chapter 4 new venture strategy copyright¸ 2003 john wiley & sons, inc. all rights reserved....

Chapter 4

New Venture Strategy

Copyright¸ 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Learning Objectives • Understand what makes a decision strategic.• Understand the interrelationships between financing

decisions and other aspects of new venture strategy.• Relate strategic decisions to the entrepreneur’s

objective of value maximization.• Describe strategic alternatives in terms of real

options.• Use decision trees to identify and evaluate real

options. • Use game trees when strategic choices depend on

rival reactions.


What Makes a Plan or Decision Strategic?

• Strategic decisions are consequential• Strategic decisions are both active and reactive • Strategic decisions limit the range of possible future

actions


Interactive Financial Strategy


Financial Implications of Product-Market and Organizational Strategic Choices


An Introduction to Options• Option - A right to make a decision in the future• Elements of an option

– An underlying asset– Exercise price (strike price)– Expiration date– European or American form

• Basic options: Calls, Puts• Financial options• Real options• Complex options

– Contingent options - created by earlier action– Options with interdependent values


The Structure of a Call Option


Realized Returns on Options


Valuing Options• Put-Call Parity

– Option Pricing Models based on no-arbitrage– Stock + Put = Call + PV(Exercise Price)– Role of complete markets

• Financial Options – Complete markets– Incomplete markets

• Real Options– Complete markets– Incomplete markets

• Complex Real Options (Rainbow Options)– Discrete scenarios– Simulation


Real Options - Some Examples

• Defer - Investing now eliminates the option to defer (learning)

• Expand - An option to defer part of the scale of investment

• Contract - The flexibility to reduce the rate of output

• Abandon - Stop investing, and liquidate existing assets

• Staging - Substitute a series of small investments for one large

• Switching - Re-deploy resources or change inputs


Examples of Real Options


Techniques for Reasoning Through Decision Trees

1. Focus on the most important decisions.

2. Reason forward to construct the tree.

3. Track certainties and uncertainties at each decision point.

4. Calculate backward to evaluate choices.

5. Select the tree branch with the highest expected value.


Decision Tree Example - Assumptions

• Demand may be high (30%), medium (50%), low (20%).• Cost of large restaurant is $750,000.• Cost of small restaurant is $600,000.• Entrepreneur will invest $400,000, outside investor

provides the rest.• Investor requires 1% of equity for each $10,000

invested.• If demand is high - PV large is $1,500,000, PV small is

$800,000.• If demand is medium - PV large is $800,000, PV small is

$800,000.• If demand is low - PV large is $300,000, PV small is

$400,000.


Accept/reject Decision to Invest in Restaurant Business


Evaluation of Accept/Reject Alternatives

• Large-scale entry:

NPV conditional on high demand

= $575,000

NPV conditional on intermediate demand

= $120,000

NPV conditional on low demand

= ($205,000)

NPV = .3 x $575,000 + .5 x $120,000 – .2 x $205,000

= $191,500


Evaluation of Accept/Reject Alternatives (Cont’d)

• Small-scale entry:

NPV conditional on high demand

= $240,000

NPV conditional on intermediate demand

= $240,000

NPV conditional on low demand

= ($ 80,000)

NPV = .3 x $240,000 + .5 x $240,000 - .2 x $80,000

= $176,000• Do not enter:

NPV = $0


Restaurant Business Investment With an Option to Delay Investing


Evaluation of Option to Delay• Large-scale entry strategy: NPV = $191,500• Delay until uncertainty is resolved:

– High demand• Build large restaurant• NPV conditional on high demand = $445,000

– Intermediate demand • Build small restaurant• NPV conditional on intermediate demand • = $160,000

– Low demand• Do not enter• NPV conditional on low demand = $0


Evaluation of Option to Delay (Cont’d)

• NPV of delay strategy:– = .3 x $445,000 + .5 x $160,000 + .2 x $0 – = $213,500

• Value of Option to Delay = $213,500 - 191,500 – = $22,000


Restaurant Business Investment With an Option to Expand Initial Investment


Evaluation of Option to Expand• Large-scale entry strategy: NPV = $191,500• Delay until uncertainty is resolved: NPV = $213,500• Build small, with Option to Expand:

– Conditional on High demand:• NPV if Expand = $580,000• NPV if Remain Small = $240,000• Conclusion: Expand if demand is high

– Conditional on Intermediate demand:• NPV of Remaining Small = $240,000

– Conditional on Low demand:• NPV of Remaining Small = ($80,000)


Evaluation of Option to Expand (Cont’d)

• NPV of Small-scale entry with Option to Expand– = .3 x $580,000 + .5 x $240,000 - .2 x $80,000 – = $278,000

• Value of Expansion Option = $86,500• Incremental value over Delay Option = $64,500

– The Options are Mutually Exclusive


Evaluation of Option to Abandon

• Large-scale entry strategy: NPV = $191,500• Large-scale entry with Abandonment option:

– Convert to office with $600,000 value – NPV of converting for entrepreneur = ($10,000)– NPV with Abandonment Option:

• = .3 x $575,000 + .5 x $120,000 - .2 x $10,000 = $230,500

– Would pay up to $39,000 extra for location that is convertible


Evaluation of Option to Abandon (Cont’d)

• Small-scale entry with Expansion and Abandonment Options:– Convert to office with $300,000 value– NPV of converting for entrepreneur = ($160,000)– NPV with Abandonment Option:

• = .3 x $580,000 + .5 x $240,000 - .2 x $160,000 = $262,000

– Abandonment has negative value for the small restaurant

– A result of discreteness of the analysis• Conclusion: Build small with Expansion Option

– NPV = $278,000


Game Trees• The Basics

– Players– Order of play– Information set– Available actions– Payoff schedules

• Strategic interaction– Cooperative and Non-cooperative games– Sequential-move game - Game tree– Simultaneous-move game - Payoff matrix

• Nash equilibrium• Sub-game perfection


Evaluating Strategic Games• Specify assumptions about rival actions and

reactions.• Develop the tree.• Prune branches involving dominated strategies.


Entry Decision Game Tree

chapter 4 new venture strategy copyright¸ 2003 john wiley & sons, inc. all rights reserved....

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