic games against both nature and competition. Management's investment decisions are made with the explicit recognition that they may influence competitive reaction, which in turn impacts the value of the firm's investment opportunity.

The strategic value of early commitment in influencing competitive behavior must therefore be offset by the flexibility or option value of waiting. In the expanded or strategic NPV framework, investment has two main effects on a firm's value compared to a wait-and-see strategy: (1) A flexibility or option-value effect. This reflects management's ability to wait to invest under uncertain conditions. Early investment, although enhancing the commitment value of future growth opportunities, sacrifices flexibility value compared to a wait-and-see strategy. (2) A strategic commitment effect. Early investment can signal a credible commitment that can influence competitors' investment decisions. In part II of this book we illustrate how to quantify these value components when determining the expanded NPV for various (R & D) investment strategies. Box 1.2 provides a simple numerical example of an option game.

(Continues...)

Excerpted from Strategic Investmentby Han T.J. Smit Lenos Trigeorgis Copyright © 2004 by Han T.J. Smit and Lenos Trigeorgis. Excerpted by permission.
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Edition details

• Publisher: Princeton University Press
• Publication date: 2004
• ISBN 10: 0691010390
• ISBN 13: 9780691010397
• Binding: Hardcover
• Language: English
• Number of pages: 504