Taking EMS mobile phone factory (Foxconn and BYD) for example, the manufacturer when they appraisal investment plan, the important consideration are the quantity of delivery, the competitor now and new factory order form price in the future, market’s point of view of up-to-date mobile phone, as well as possibly make the investment strategy in the new market competition change. Obviously, when company incumbent makes certainly fixed produces investment plan, the difference of the demand of products may change the present value of income and the rival’s investment in the future will be the most important challenge.
This thesis is based on the investment decision analysis foundation method and considers the characteristics of investment strategy. Then, the method observes the
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used literatures and past real cases of different industry to prove the practicability of the game theory, and proposes an approach which combines the game theory and real options in the decision analysis. Eventually, this paper utilizes the options-game approach which is the best strategy investment pattern in the EMS industry. The main innovations of this thesis are:
1. This research has established the options-game approach application method in the investment strategy of the EMS industry.
2. This research has analyzed how to distinguish between flexibility value and the strategic value in the investment through the practical application, and how to choose the optimal investment strategy.
In our study, we introduce the purpose and research areas in section 1, and then review previous literature in section 2. Next, we make specific statement about the background of Foxconn and BYD in section 3. In the section 4 and 5, we introduce the methodology and give the numerical result by case application. Finally, we give the conclusion of our study in section 6.
2. Literature Review 2.1 Real Option Model
2.1.1 Introduction
The real option model is a concept comes from the financial options. Financial options are one kind of contract, and it entrusts holder in certain time to purchase or sell specific quantity financial product right using the price which has agreed beforehand. While financial options are written on an underlying financial asset, a real option is based on an underlying real asset. Similar to a financial asset, the future value of the underlying real asset is uncertain. Real option entrusts with the right is also the options to investment or management. If company has real option to act the
value change, chooses the investment plan or management nimbly depend on the basic property in certain deadline.
Black and Seholes (1973) proposed the famous option pricing model, and this model solved the European stock option pricing problem; Cox, Ross and Rubinstein (1979) founded the discrete time binomial option pricing law. These three articles have laid the financial option pricing rationale, and impelled the 20th century finance option to develop enormously.
The concept of option contains limits not merely of the financial derivation tool along with the option theory and the real situation development. Moreover, it has represented one kind of new financial thought, the financial theory and the real option theory. This kind of theory may widely apply in the each aspect of economic life, and smoothed the way for the economic evaluation in many domain applications.
At the end of 1980s to the beginning of the 90's, the real option theory appeared in the domain application and the promotion of enterprise’s investment strategy, and it have represented the West in the aspect of business management breakthrough recently. Myers (1977) for the first time proposed " the real option " concept, and first conducts the profundity research to the option pricing theory in the investment project.
He proposed that DCF-NPV is not suitable for to the investment strategy valuation, since the economic value of the investment strategy is composed completely by two parts: one was (static state, passive) direct cash flow NPV, and the other one was management elasticity and the strategy interaction option value.
2.1.2 Common Corporate Real Options
The real option is one new thinking mode, and it can help enterprise innovate their investment decision with this new method. Facing uncertainty environment challenge, the enterprise policy-makers should adopt positive treatment of the uncertainty of
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investment. In addition to discover any kind of uncertainty factor in the project, and uses these factors to enhance the project value. Specifically, enterprise can use the option to defer, option to growth, option to abandon, option to expend, and other corporate real options to increase project management flexibility and to dodge the risk of investment plan.
Kester (1984) compared some investment strategy with the option who can bring the investment opportunities and create the value in the future, and proposed the investment strategy and the option had similarity; Amram and Kulatilaka (1999) pointed out the real option is one of the thinking who introduced into the interior of the enterprise investment strategy decision-making from the money market rule. It can help the superintendent uses it to mark out plan and manage the investment strategy effectively.
Faulkne (1996): Regarding the valuation of investment strategy, real options method even better. He points out many well-known Japanese enterprises, taking example for EastrnanKedak now is uses the real option method to value at the investment strategy. This method is conducive to expose the neglect option value of DCF-NPV, and has guided the massive capitals to invest in the project correctly. Thus, it impelled the Japanese economy development in bloom. Dixit and Pindyck (1994) and Sharp (1991) employ the idea of real option to analyze firm’s investment strategy.
They were merely carried on the analysis in theirs descriptions from the specific aspect but not involved to the nucleus. They had not been able to reflect the real value in special cases and make the correct investment decision.
Using the theory of real option to make investment strategy has further development and more comprehension. Since the investment strategy usually has many stage, many decision points, more and more scholars regard it as the compound option. At the same time, real option pricing method is no longer limits to
Black-Scholes option pricing model and Cox-Ross-Rubinstein option pricing models.
Instead, it depends on the revision and relaxation of situations which have certain conditions or proposes to set new pricing model.
For example, Kulatilaka (1998) indicated that there are many interactions of real options in an identical investment strategy, and he emphasized it cannot estimate value by itself in the identical investment. Copeland and Antikarow (2001) constructed the multi-stage compound option using Cox-Ross-Rubinstein option pricing models, and appraised multiple period investment plans. Real option pricing model of investment strategy provided the realistic decision method in the economic life.
2.1.3 Real Option Diagnosis Research
Paddock, Siegal and Smith (1988) analyzed the right of rent in an offshore oil field project, and compared the difference between the value of traditional method of DCF and option to defer. Bailey (1991) examined the contingent-claims approach to valuing real assets. Empirical tests using prices of rubber and palm-oil estates and, the real option model differs markedly from conventional discounted-cash-flow models.
Quigg (1993) first examine the empirical predictions of a real option-pricing model using a large sample of market prices.He found empirical support for a model that incorporates the option to wait to develop land. The option model has explanatory power for predicting transactions prices over and above the intrinsic value. Herath et al. (1999) offered that the NPV model is able to account for the sequential nature of decisions involved in an R&D project – the option to wait – without assuming the existence of a market valued security that reflects the project. He find that additional option valuation assumptions to reflect uncertainty bring little analytical advantage and great practical problems. He and Park (1999) also developed a valuation model
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incorporating the risk-free arbitrage features of the binomial option pricing model into a decision framework and applied it to the introduction of a new product: the new Mach III from Gillette. They demonstrated the value of innovation and its impacted on the stock value.
2.2 Game Theory
2.2.1 Introduction
In the game theory proposed by Von Neumann and Morgenstern (1942), they advocated when taking an action, the player should not only consider their own gains, but must also further consider the opponent’s behavior, with its emphasis on a zero-sum game. It describes a situation in which a participant's gain or loss is exactly balanced by the losses or gains of the other participants, yet its application is very limited. It will be inapplicable when the counterparties are acting rationally in a strictly competitive non-zero-sum game.
Until Nash (1950) proposed Nash Equilibrium, showing that in non-zero sum and non-cooperative game, equilibrium must exist. As long as the opponent’s strategy is identified, the competitor will be able to make the optimal response (best response).
When each player has chosen a strategy that they consider as their best response, then the current set of strategy choices and the corresponding payoffs constitute the Nash equilibrium.
Game theory divides into two parts, one is cooperative game, and the other one is non-cooperative game. Cooperative game permits of profits, to some degree, consultations, negotiations, and even collusions between players, but cooperative Game does not allow both players to implement communication and negotiation.
Hence, Non- Cooperative Game more conforms to the industrial competition situation.
For a company, it has to make strategic investment decisions all the time. That is, a
company must deliberate not only the competitor's reactions, but also exponential effects of the competitor’s reactions to company's value, including positive and negative effects.
2.2.2 Game Theory Diagnosis Research
Chuang, Wu and Varaiya (2001) applied a Cournot model to analyze industry investment, market participation, and the reliability of multi-player expansion rather than expansion by a traditional monopolist. Butterfield and Pendegraft (2001) cited game theory and an extension, the theory of moves, are presented as alternative methods of modeling IT investment decisions. This technique specifically considers investments motivated by operating or competitive necessity.
Kaleelazhicathu (2004) considered which game theory is a tool primarily used to solve multi-personal decision problems. Oligopolies like mobile communications industry, with typically 3 to 6 operators, provide ample opportunities to use game theory in solving such problems. His thesis gives an overview of game theory and looks at areas of application within the mobile industry. It also mentions the relevance of game theory in the Mobile Operator Business (MOB) game.
2.3 Real Options and Games
For the early literature about real options, researchers either ignored competitive entry or assumed that it was exogenous. If there is competition, each firm’s payoff is affected by the actions of the other players, and competitive interaction can change the optimal investment criterion. McGahan(1993) explored the tension between competitive pressure to invest and the real option value in an entry opportunity under uncertainty about demand. If an outsider's expectation about buyer valuation makes entry appear less attractive and if an incumbent can keep proprietary its updated information about demand, then it may be able to secure its advantage and partially
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deter imitators without a substantial initial capacity investment. Kulatilaka and Perotti (1998) proposed that in a Cournot duopoly setting the first firm to invest can gain a strategic advantage since market share and the value of early investment increase more with higher demand uncertainty than does the value of waiting. In addition to, they consider a Stackelberg growth option when a firm has a first-mover advantage and also conclude that higher demand uncertainty justifies earlier exercise of the growth option in 1999.Huisman (2001) showed that the new theory of strategic real options can be used to fill the “empty hole”. Based on the work by Smets (1991) standard models are identified, and they are analyzed by applying a method involving symmetric mixed strategies. Finally, they established to what extent investments are delayed when technological progress is anticipated, and it is found that competition can be bad for welfare.
In the real competition environment, game theory reveals the strategic effect adopted by rival companies in the duopoly market. It strengthens real option theory which takes variety of opportunities for investment and management flexibility as options to analyze. Paxson and Pinto (2004) major reported investment plans indicate
“leader-follower” patterns. Using three real competition options models (The options-game approach), they determine the optimal timing of 3G investment of one Portuguese mobile company, Optimus, taken as the follower. Smit and Trigeorgis (2004) synthesize the newest developments in corporate finance and related fields, in particular real options and game theory, to help bridge the gap between traditional corporate finance and strategic planning. They analyzed competitors’ interaction in this game based on the theory of duopoly market and divided competitors’ responses into Strategic Substitute and Complement. Moreover, they illustrate the use of real options valuation and game theory principles to analyze prototypical investment opportunities involving important competitive/strategic decisions under uncertainty in
2006.
The response of competitors to enterprises’ investment strategies is evaluated through the analysis of the options-game approach in order to calculate the profit. The blind spot of real options which derives from neglect of competition in the dynamic market could be amended by means of game theory. Owing to the deficiency of entering limit, it causes competitor situation in distribution of new products, marketing plan and R&D. The decision-making pattern which is proposed in this research will be discussed and be explained through EMS investment competition cases in the section 5.
3. Overview of the EMS Industry
A generalized coordination EMS industry provides the service of entire process manufacture and the wholesale solutions for the international OEM; therefore, the OEM industry can apply the outsourcing strategy on enhance its core competitive power. For example, in the strategic cooperation implemented by Sony Ericsson Corporation and world-wide EMS enterprise Flextronics, Sony used OEM and passed on most of its products to electronics manufactory such as Flextronics, and mainly focused on R&D and marketing. Within years both companies reached to a great success. Similarly, Nokia Corp. used the same strategy with Foxconn and obtained the vast success in global market as well.
3.1 Foxconn Electronic Company
Foxconn is the trade name of the Taiwan based firm Hon Hai Precision Industry Corporation. Foxconn is the largest manufacturer of electronics, and mainly manufactures on contract to other companies. Presently, Foxconn has 40% market share in 2G and 3G mobile phone EMS industry. Although sometimes referred to as the OEM, Foxconn would be more accurately described as the original design
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manufacturer (ODM).
The global wireless communication industry is bloomy development, which attracts ESM industry to invest and to compete intensely. Under such circumstances, Hon Hai has set the Foxconn Precision Component Beijing Corporation in order to obtain the orders from Nokia, this business pursuit consist with of which that of Hon Hai : Hon Hai tends to set the R&D center nearby its major customers or to merge its component factories. Foxconn proceeds to vertical integration to enter the 2G and 3G mobile phone markets, and strives to obtain the orders from the first three international mobile phone corporations (Nokia, Samsung, and Motorola). The M&A strategy is provide to be successful, which is manifested in the fact that the 25% of Nokia’s output and 40% of Motorola’s were mainly taken by Foxconn. For instance, Foxconn not only merged Nokia’s component factory in Finland to successfully strive the orders from Nokia, but also acquired the ODM factory, Chi Mei Communication Systems (CMCS), to improve the quality of its product research and development since CMCS has a strong team in designing. Nevertheless, due to decrease of Motorola and increase of Samsung and LG, Foxconn in 2007 turned its goal orders to Korea mobile phone corporations.
3.2 BYD Electronic Company
BYD Electronic, the subsidiary of BYD Company Limited, is engaged in the manufacture and sales of mobile phone components, mobile phone modules and assembly services to mobile phone manufacturers. Presently, BYD has 10% market share in 2G and 3G mobile phone EMS industry. One of its customers is Nokia, which is the world’s leading mobile phone supplier.
In 2003, BYD followed Foxconn’s “the reversion of vertically integrated strategy” and started to enter the EMS industry. Due to the growing demands on
mobile phones in the global market, the mobile manufacturers have been moved to Asia and other new markets as Russia, Brazil, Mexico and Eastern Europe. Besides, the companies famous for designing mobile phones (such as Nokia, Motorola, Samsung, LG and SonyEricsson) have adopted the outsourcing strategy. They tended to choose the suppliers who pursue a vertical integrated goal and provided manufacturing/service platforms for global use as their cooperative partners.
Therefore, BYD, proceeding as vertically integrated, started to offer mobile phone assembly service for Nokia and Motorola. In 2006, BYD firmly established their roles as “component suppliers of one-stop mobile phone” in the international market. After that, BYD further advanced the ability of product design and its production capacity to provide high-end products. It expanded new production facilities at Huizhou in Guangdong Province (China), Chennai (India), Komarno (Hungary), and Cluj (Romania) in order to make a platform for globalization production. At present, its assembly services for mobile phone modules have included the manufacturing of battery, keyboards, and cell phone components. Hence, BYD has obtained the authorization to assembling mobile phone.
4. Methodology
This section 4.1 and 4.2 follows Smit (2003) and then we use decision tree to describe the expansion of EMS industry. Afterwards, we evaluate the value of real option by the present value of growth opportunities (PVGO) approach, and use the decision tree which integrates game theory to be the target of this paper analysis.
4.1 Competitive Strategies Depending on Type of Investment and Nature of Competitive Reaction
Before the development of game theory, it is generally believed that the company may neglect the influence of strategies on the competitors’ responses in perfect
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competition or the monopoly market, which is not true under duopoly market. Game theory is the method to understanding how interactions of decision making happen.
Fudenberg and Tirole (1984) presented that the outcomes of many strategic interactions in industrial organizations can be predicted by using the basic framework of strategic effects in simple two-period model, in which the interactions between company and its rival’s influence on the investment decision ware analyzed. The response of competitor investment is faced by two affects (See Table 4.1):
(1)Nature of competitive reactions: Contrarian or Reciprocating
(2)Competitive strategies on type of investment: Tough or Accommodating
Specifically, a competitor’s response to a strategic investment decision is likely to depend on two dimensions: the type of competitive actions－strategic substitutes or complements－and whether the strategic investment is tough or accommodating.
Table 4.1
Competitive Strategies Depending on Type of Investment and Nature of Competitive Reaction
Contrarian
Source: Smit and Trigeorgis (2004) pp. 232
4.1.1 Strategic Substitutes versus Strategic Complements
Strategic Substitutes (Quantity Competition) or Strategic Complements (Price Competition) has an essential difference: (1) Strategic Substitutes is the competition
type where a competitor’s response to a strategic investment decision is using quantity
type where a competitor’s response to a strategic investment decision is using quantity