Real Options Approach and Game Theory

Real options analysis is one of the most appropriate methods for assessing the investments in VC firms involving uncertainty. Real options approach (ROA) provides some new insights with respect to the role and impact of uncertainty on investment value that runs counter to conventional thinking. Merton (1973) showed that investment was of higher option value in a more uncertain market because of the flexibility of the investment decision. When assessing the value of an investment project, apart from expected future net cash inflow, the assessment should include the management flexibility value implied by the uncertainty of the investment environment. This included the probability that managers will receive new information, have latitude for management flexibility, and the ability of decision-makers to respond to new information, etc. (Copeland and Antikarov, 2001). Clemons and Gu (2003) presented a partial information technology investment as an strategy option to preserve flexibility and to speed up subsequent choices, and saw completing the future contingent investments as exercising the strategic options created by initial investments. Taudes et al. (2000) implied that the value of information technology investment could be defined as the sum of economic value and option value. Cucchiella et al. (2010) explored the ROA help the manager to consider the manufacturing flexibility and, as a consequence, to improve firm performances. Fig.2 showed the managerial flexibility value (Copeland and Antikarov, 2001).

Fig. 2 Managerial flexibility value Source: Copeland et al. (2000).

Real options are the right, but not obligation, to take an action, include deferring, expanding, contracting, or abandoning. The value of real options depends on six basic variables (Copeland and Antikarov, 2001). These six variables are illustrated in Fig. 3.

Fig. 3 Six variables that drive the real options analysis value Source: Copeland et al. (2000).

The traditional approach is to make investment decisions based on net present value. This assumes the existence of a static investment environment and takes only net cash flows into consideration. However, it is very important to analyze a dynamic investment environment in order to devise a flexible investment strategy to cope with future uncertainties in the investment environment. For that reason, the ROA has rapidly gained popularity as an investment decision method. The investment decisions based on the ROA emphasize the value of flexible

management and options ( Dixit and Pindyck, 1994). With regard to the management strategies of firms investing in uncertain environments, many such firms apply real options analysis (Chi, 2000; Reure and Leiblein, 2000), because of its ability to flexibly adjust investment strategies as new information is received.

In the recent years, scholars have stressed that the influence of decisions from competitors is also an important factor affecting the value of flexible management. Kulatilaka and Perotti (1998) suggested that when competitors appeared in the market, waiting to invest means forfeiting the first-mover advantage. Enterprises consequently cannot adopt a waiting strategy solely in view of market uncertainty and must take competitors into consideration when drafting investment strategies. As a result, the assessment of an investment case must therefore combine real options analysis with game theory. In a highly uncertain and complex investment environment, managers’

investment decision-making must employ a dynamic decision-making analysis model, and the real options approach was more capable to respond to complex investment environments than the traditional net present value method (Myers, 1977; Dixit and Pindyck, 1994). In addition, corporate strategies must be taken into consideration in order to further rationalize the expected results of analysis. Smit and Trigeorgis (2006) pointed out that strategic investment projects should be based on an expanded (or strategic) net present value (NPV) criterion that incorporated not only the passive (or direct) NPV of expected cash flows from investing immediately and the flexibility value from active management (real options), but also the strategic (game theory) value from competitive interactions. Smit and Ankum (1993) applied the game options principle as an analytical tool to evaluate a project’s value and support the overall operating and investment strategy. Smit (2003) showed that the game options approach could make a more complete assessment of a strategic option value in an interactive competitive setting. Miller and Waller

(2003) pointed out that project planning was an important decision management tool and encouraged managers to utilize real options to process investment evaluation under future uncertain conditions and to explore how to use the opportunity to evade potential threats. Yeo and Qiu (2003) suggested utilizing the ROA to allow for a more feasible judgment in making investment decisions.

Aloysius (2002) introduced the concept that the most suitable investment decision for investors involved cooperation via symmetrical information in the duopoly market. The advantage for competitor is that cooperation will not be the most appropriate approach. Kong and Kwok (2007) applied real options and game theory to analyze the oligopoly market. Assuming that there are two competing firms and they have incurred asymmetric sunk costs, there will be a leading investor in the market. The firm with a competitive edge will make the first investment, or the two firms will invest at the same time. If a firm is more competitive, it will enter the market by setting up an optimal investment threshold value for the market leader and follower.

When the preemptive thresholds of both firms happen to coincide, the two firms will enter the market simultaneously. Smit and Trigeorgis (2006) applied real options and game theory to the investment planning of strategic alliances. Pawlina and Kort (2006) noted that in an oligopoly, the investment costs are asymmetric and there is an optimal investment strategy. The study’s result shows that a marginal increase in the investment cost of the firm with a cost disadvantage can enhance that firm’s own value within a certain range of the asymmetry level. Jin et al. (2009) used a financial tool “option-based” mathematical model for the joint production and the maintenance system provided useful maintenance decisions in the environment of uncertain demand. Hsu (2010) considered ROA to model venture capital investment opportunities. The paper found that staging not only gives the VC a waiting option but also mitigates the agency

problem of the entrepreneur undertaking too conservative activities.

De Giovanni et al. (2008) analyzed the dynamic structure of a return process using subordinated laws and showed how subordinated models can be used to price contingent claims.

The subordinated asset price models will consider the hyperbolic model. Kalashnikov et al. (2009) justified the concept of conjectural variations equilibrium applied to the mixed duopoly model by demonstrating the concavity of the expected profit function. Huang and Hsu (2008) enhanced the capability of explaining intemporal decision-making behavior and proposed an anticipative hyperbolic discounted utility model that revised the conventional hyperbolic discounted utility model by introducing anticipative parameters under the consideration of the anticipation of future gains or losses. Therefore, the paper assumes that the investment additional returns to obtain extra from the competition between two competing VC firms form a hyperbolic function.