2. Options
2.2. Real Options
Options to develop “real asset” for a company is dependent on the choices of busi-ness investment. When the options or choices follow a specific intent or plan, these real options become strategic maneuvers to fulfill a purpose. Although different type of
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purpose maybe to reach a specific position or product portfolio, the end goal boils down to maximizing the timing of business opportunities in the market in order to maximize the earnings.
For a venture capitalist the real option is to decide whether to finance the next stage of a start up. Or a retail chain deciding whether where and how to expand its store.
Or a multinational company to shift operations to a plant to another country, to out-source or to abandon an unprofitable division. Real-options are an integrated part of business development and implementation. Using Real-option offers new insight to how the business development should be planned to how business should be implemented in an uncertain future.
Like its financial market option, real options are more valuable with greater varia-bility. Unlike financial options, real options cannot be traded. For example, investment in R&D cannot be easily traded on the market. Even if the R&D outcome in term of pa-tent can be traded, it has limited liquidity.
Table 1 Real Options practiced in business shows different types of real options and its effect studied by academics. The most notable and basic ones are the option to defer and growth option which allows managers to choose the timing and recognize that option leads other options. It implies that manager “can and do obtain valuable infor-mation after a project is launched, and that their informed actions can make a big
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ference”. (Reach, 2003)
Table 1 Real Options practiced in business1
Thus far real options have been discussed in the context of the business world and business strategy. In general sense, real option resembles human decision behaviors and occurrence in daily life. It is a common expression to keep open options and only decide to exercise these options if events turn out favorable. Intuitively it is understood that
1 (Trigeorgis & Smit, 2004, p. 108~109)
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each option has its cost and the goal is to weight the cost benefit relationship based on the situation in order to maximize the utility.
One common example of real option in real life is going to the movie theater to watch a movie. The movie Titanic received recommendations and praises from critics and spectators. However a person who hasn’t seen the film won’t know if it’s good until he or she purchases the admission ticket and watch the movie. In such case going to see the movie is an option. The exercise cost is the admission ticket (or time spent in the theater) and the value is the entertainment utility.
Another example is going on vacation. A family may have different vacation plans and each with its own cost. These different plans vary from going to the nearby park to travel to another country. The further away the vacation spot is, the greater the chances are the enjoyment of the vacation. There are uncertainty in utility value going out of country but it is precisely this uncertainty which may create a memorable experience.
Despite its long history in commercial and financial market use, option did not be-come a main stream investment tool until early 1970’s. Nobel Laureates Robert Merton and Myron Scholes published in 1973, “The pricing of Options and Corporate Liabili-ties”, putting forth the famous Black-Scholes model. They laid the ground work for op-tions and derivative pricing, thus expanding the scope of opop-tions by considering equity as an “option of the firm”. (Trigeorgis & Smit, 2004, p. 93). Ever since that year,
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tions have developed to become a fundamental part in global capital markets. Real op-tions have developed since then by borrowing the methods from the financial markets.
It gained momentum in 1990s with numerous academic papers and books being pub-lished hailing it as the next evolution of Net Present Value in corporate finance. The re-search has been led by academics like Professor Lenos Trigeorgis (University of Cy-prus), Professors Eduardo Schwartz (from UCLA), Gonzalo Cortazar (from PUC), Michael Brennan, and Avinash Dixit. It has seen exposure in public media like Wall street journal and Harvard Business Reviews. It is even taught in some business school’s MBA curricula.
2.3. Current ROV World Adaption
In 2000, Bain & Company conducted a survey of 451 senior executives across more than 30 industries regarding their use of 25 management tools. Just 9% used real
options, which ranked next to bottom on the list (only market-disruption analysis, a
“new economy” technique, scored lower). And whereas the average defection rate for all
tools in the study was 11%, 32% of real-options users abandoned the technique in 2000.
As for “basic” capital-budgeting tools, net present value (NPV) topped the list at 96%.
(Reach, 2003)
Real Option Valuation (ROV) in practice today is mostly limited to pioneering
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consultants and academics. Academic communities are backing up the support of ROV, notably “real option org”2 which holds annual international conference on real option.
Papers on the applications of ROV have been published on pharmaceutical projects and natural resources mining. Consultants specializing in ROV method provide business modeling, software tools and ROV training courses. Both communities are doing their part to spread the merits of ROV method. However in the eyes of business community Real Options Valuation is a “black box.” The sophisticated mathematics (such as par-tial differenpar-tial equations) of real options, and the consequent lack of transparency and simplicity, are real concerns.
Table 2 Bain Consultant Survey of Top Management Tool3
2 www.realoptions.org
3 (Bain & Company)
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In Table 2 Bain Consultant Survey of Top Management Tool, Real Option Valua-tion is not listed in the past decade. Strategic planning on the other hand has been on top of list and on management’s mind. One of the reasons, for its popularity is manage-ment’s need to address the dynamics of the changing environment. ROV is such a tool despite its lack of recognition.
From the aforementioned obstacles, this paper is proposing to apply ROV based on simple math and strategic planning framework. The real option analysis and valuation method applied in this paper is based on the book, strategic investment: real options and games, by Han T.J Smit and Lenos Trigeorgis.
3. Strategic planning
Strategic planning is the balance between commercialization of cash generating investment and the development of future growth opportunities. A proper balance be-tween current cash and future cash among these is necessary for the long term strategic and financial success of the firm. Companies must often pursue parallel strategies with one focus on today’s capabilities while simultaneously developing new capabilities for the future (Abell, 1999). The balance between the present and future focus partly de-pends on the situation. The future component acquires more importance during volatile periods while the present focus component dominates more in more stable times.
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Traditional product portfolio planning approaches have tried to address this prob-lem through the famous BCG matrix developed in the 1970s. The matrix has two main metrics: short term profitability metric and a growth potential metric. The intent is to find the optimized portfolio of business the company. By placing the product and ser-vices position (star, cow, dog, question mark) within the matrix, the company can make tradeoff decisions between current profitability versus future growth (as in option space).
To consider future growth is to ask a company what market opportunities exist for economizing use of its resources. A firm must identify growth opportunities in market and activities in which its distinctive capabilities are relevant, and then put together complementary resources needed to capitalize on these growth opportunities. Once management understands which of its resources and core capabilities are most important and relevant, it can make the right investments to enhance its competitive advantage.
To understand the nature of competitive advantage is to distinguish between those resources and capabilities that are idiosyncratic to the firm and those that can be readily acquired in the market place. If a particular resource or capability can be bought readily in the market place or is controlled by several competing firms, it is unlikely to be a source of enduring competitive advantage as a competition will erode any above-normal profits (Barney, 1986). The exploitation of such firm-specific resources is considered a
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fundamental determinant of value creation by the firm (Wernerfelt, 1984)
3.1. Competition and strategy
How well a company competes in the market significantly changes the outcome of the intended plan. One particular view on competitive strategy is to employ flexibility and inflexibility in the market. As the competitive environment changes quite frequently, flexibility in strategic investment allows firms to optimize their investment and value creation. A firm should invest in those resources and competences that will give it a dis-tinct advantage given the right favorable market condition.
Inflexibility on the other hand, based on industrial organization economics and game theory shows that strategic commitment can be valuable. When a firm commits itself in an irreversible way to an investment or strategic plan, it can influence the stra-tegic actions of its competitor (through game theory analysis). By consolidating the re-source position and affecting the acquisition cost (exercise price) and the profit stream (underlying value) of the other player, the former can put the competitor in a weaker position.
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4. Strategic planning and Real Op-tion ValuaOp-tion
Companies attempt to manage both positions simultaneously while making a gradual transition to the new position as the old one matures or deteriorates. Option theory can add significant insight to such an adaptive approach as it does not treat the amount, trajectory, and pattern of related outlays in a static way but rather permits peri-odic adjustment and revision of decision depending on market growth and unexpected market development. Option analysis allows for adjustment or switching along various alternative path as the strategy unfolds, making it possible to determine the value (and reap the benefits) of a flexible strategy.
Strategic investments for R&D projects can no longer be looked at as in independ-ent, stand alone project but rather as links in a chain of interrelated project. To get to the intended strategic position the earlier investment are the prerequisite for the one to fol-low after. A pilot venture, a first generation technology, a new drug, or a strategic acqui-sition in a new geographical area may bring additional strategic value to the firm by generating follow-on investment opportunities.
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4.1. Real Option Growth Matrix
The Real Option Growth matrix proposed below embeds the dynamic op-tions-based valuation as part of the two main dimensions of portfolio-planning analysis (like BCG matrix) as presented in Figure 2 Value of Call Option.
The total value creation (expanded NPV) of a project consists of the Net Present Value (NPV) plus the Present Value of the Growth Option (PVGO). The first dimen-sion(base NPV) represented by the horizontal axis captures the value of the stream of earnings or cash flows expected from current operation or existing assets under a steady-state or no-further growth policy.
Figure 1 Real Option Space4
Expanded (strategic) NPV = base NPV + PVGO Equation 1
4 (Trigeorgis & Smit, 2004, p. 77)
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The second dimension represented by the vertical axis is the Present Value of Growth Option (PVGO). It is a measure that incorporates both the volatility and mana-gerial flexibility/adaptability. It involves not just volatility in price or demand from the market but also management’s ability to respond to technological change, competitor’s moves and other unexpected developments.
The location of an investment opportunity is determined by its NPV and its PVGO metrics. Opportunities (projects, business units, or firms) may fall in different regions in option-value spaced based on their current profitability and relative growth option value (PVGO).
The filled circle is the underlying asset value of the project and the unfilled circle is the exercise price. As the project tends to maturity it moves upward and if the plan goes well (with market condition favorable) the project move toward positive NPV space. This is the preferred path of a project’s development.
4.2. Call option valuation
Investing in R&D derives strategic value from generating the opportunity to com-mercialize later under the right circumstances. This is like a call option with a right to buy or sell an asset but implies no obligation to do so. The call option value is deter-mined by finding exercise value in the up state and down state as seen in Figure 2 Value
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of Call Option. Next by deducting the exercise value by exercise cost at each state at the exercise time the underlying value at that point can be obtained. If the resulting call value is positive after deducting the exercise cost then the option should be invested.
Vice versa, if the resulting call value after deducting the exercise price is negative then the option should not be invested.
Figure 2 Value of Call Option
Finally by using the binomial neutral valuation as in
C =
�pC+(1+r)+(1-p)C-�Equation 2 the call option value at time zero can be determined.
C =
[pC++(1−p)C(1+r) −] Equation 2Where,
p =
[(1+r)V−VV+−V− −] Equation 3And,
r = risk free discount rate
Note that if there are no options or other asymmetries, applying this risk-neutral probability p would give the same present value as traditional DCF valuation
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4.3. Project development and Risk
The R&D project process generally can be broken down into three stages: concept study, design verification and implementation and launch. At the concept study stage the company make exploration of different options available in the industry. Company must ask the question does this business opportunity realize its value primarily through direct measureable cash flow or through growth options or strategic values. At the end of the study the company can identify and create reachable option or options of different pro-jects to be realized to generate future cash flow or strategic position.
At the development stages, firm assembles its resources and manpower to develop product from the drawing board to physicality. In this stage the firm faces specific tech-nical or resource allocation uncertainties. In parallel company may and will probably face similar product development competition from rival companies.
At the end of the development, the company faces uncertainties over cash flows primarily from uncertainties in demand, competition or cost of production fluctuation.
Risk in an investment project can be categorized as endogenous and exogenous.
Endogenous risks are firm specific risk. They are the managerial effectiveness in using firm’s asset through firm’s process to create its specific value. These risks are foreseea-ble and controllaforeseea-ble by the firm themselves. The exogenous risks in contrast are
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foreseeable and uncontrollable to the firm. They are the consumer response risks, mar-ket competition risks and macroeconomic risks.
The future cash flow forecast based from primary variable such as the costs of la-bor, material and the price of the products sold are firm specific. The uncertainty pre-sented in the exogenous risks is the main worry managers have to contend with in order to ensure the project meet its intended success. The resolution of (various types of) un-certainty is important for portfolio planning as it determines the relative attractiveness of growth option value and the time-trajectory of the project evolution in option space.
It may be worthwhile to wait and see or to commit to a project depending on the competitive landscape. The timing of exercising the option is the tradeoff between stra-tegic commitment effect and flexibility effect to wait and see. This can be represented by the pay off table in game theory. This is taken competitive strategy and environment in to effect where it is no longer an internal option portfolio optimization.
5. Case Study
Mark has been sitting in front of his laptop for two hours. He has been staring blankly at his screen and feeling lost for the task he has to accomplish. The deadline to present the result of his findings in three days and Mark has to be able to find a way to navigate through market uncertainty and risk for his projects and present justifiable
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course of action to the management team.
Being a project manager in a LCD television consumer electronics manufacturer, he has been trusted by his company with an innovating project that will change the way television is used. Company A is pioneering a new platform that will greatly increase functionality thus making the TV “smart”.
5.1. Smart TV
Company A is LCD TV set maker using Design A to build the new platform TV.
Design A is using a modular design build from existing CPU. Although it’s processing power is very high it lacks all the functionality that would complete the platform. Thus, to complete Design A functionality, it would require additional IC components which increases the overall cost of the Design.
Joining company A is an alliance of other companies in the LCD TV value chain who believe this “smart” TV is the next step of LCD TV technology evolution. With the alliance, Mark is able to assemble a good team of engineers with the right skills and other relevant resources needed to develop the new platform. The daunting task now for Mark is to show that the platform is not only technically feasible but also business fea-sible. He will have to evaluate the value of this project.
From his market and business study, Mark has found that the company’s primary
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market in United States has a TV population of 290 million who own at least one TV and 114.7million household with at least one TV (Nielsen, 2011, p. 2). Couple with that the United States has 192 million broadband owners and 85.9 million household with broad band (Nielsen, 2011, p. 2). The target populations for smart TV are both the TV population and broad band owner.
Overall the market is greatly saturated. Around 30 million of LCD TV was sold in 2010 and the overall forecast would decline for the first time since volume shipments began in 2006. According to market research firm, 83% of people in the US weren't go-ing to buy a new TV in the forthcomgo-ing year; only 13% did plan to. That was worse than earlier in the year, when 66% were saying they wouldn't buy. The reason for low-ered consumer demand is the 2008 economic recession that was still fresh in people’s mind. People wanted HDTV bought one while credit was cheap and don’t need to re-place them (Arthur, 2011). Despite the gloomy market forecast, other analyst believes there is still a great demand due to the recent rise and availability of online streaming video. Consumer wants more video contents and most importantly they want to have the control of the video contents. This mean they want to have the right video contents whenever and wherever they want to watch it. Still, the top priority for LCD TV pur-chasing consideration is the price which then is followed by the features like smart TV.
Still, Price is the determining factor that changes the competitive nature and market
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landscape of LCD TV.
5.2. Product and positioning
The new platform top feature emphasizes on its performance to watch online video
The new platform top feature emphasizes on its performance to watch online video