國立臺灣大學企業管理碩士專班 碩士論文
Global MBA College of Management
National Taiwan University Master Thesis
實質選擇權與策略投資個案評估
Real Option Valuation and Strategy Planning Case Study
蕭志育
Chih-yu Henry Hsiao
指導教授：胡星陽 博士 Advisor: Shing-Yang Hu, Ph.D.
中華民國 102 年 6 月 June, 2013
Abstract
Technology companies today have to embrace new technology to generate future income. Due to market uncertainty, being the first mover may not result in strategic or financial advantage in an unfavorable market condition. Conversely being late in the competition, may result in no market share for profit and growth. Success depends on the condition of the market. The challenge for managers is the timing to choose to adapt the technology and the type of technology to be employed.
In this paper, real option valuation in the context of strategic planning is used to tackle this challenge. Methods proposed in this paper show that managers can quantify market uncertainty which can help to optimize the investment financial and strategic value of new technology investment.
Table of Contents
1. Introduction ... 1
2. Options ... 4
2.1. Financial Options ... 4
2.2. Real Options ... 5
2.3. Current ROV World Adaption ... 9
3. Strategic planning ... 11
3.1. Competition and strategy ... 13
4. Strategic planning and Real Option Valuation ... 14
4.1. Real Option Growth Matrix ... 15
4.2. Call option valuation ... 16
4.3. Project development and Risk ... 18
5. Case Study ... 19
5.1. Smart TV ... 20
5.2. Product and positioning ... 22
5.3. Industry & competition ... 24
5.4. The Investment outlay ... 26
5.5. Product costing and forecast ... 29
6. Static NPV Analysis ... 32
6.1. Company A Rate of Return ... 32
6.2. Static NPV calculation ... 33
7. Real Option Valuation ... 35
7.1. Forecasting and market trend ... 37
7.2. Real Option Valuation calculation ... 38
7.3. Real Option Drivers... 45
7.4. Changing variability and changing forecast ... 48
7.5. Competition ... 49
7.6. Additional Real Options ... 53
7.7. Total Product Line in Option Space ... 54
8. Conclusion ... 56
References ... 63
Appendix ... 64
List of Tables
Table 1 Real Options practiced in business ... 7
Table 2 Bain Consultant Survey of Top Management Tool ... 10
Table 3 New Platform Investment Outlay ... 28
Table 4 Follow Up Project Investment Outlay ... 29
Table 5 Smart TV total product line product costing ... 29
Table 6 Total Product Line Forecast ... 30
Table 7 New Platform Static NPV and Variation Outcomes ... 40
Table 8 Follow Up Project Static NPV and Various Outcomes ... 42
Table 9 Summary table for static NPV and ROV and Decisions ... 44
Table 10 Game Competition between Company A and B ... 52
List of Figures Figure 1 Real Option Space ... 15
Figure 2 Value of Call Option ... 17
Figure 3 New Platform Cash Flow ... 33
Figure 4 Total Product Line Cash Flows ... 34
Figure 5 Decision Points along Project Development for Defer Option ... 36
Figure 6 New Platform Cash Flows Expected Outcomes ... 38
Figure 7 New Platform Call Options Valuation ... 39
Figure 8 Follow Up Project Cash Flow Expected Outcomes ... 41
Figure 9 Follow Up Call Options Valuation ... 42
Figure 10 Total product line decision tree analysis ... 45
Figure 11 Real Option Drivers ... 45
Figure 12 Changing variability and ROV outcomes ... 48
Figure 13 Company B Cash Flows ... 51
Figure 14 Total Product Line Prefer Path in Option Space. ... 55
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1. Introduction
Real Option Valuation is a valuation method that assists in decision making under uncertainty by adapting the techniques developed from financial options to real life de- cisions. In contrast with traditional corporate finance tools like Net Present Value (NPV), option are more with uncertainty and variability and it is the option value that will allow a company to grow in the future.
Technology companies have to adapt new technology to generate future income for the company. In a time where the product life cycle is getting shorter and shorter adapt- ing to the right technology mean survivability. However, what often occur is that first mover may not have the strategic or financial advantage. Conversely being late in adapting the new technology means no room in the market for profit and growth.
Therefore the timing of adaption is vital to the project’s strategic and financial success.
RD managers are faced with difficult situation when to commit to an investment given the uncertain market demand. These market uncertainties often are accompanied with voices of vague, overly optimistic and questionable market growth estimates. Be- cause of these reason, it is difficult for managers to make a decision of what and when to make the investment. Moreover, the corporate financial tool offered like the tradi-
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tional Net Present Value (NPV) is unable to help with this market uncertainty situation.
So managers typically have to rely on their intuition and experience to guide them in strategic investment. Manager’s intuition and experience is important but when situation turn worse manager needs a tool to reassure and back up his/her decision. Furthermore, a company’s value creation depends on a series of interrelated investment to get to the intended strategic position. Manager’s needs a tool to help them on this obscure and low visible path.
This paper seeks to use real option valuation to address managerial discretion in strategic and financial planning to optimize the timing to adapt to a technology to maximize its strategic and financial value.
Target Group
The target group for this paper is mainly for technology company management practitioners. It seeks to use Real Option Valuation in the project valuation process within a company without significantly hampering the valuation process by using diffi- cult financial theories or increasing the workload.
The paper is also for equity research analyst and scholars with an interest in finan- cial valuation theory whether this addition to the real option theory is applicable on any level.
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Delimitation
This thesis is method-oriented and will thus focus on application of ROV for practition- ers with limited financial background or non-financial background who are valuing technology development projects. This thesis is NOT for valuation of company or pro- jects for the stock market.
Methodology
The paper seeks to use both qualitative analysis and quantitative analysis. The qualitative analysis will be used to evaluate the use and limits of the valuation method in the company as well as analyzing the case background environment.
The quantitative analysis is to use the Real Option Valuation method in the com- pany by using fictitious project data through actual company data and industry report.
The advantage of such method allows construction of complete data. The disadvantage is that the case study result does not directly relate to any specific company.
Source criticism
The primarily project data used are sources from industry contacts which maybe colored with some biases. On the other hand, sources used from secondary sources, from business articles and industry report are also biased in the way they are overly op-
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timistic. Given the fictitious nature of the overall data, they are used in purely for com- parison purpose and does not have any representation in actual situation
2. Options
2.1. Financial Options
Option originated in the financial world as a mean to give a person to the right ac- cording to a contract to buy or sell an asset at an agreed fixed price on or before a given date or before it (Jordan, Ross, Westerfield, & Jaffe, 2011, p. 561). The owner of the contract can decide to exercise the right if it is advantageous to do so. If it is not advan- tageous to the person the owner of contract can simply abandon the option and the only loss would be the cost of the option contract. Whether it is advantageous or disadvanta- geous to exercise the option depends if the contracted price is above or below the agreed fixed price.
Two common types of options are traded today. The first is the call options which give the owner of the contract to buy an asset at a fixed price before a particular time.
The second is the put option which gives the owner of the contract to sell the underlying asset. For a call option, the option owner profits if the asset market price is above the exercise price. Vice versa for a put option, it is profitable if the asset’s market price is
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below the exercise price.
The value of an option can be decomposed into two parts. The first part is the in- trinsic value of the option from the difference of expected exercise price and the current asset’s underlying price. This is based on the assumption that the expected exercise price is at low or no risk. The second part is the time premium value the extra the in- vestor is willing to pay based on the possibility that the underlying asset will rise ( if it is a call option) or fall ( if it is a put option) prior to the expiration. This possibility or variability is the interesting part about option because the greater the variability of the underlying asset the more valuable the option will be. In comparison, stock will de- crease in market value as it rises in variability.
Due to option’s characteristic of risk and reward, many investors develop invest- ment strategy to incorporate option into their investment portfolio. Option can be pur- chased for high risk assets while mixing lower variability asset investment. The out- come of such portfolio is maximized.
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 dif-
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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 options by considering equity as an “option of the firm”. (Trigeorgis & Smit, 2004, p. 93). Ever since that year, op-
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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 differential 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 Valuation
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 controllable by the firm themselves. The exogenous risks in contrast are un-
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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 forthcoming 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 content. It packs the computing power borrowed from computer to enable parallel flash video performance. More over due to the full functionality operating system on the power computing power it boasts the same experience to surf internet as well as allow- ing users to install APPs/software. In addition, the versatile operating system enables full web browsing compatibility (like HTML 5, flash and Java). In addition, the new platform includes video camera to allow video conferencing and social media interac- tion.
There are numerous obstacles the development the team has to address in order to have a successful product. The first obstacle is the user interface to control the TV.
There are numerous feature enabled in the smart platform that requires complicated command of inputting, browsing and selecting. The design team has chosen a similar interface that borrows from computer mouse and keyboard.
The second obstacle is to design the smart TV to be smart enough to find the right video content and display it at the time the user desires. For this the design team has made tracking software that allows the user to select the preference and follow up on
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filtered video content. However, due to the video content ownership issue, the platform team can only make the software compatible to few of the video content source websites like YouTube.
The third obstacle is to design the smart TV to behave like a TV. This will differen- tiate itself from its substitutes like tablet or PC. One particular example of TV behavior, the development team has to optimize the operating system to allow on screen display within seconds turned on like a normal TV.
The last obstacle is for the development team to differentiate the Smart TV from other connected TV. The main difference between Smart TV and Connected TV is Con- nected TV has no control of what App/software is installed. In contrast the Smart TV allows the user to control the App/software to install. The connected TV does not have a fully functional operating system. The Smart TV has a fully functionally operating sys- tem.
The new platform is at the point to cross the chasm to the majority of users. The technology is at its embryonic stage with early adaptors owing earlier version of tech- nology. The industry recognizes the potential of the opportunity and is responding ac- cordingly. It has altered its value chain and distribution channel in response to catch the first wave of early majority users. The developers from the value chain have thus far delivered the right hardware functionality to meet the needs of early majority.
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The company is hoping to position itself in a new emerging market- the TV soft- ware/service market. This way the company is hoping to transform its business model from one time purchase of a piece of hardware equipment to repeated purchase of ex- tended product/service. If successful, the company will become the new channel reach- ing directly into the heart of consumer’s home. This will generate additional profit for years to come.
5.3. Industry & competition
The LCD TV Industry is always seeking business opportunity. This is done in two ways. First way is through technology innovation and entices consumers to adapt and purchase. For the smart TV, the industry is divided into two different product strategies.
One strategy is to make the TV smart by make it the hub to all internet enable device at home. The other strategy is to make the TV dumb by make it into a simple monitor with large expansive input and output capability to other devices like smart phone, PC and Tablet.
The second way is to improve its operational bottom line. This is done by forming strategic alliance between key component makers like panel and system integrators to lower the overhead and material cost of both companies.
Price war is common amongst brand. This in turn has created the expectation for
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price drop in consumer’s mind reinforcing the price war. Therefore, promotional events with deep price cut are common and are treated as useful way to generate revenue.
Due to the advent of technology and the company driving them, there are numer- ous new entrants to TV industry. Typically, the entry barriers for TV industry is high because of the high financial cash flow needed to fund the operation. However, the new entrants are titans in their own industry with resources and capital like Intel and Apple.
These companies are making related diversification to provide additional product and service to their existing customer through their existing channels. Similarly there are outside players who are participating indirectly in the industry adding opposing force to the development of the smart TV. With the announcement of launch of Sony Google TV in 2010, ABC, CBS, NBC joined Hulu blocking Google TV from accessing full epi- sodes (Goyal, Cambel, & MacGuire, 2011, p. 39)
Innovation in the industry sighted well in advance. Typically, the numbers of available new technologies are limited because the technology needs numerous sup- porting business partners. The more disruptive the technology the more partners are needed to support it. Therefore, the adaption to new technology is to join the right alli- ance and hope it will become the de-facto standards. For example, to build High Defini- tion TV needs HD IC and HD panels (which in turn needs its own HD driver IC).
Mark has reviewed all the market and industry information. He is quite excited that
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there is chance that the new platform can be a disruptive innovation. At the same time he is worried how the consumer will respond and adaption rate of the new platform.
Specifically when will the platform reach a tipping point to become widely accepted (maybe in two year, three years?).
Mark is also concerned that the development of Eco-system through attraction of platform’s third party developers and content provider won’t be fast enough to create a sizable Eco-system to differentiate the product and attract users. Should Company A develop the platform now while at embryonic stage?
In three days, Mark will have to present his findings to management to make a managerial decision.
5.4. The Investment outlay
The total project development time is expected to be two years. The investment outlays are broken down into five different categories: Tooling cost, manufacturing equipment cost, sample cost, licensing cost, man power cost. The Tooling cost plastic
injection mold, metal stamping molding. Not all parts require new tooling or molding because some parts can be common parts sharing from other TV.
Most the equipment needed for the production is already available in the factory.
The additional equipments are automated test machines designed to test operating sys-
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tem and software response of the TV. For licensing, budgets are needed to purchase rights to the use of video and audio codec and software app to be pre-installed. In the case for Smart TV, the alliance has agreed to burden most of the cost thus majority of licensing cost is paid for and decreasing the investment needed. Although cost effective, the down side is that the new platform developed will be shared proprietary technology.
Hardware engineers, software engineers as well as mechanical engineers constitute the main project team. Due to the complexity of new platform software four hardware engineers and ten software engineers are needed. Two mechanical engineers and three support personnel consisting project managers and production engineers are estimated to design the mechanical structure and coordination of the project. During the develop- ment, development samples are needed for each functional team (ME, SW, HW) to de- velop and verify their design. In addition these development samples are needed to run quality and reliability test as well as sending out out-house developers to verify and cer- tify the design.
The above assumptions for the new platform development are estimated with cost and summarized in Table 3 New Platform Investment Outlay. The total cost of devel- opment of new platform comes to a total of 4.025 million USD for the first year and 0.95 million USD for the second year.
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Table 3 New Platform Investment Outlay
For the follow up project, it is following a water fall product strategy to take as much existing parts and functionality of new platform and update to market competitive product specification. As such, the development of the follow up project is simpler. The total project development time is expected to complete in one year. The look of the TV is modified to provide new look to the consumers therefore new plastic and metal moldings are still needed. Additional manufacturing equipments are bought to accom- modate the expanded production capacity. Overall facility and production capacity are expected to satisfy the demand of the follow up forecast. Additional licensing costs are expected to incur as additional SW/APP features are need to remain competitive in the market .Both the man power and the development sample are reduced due to the smaller amount of work needed. The aforementioned assumptions are summarized and a total cost is estimated to be 1.82 Million USD in shown in Table 4 Follow Up Project In-
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vestment Outlay.
Table 4 Follow Up Project Investment Outlay
5.5. Product costing and forecast
Mark has discussed with engineers, sales and marketing and decided on a “water fall” product strategy with each product life of two years. Table 5 Smart TV total prod- uct line product costing shows a summary of the product strategy.
Table 5 Smart TV total product line product costing
The new platform allows company A to develop additional follow up projects (wa-
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terfall model strategy) that enables firm B to capture additional value from the platform developed. This will mean that the premium model launched at year 2 will repositioned to be middle competitive model launched in year 4. It is expected that the both the new platform and the follow up products to be reduced in price to stay competitive in the market.
The forecast for a new technology is tricky. Mark has discussed with sales, mar- keting and channel to present the forecast in Table 6 Total Product Line Forecast.
Table 6 Total Product Line Forecast
The forecast in Table 6 Total Product Line Forecast is based on experience of past shipment, value chain commitment level, manager confidence level and channel distri- bution survey. Other forecasting method considered are to use similar product referenc- ing by taking similar product models in the past history and use it as a guide to its product introduction onto market and product life cycle progress. This is done by con- sidering the usage model (how it is used), its price level, purchasing habit (where it is purchased) and preferences (form, color factor). However, Mark had problem with
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finding a similar referencing model based on the above criteria. Other comparison mod- els are either too small, the price level not in range or product is too old with the market environment changed a lot since then.
Another forecasting method to consider is the market Share forecast analysis. This is done through the use of external data and industry analyst projection. By taking the analyst global projection and the North America region market share and finally the brand market share in the region, Mark have found a forecast in comparison with fore- cast he has received from sales department. However, since the analyst forecast is usu- ally overly optimistic and the market share changes drastically each year, the market share forecast could not be used to make direct comparison and adjustment to the com- pany forecast.
The last method Mark is considering in using is the replacement ratio of TV. This method is good because the TV market has saturated. The replacement ratio still need to consider the expected TV brand market share as well as the Smart TV expected adaption rate both of which is subject to change and produces only reference result.
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6. Static NPV Analysis
6.1. Company A Rate of Return
Capital Asset Pricing Model’s expected return on a security as defined by
E(R) = R
f+ β × (E(R
m) − R
f)
Equation 4 (Jordan, Ross, Westerfield, & Jaffe, p. 384) Where,• Rf = Risk-free rate= 1.88% (Trading Economics)
• β = Beta of the security = 1.07 (Morningstar)
• E(Rm) = Expected return on market = 8% (Fernandez, Aguirreamalloa, & Corres, 2011, p. 3)
Re= 1.88% + 1.39 x (8% – 1.88%) = 8.43%
Next, Weight Average Cost of Capital (WACC) is defined by
WACC = �
S+BS� × R
s+ �
S+BB� × R
B× (1 − t
c)
Equation 5 (Jordan, Ross, Westerfield, & Jaffe, 2011, p. 414)Where,
• Rs= Equity discount rate = 8.43% (from Capital Asset Pricing Model)
• RB= Debt discount rate = 2.46% (Amtran, 2012, p. 30)
• �S+BS �= Portion of total value by equity = 0.52 (Amtran, 2012, p. 8)
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• �S+BB �= Portion of total value by debt = 0.48 (Amtran, 2012, p. 8)
• (tc)= Corporate tax rate= 15.29% (Amtran, 2012, p. 8)
WACC = 8.43%*0.52 + 2.46% x 0.48 x (1-0.1529) =7.5613%+0.1861%= 5.386 % The discount rate to be used for the following static NPV calculation is 5.39%.
6.2. Static NPV calculation
By representing visually the cash outflow and cash inflow over time, Figure 2 can be generated to aid the Net Present Value ( NPV) calculation.
NPV = ∑ C
Ti=0 i, where C
iis cashflow
Equation 6NPV = −4.525 − 0.95
(1 + 0.0539)1+ 8.85
(1 + 0.0539)2+ 15.12
(1 + 0.0539)3 = 15.46
Figure 3 New Platform Cash Flow
Traditional static NPV using discount cash flow (DCF) method calculates the pro- ject to be $15.46 M. The cash flow is discounted at a rate of 5.39%.Given the positive result of the calculation, the static NPV would suggest to the managers to invest in the project. This is based on management committing to the investment of year 0 and year 1
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R&D investment for the project. Similarly for the total product line which includes new platform and follow up project, the cash flow can be represented as Figure 4 Total Product Line Cash Flow.
Figure 4 Total Product Line Cash Flows
For the follow up project, applying the Net Present Value (NPV) is:
NPV=
∑ C
Ti=0 i, where C
iis cashflow
Equation 6.The result is $58.06M. Again, the cash flow is discounted at a rate of 5.39%. Since this is also a positive result bringing in revenue stream, NPV method would suggest to the managers to invest and commit to investment in the new platform and follow up project.
The static NPV would be accurate if the forecast is the same as the actual demand.
Unfortunately there is uncertainty in the market demand. This would make the invest- ment calculation invalid due to the changing nature of the market. Managers will most
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likely need to make additional or corrective calculation when there are new inputs from the market status update. Or managers will have to include contingency planning or calculation to take into account the market dynamics.
The static NPV also doesn’t take into account the grow option of the new platform.
In another word, the more lucrative revenue stream of the follow up project would fol- low only after the development of the new platform project. The independent evaluation nature doesn’t indicate however the strategic importance of new technology nor the value of the new competence.
Theoretically the project budget is allocated and committed. However in real life the annual budgets are made year by year with inputs as to project status and market outlook. The managers could base on these inputs make alterations to continue or dis- continue with the project. However, the manager would never find out if he or she doesn’t make the first year 0 investment.
7. Real Option Valuation
Mark has learnt about Real Option Valuation calculation in his MBA school. He is keen to put what he has learnt to the test. Especially, he is looking forward to presenting the project valuation with a holistic view to his boss.
There are various decision points that the manager can consider to continue in-
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vestment in the project. These are major decision points that management have to con- sider to continue or to abandon and divert the resources to other projects for value crea- tion. Below illustrates the correlating decision points to the investment outlay and cash flow to represent different timing points of decision
Figure 5 Decision Points along Project Development for Defer Option
The timing of decision is a not exact but a window of opportunity. This should be correlated with the relationship of development lead time and market launch time. For example for Christmas boxing day sales, the company should launch to product to mar- ket two month in advance to allow distribution to channel and advertisement events to promote awareness. Including the R&D development lead time, management should be making the decision total of 8 month prior to decide whether to invest in the project. In addition, management should also take into account competitor’s product portfolio around the same time frame. Therefore there are only specific time-frames managers can make a choice.
Taking in time frame into consider, R&D manager should consider whether the
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company should commit to new platform R&D first year investment given the market condition and internal resource and capability. Should the company commit to the sec- ond year new platform R&D investment (as well as the necessary market investment) to launch the product into the market after R&D results are known? Finally, should the company commit to the follow up project investment given the market condition?
7.1. Forecasting and market trend
To take in account of the market dynamics, Mark is preparing to include an extra element in the forecast: the market dynamics. First of all, sales forecast reflect the com- pany ability and value creating to the market. This should be done first to evaluate the firm’s position in the market. In a way it represents his/her confidence level of forecast (product) in the market. High confidence means lower variability and low confidence means higher variability of the accuracy of the forecast.
The up and down trend of market variation represents manager’s response of his/her forecast to the market. It is his/her sentiment whether the market is bull or bear like financial market. It is a representation whether the market is in good economy so consumer has good purchasing ability. It is also a representation whether or not the consumer is acceptable to the product (their willingness to purchase).
Mark is estimating the market upward trend to be a factor of 2 for the better than
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expected case and the market downward trend to be a factor 04 for the worse than ex- pected case. Since there is no evidence to back up this, Mark feels that ultimately these factors are decided by the senior manager’s interpretation.
7.2. Real Option Valuation calculation
The first step of Real Option Valuation calculation is to calculate the value of the CF of the project at time zero. The present value (PV) of new platform is calculated to be at $19.88M. The PV is discounted at a risk neutral rate of 1.88% (Trading Economics).
Figure 6 New Platform Cash Flows Expected Outcomes
The second step is to estimate the market variation of upward trend and downward
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trend. In this case the management and the project team estimate the market upside to have a yearly increase of 2 times and downside to have yearly decrease of 0.4 times.
Given these estimates, the market variations is projected to the point where product is launched by multiplying the Present Value of the Cash flow with the upward trend of 2 times and downward trend of 0.4 times. This is shown in Figure 6 New Platform Cash Flow Expected Outcome. Using the upward and downward trend factors, the market variation varies between better than expected and worse than expected result from the forecast.
Figure 7 New Platform Call Options Valuation
The third step is to calculate the option value and deduct the exercise cost. Taking the expected value at year 1, where the option can be exercised with a cost of 0.95M, the call option value can be obtained. Next, using the binomial risk neutral calculation, the call value can be obtained at $18.94M. The binomial risk neutral probability is at a factor 0.38675.This is shown in Figure 7 New Platform Call Option Valuation.
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The final step is to calculate the static NPV new platform.
Table 7 New Platform Static NPV and Variation Outcomes
Differently from the static NPV presented before, the static NPV calculated in op- tion valuation depends on the number of investment that has been invested. For new platform, first stage at year 0 is committed for the calculation and is deducted from the PV of cash flow. At year 1, there are no more option values and the expanded NPV would simply be the static NPV value. Given the different variation of the new platform, the year 1 investment is deducted to determine different NPV outcomes. This is shown in Table 7 New Platform Static NPV and Variation Outcomes. At year 1, both state of the remaining static NPV are positive outcomes. This indicates that the project is a go for investment.
The total expanded NPV would be 16.36 plus 19.95 which would total $36.31M.
The result is positive and would indicate an investment decision to the new platform project.
The follow up project would follow the same step as the new platform by using the
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same upward and downward trend factors with the different that it would vary over a longer period of time. Again, the follow up project present value of cash flow is dis- counted at a risk neutral rate of 1.88% (Trading Economics).This is shown by Figure 8 and Figure 9.
Figure 8 Follow Up Project Cash Flow Expected Outcomes
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Figure 9 Follow Up Call Options Valuation
At year 3, the option can be exercised with a cost of 1.82M. Taking the difference, the call option value is obtained. Then by using the binomial risk neutral calculation, the call value can be obtained at year 0 as shown in Figure 9 Follow Up Call Option Valua- tion.
Table 8 Follow Up Project Static NPV and Various Outcomes
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At year 0, the cash flow is simply the PV of future cash inflow of year 3 and 4. There is no investment outlay to deduct because the project investment cost is deducted as option exercise cost in year 3. Compare to new platform, the outcome variations for follow up project is much larger because the project is longer in time and thus more uncertain. At this point, there is no more option value and the expanded NPV would simply be the static NPV value. This is shown in Table 8 Follow Up Project Static NPV and Various Outcomes.
The total expanded NPV would be 40.78 plus 24.71 resulting in positive outcome of $65.49M. This would indicate the follow up project to be a worthy investment. To get to follow up project, the company would have to invest in the new platform first. This is like multiple investments in different stages and inter-related project. The new platform can be seen as the cost to get to the lucrative follow up projects. For the Real Option Valuation, the new platform is an option on option for the follow up projects.
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Table 9 Summary table for static NPV and ROV and Decisions
From Table 9 Summary table for static NPV and ROV and Decisions, the static NPV total product line is $68.01M and comparatively the Real Option Valuation (ROV) is $99.78M. Both results would show that the investment is a go. The difference be- tween the two is ROV account for the uncertainty in the market and quantify it as option value. Thus, ROV total product line result is greater than static NPV product line.
However, the results can change based on how market condition turns and managers should adapt to the changing situation. This can be illustrated by the decision tree anal- ysis as shown in Figure 10 Total product line decision tree analysis.
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Figure 10 Total product line decision tree analysis
Year 0 and Year 1 is the investment decision for new platform and Year 2 and Year 3 is the investment decision points for follow up projects. The crucial decision points are mentioned before in figure 6. Because all the expanded NPV are positive for new platform and follow up in various decision points all points would be a go decision.
7.3. Real Option Drivers
Figure 11 Real Option Drivers
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In Figure 11 Real Option Drivers illustrates the drivers for Real Option Valuation method. Beside the static NPV drivers, the only additional real option valuation key drivers are the upward and downward trend factors. Real Option Valuation method pro- posed is an add-on of existing static NPV thus making static NPV drivers as important drivers to proposed ROV method.
Planning stage, forecast are projected based on product pricing and sales. The product pricing is based on marketing position to either enter a market or defend a posi- tion in the market. In addition, product pricing which is about development of a product is about the strategic position in which the company is to acquire a key technology to enhance its innovative capability. Given the scope and importance involved in the pro- cess, in most company, sales, market, R&D and management are involved in shaping the product concept.
With the product pricing assumption in hand, the product can be forecasted for projected sales. The product is tested based on its functionality, form factor and price how many people will be accepting the new product as compare to competitor brands.
In the case of innovative product the question then becomes how many people will adapt to the new product compare to its substitutes. For most company the methods to quantify acceptability and adaptability into projected sales are based on experience, market research and analysis or comparable product in the market. All these methods
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are subjective based on the assumption of person in charge and are based on limited in- formation. Note, although there is more complicated mathematical model available in theory, most company chooses to keep it simple for the sake of understanding.
So far the two important drivers, product pricing and forecast sales, the result pro- duced from planning process are all based on condition that is changing with time. This makes controlling them very difficult and often time futile since changes will certainly occur. Once a change occurs the static NPV must be recalculated to reflect the new situ- ation. Methods have been developed like contingency planning to take into account the changing of situation. However, contingency planning does not present the whole pic- ture of the valuation of the project as well as the contingency cost and or value to the risk and opportunity of the situation.
Comparatively, the market and corporate rates is taken from more constant nature to the product costing and projected sales forecast. Corporate rates are derived from ac- counting information based on company current and past financial status. The market rates are taken from market references. Both rates are comparative less volatile and more certain because longer time needed to change to macroeconomic or the financial structure of a company. The corporate and market rates are derived independently by financial and accounting department. They would work together with sales and market- ing to forecast next year revenue and budget needed to develop the projects to meet the
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target. Most likely, for financially healthy company the corporate finance structure (eq- uity and debt) and capital financing policy is kept at the same keep the sustainability of the company. Any financially troubled company would likely to avoid investing in un- certain projects and stick with cash generating projects until the financial status im- proves.
7.4. Changing variability and changing forecast
Figure 12 Changing variability and ROV outcomes
Variability is defined as the difference between upper and lower factors. For exam- ple the initial forecast of upper factor multiplication 2 and the lower range multiplica-
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tion 0.4, the difference would be 1.6. Increasing variability increases the expanded NPV because the option value would change as represented by Figure 12 Changing variabil- ity and ROV outcomes. The reason why there is a shift in variability can be because the market outlook has turned better or worse. Either way, changing the variability is changing the basic assumption of Real Option Valuation modeling and should do so if the range of the original variability does not encompass the new market condition.
Changing the forecast would directly affect the median point of the risk neutral probability thus affecting both the static NPV value and option value. The higher the median (forecast), the higher the result expanded NPV (while keeping variability con- stant). Conversely, lowering the forecast the outcome expanded NPV would be lower.
The reason forecast should change in Real Option Valuation should be because there is a change in company strategy or a change in industry value chain.
7.5. Competition
The purpose of competitor profiling is to find how the competitor will behave so that the company can predict the competitor’s future strategy and position. In doing so, company can adjust its own plan to eliminate rivals dominant strategy and establish its own dominant strategy
The company has for the past few years now competing with company B for mar-
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ket share. Company B has the higher market share position and it is bigger in size.
Company B’s product line is both broader and deeper than Company A. Company B is delivering products that are industry leading company. Therefore over the past couple of years, Company B is able to command a higher profit compare to industry average. Its competitive behavior usually follows committing and offensive pattern.5
Comparatively, company A is smaller in company size but focused primarily on television products. Its successful formula is to deliver cost effective value to the cus- tomer. Company is proud to be flexible on the bottom line while delivering innovative products. Its competitive behavior usually follows flexible and offensive pattern.
Based on competitor’s product strategy and position, company A estimates the fol- lowing cash flow scenario in Figure 13 Company B Cash Flow.
5 See Appendix Competition strategy frame work
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Figure 13 Company B Cash Flows6
If there is direct competition for market share cost each company to reduce their revenue, Company A estimates that for new platform company A will suffer a 5% re- duction in forecast for new platform. Conversely, company B would suffer 3% reduc- tion in forecast. This would be the case if market condition is better than expected (V+).
Similar estimates for follow up are company A would suffer 25% and company B would suffer 20%. This would be the case if the market condition turns out better than ex- pected (at V+++).
The new platform has less effect in forecast from competition because the new technology is seeking to expand the market pie. On the contrary, the follow up project
highly competitive for the market pie. Also, it is a contest to set industry and innovation
6 See Appendix Competitor information
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standard. Competition driver at this point would probably emphasize on operation effi- ciency and scale competition.
Game theory can be applied to find the dominant strategy to wait or invest for both companies. In the cases where both company invest and compete, both company would suffer a reduction in forecast due to competition as aforementioned. In the case of wait, real option valuation would be applied for both company A as well as company B. In the case where one company invest and other waits, there would be no reduction in forecast from competition. The result of such evaluation is represented by Table 10 Game Com- petition between Company A and B.
Table 10 Game Competition between Company A and B
The dominant strategy for company A is to wait. The dominant strategy for com- pany B is also to wait. In such case, company A would lock company B in a prisoner dilemma and Nash equilibrium would be achieved.
Despite the predicament in year 0, the market condition could change in year 3. For
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the best market condition of D+++ for new platform, there is direct competition be- tween the two companies. This would result in $282.54M for company A and $410.08M for company B. Conversely for the worst market condition of D---, there would be no competition because the worst case Company A would result in $0.49M and company B would result in $0.47M outcome.
Mark is now able to produce a comprehensive plan through the real option analysis and valuation. He is able to deliver a value over uncertainty as well show how competi- tion can affect the outcome. In addition, he has given a map to the company and informs them where they are and how they can get to its destination. Now he has to consider the possibility that the market will still perform worse and out of expectation of market trend forecast. For this Mark is creating two additional options into the project plan.
7.6. Additional Real Options
Managers can create additional real options to adapt to the market condition. If the market turned out to be outside the estimated market trend then the manager can aban- don the project by choosing the salvage and switch options to minimize the sunk cost.
These additional options can be incorporated in advance as part of the valuation process and carried out based on the condition.
The switching option allows the company to change product type from TV to set
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top box. Engineers can be switched to work on the new product type. Mechanical molds can be switch to be used in current product or next generation product line (some parts are switchable but some parts are one way ticket). Production equipment can be modi- fied or sold on the market. However the switch to a different product will likely to incur additional cost for example new mechanical parts or additional time and documentation.
There is also the timing for this option execution. In consideration of the market launch schedule, design modification lead time, there are points with no turning back where there is no more room for flexibility.
The Salvage option is relatively straightforward as to sell the production equipment and allocate the engineers to other projects. There could also be a timing issue for exe- cuting this option because the resale value depends on the resale market’s trend.
7.7. Total Product Line in Option Space
Representing visually of the projects in the option space, it can be shown how the project can be travelled on a preferable path Figure 14 Total Product Line Prefer Path in Option Space. Both projects are presented by their best and worst case scenario. The new platform can be seen as option on option for the follow up project (compound op- tion). It is in the “maybe now” region because it can derive additional value from the spin-off project of the follow up project. In both projects where the best case scenarios
