Section 2 Literature Reviews
2.4 Options Game
For a project with uncertainty, managers can make a good decision by using the real options approach considering the flexibility of a project. Meanwhile, managers also have to deliberate competitors’ behaviors, so game theory is involved. TABLE 2.4 shows the related literatures of successive stages of analysis for the options game methodology, and the table clarifies between the one-stage and two-stage investment
problems and their varieties.
(TABLE 2.4 is about here)
Kulatilaka and Perotti (1998) pointed out that a company would gain more market shares when it had more strategic investment of growth options. Cottrell and Sick (2001) indicated that an enterprise would own the first mover advantages when the enterprise was the first investor of a field, and the investment project would generate the convenience value. They also stated how a follower might gain more profits by using the right of wait and see.
Isik et al. (2003) found that a project decision of a company was influenced by costs, market demand, and competitiors’ uncertainty through using the options game method. Furthermore, Murto (2004) found out the best timing for abandoning in a declining duopoly market by the same method. Smit and Trigeorgis (2006) also derived the best R&D strategy for consumer electronic products, telecommunications, and pharmacy industries.
TABLE 2.1
Merits and Drawbacks of the Six Traditional Investment Methodologies
Investment Model Merits Drawbacks
Net Present Value (NPV method)
1.It is easy to calculate
2.It considers all cash flows and time value of money
3.Value can be added
4.The highest-value project can be chosen from many exclusive projects
It is hard to decide an appropriate discount rate
Internal Rate of Return (IRR method)
1.It considers all cash flows and time value of money
2.It obtains an implied rate of return
1.NPV and IRR may cause different results in the same project
2.It may result in multiple real or imaginary roots
3.It is not suitable for exclusive investment projects
Accounting Rate of Return (ARR method)
1.It is easy to decide a proper investment project
2.It considers all cash flows
1.It does not deliberate time value of money and cash flows of whole periods
2.The critical point of whether to invest is subjective rather than objective
Payback Period (PB method)
1.It is easy to calculate
2.It considers the liquidity of projects
1.It ignores the cash flows which come after payback periods
2.It is not suitable for long-term periods projects
3. Time value of money is not included Discounted Payback
Period (DPB method)
1.It is easy to calculate 2.The liquidity of projects is
considered
3. Time value of money is contained
1.It ignores the cash flows which come after payback periods
2.It is not suitable for long-term periods projects
3. Time value of money is not included Profitability Index
(PI method)
It is often collocated with IRR to evaluate a project
Sometimes it has different results with NVP
Source: Lin (1990)
TABLE 2.2
Definitions of Important Variables between Real Options and Financial Options
Call option Variable Project
Stock price
V
Present value of expected cash flows Exercise priceI
Present value of investment outlays Time to maturityT
Length of deferral timeRisk-free rate
r
Time value of moneyVariance of stock returns
σ
2 Volatility of project’s returns Source: Smit and Trigeorgis (2004), p. 12TABLE 2.3
Common Corporate Real Options
Type of option Relevant Research Description
Option to defer (simple option)
McDonald and Siegel (1986); Paddock, Siegel and Smith (1988); Ingersoll and Ross (1992)
Management holds a lease on (or the option to buy) valuable land or natural resources. It can wait to see if output prices justify constructing a building or plant, or developing a field.
Growth Option (compound option)
Trigeorgis (1988); Pindyck (1987); Chung and
Charoenwong (1991);
Smit (1996)
An early investment (e.g., R&D investment) or a strategic investment is a prerequisite or a link in a chain of interrelated projects, opening up future growth opportunities (e.g., a new generation product or process).
Option to abandon
Kemna (1988); Myers and Majd (1990)
If market conditions decline severely, management can abandon current operations permanently and realize on secondary markets the resale value of capital
equipment and other assets.
Option to expand
If market demand turns out to be more favorable than expected, management may increase capacity or accelerate resource utilization. Management may also extend production if the life of the project is longer than expected. Conversely, management may reduce the scale of operations.
Option to temporarily shut down
Bernnan and Schwartz (1985)
If operations are less favorable than expected, management may temporarily halt and then start up again.
Option to switch
Kulatilaka (1988 and 1995); Aggarwal (1991);
Kogut and Kulatilaka (1994); Kamrad and Ernst (1995)
If prices or demand changes, management may change the project mix of the facility (“product flexibility”).
Alternatively, the same outputs can be produced by different projection processes or inputs (“process flexibility”).
Source: Trigeorgis (1996)
TABLE 2.4
Successive Stages of Analysis for Real Options Game
Type of option game Relevant Research Problems Description Implication One-stage games proprietary options to invest.
Incentive to delay
Dixit 1979, 1980; Spence 1977, 1979; Kester 1984;
Baldwin 1987; Trigeorgis 1988; Ghemawat and del Sol 1998; McGahan 1993; Smit and Ankum 1993
When shared opportunities face a competitive loss, a game-theoretic treatment becomes necessary.
Timing is a tradeoff between flexibility value and commitment.
Two-stage games with no competition
McGrath 1997; Bettis and Hitt 1995; Bowman and Hurry 1993
Investment in growth options; for instance, the analysis of R&D
opportunities to acquire a proprietary option to proceed with the commercialization investment in the stage 2
Negative NPV of the first stage can be justified for its growth option value
Two-stage games Lim 1985; Daughety and Reinganum 1990;
Spencer and Brander 1992; Kulatilaka and Perotti 1998
R&D strategy of the stage 1 faces (endogenous) the nature of competitive reaction the stage 1 influences the value of stage 2
Trade-off between cooperation and competition Competition vs.
cooperation in stage 1 (joint R&D ventures)
Kogut 1991 The value of stage 2 is affected by the cooperation competition of stage 1
Evolution of cooperation in technology intensive industries
Source: Smit and Trigeorgis (2004), p. 220