Strategic Management/Business Policy

Power Point Set #8:Competitive Dynamics: Real Options

Competitive DynamicsCompetitive dynamics: results from a series of competitive actions and competitive responses among firms competing within a particular industry.

Mutual interdependence: results when companies recognize that their strategies are not implemented in isolation from their competitors’ actions & responses.

Eastman Kodak and Fuji Film, for example, continue to engage in a series of competitive actions and responses in an effort to establish competitive advantage.

Competitive DynamicsA first mover is a firm that takes an initial competitive action.

Successful actions allow a firm to earn above-average economic returns until other competitors are able to respond effectively. In addition, first movers have the opportunity to gain customer loyalty.

• For instance, Harley-Davidson has been able to maintain a competitive lead in large motorcycles due to intense customer loyalty.

Competitive Dynamics

A first mover faces potential disadvantages:

• High risk;

• High development costs; and

• High demand uncertainty

Competitive Dynamics

A “second mover” is a (second, third, fourth, etc.) firm that responds to a first mover’s competitive action often through imitation or a move designed to counter the effects of the initial action.

BankOne was a fast second mover in Internet banking.

New Balance is a successful second mover in the athletic shoe industry.

Competitive DynamicsSecond mover advantages include:

Reduction in demand uncertainty;

Market research to improve satisfying customer needs;

Learn from the first mover’s successes and shortcomings; and

Gaining time for R&D to develop a superior product

Scenario Analysis -The Relationship Between Finance & Strategy

Traditional Evaluation Of Financial Projects

Net Present Value or Discounted Cash Flow Analysis

time

CF

+

-

Traditional Evaluation Of Financial Projects Net Present Value or Discounted Cash

Flow Analysis

time

CF+

-

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3 Basic Factors Determine 3 Basic Factors Determine C/S Market ValueC/S Market Value

1) Amount of1) Amount of

2) Timing of2) Timing of

3) Risk of3) Risk of

Expected cash flowsDiscounting Cash Flows

NPV =CF1

1+r +CF2

(1+r)2 +CF3

+ …CFt

+ +

Horizon Valuet+1

NPV: Net Present Value

CFt: Cash Flow at time t

r: Discount rate

Horizon Value: Value of ongoing enterprise after time t

(1+r)3 (1+r)t (1+r)t+1

Scenario Analysis -The Relationship Between Finance & Strategy

Differences Between Strategy and Finance:

Finance: Payoffs are determined exogenously or by chance

Strategy: Our actions affect the economic payoffs we are likely to experience

Decision-Theoretic Vs. Game-Theoretic Analysis:• Games against “Nature” Vs. Games against other people

©The McGraw-Hill Companies, Inc.,2001

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Irwin/McGraw-Hill

How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project.

Scenario Analysis - Project analysis given a particular combination of assumptions.

Simulation Analysis - Estimation of the probabilities of different possible outcomes.

Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

Trigeorgis (1997): Real Options

A theoretically-accurate NPV analysis should include real options values.

The asymmetry deriving from having the right but not the obligation to exercise an option is at the heart of the real options value.

Managers making investments under uncertainty can create economic value by building in flexibility, because flexibility has economic value.

• Real Options: Managerial Flexibility and Strategy in Resource Allocation

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Defer

Expand or contract

Abandon

Switch inputs or outputs

Grow

To wait before taking an action until more is known or timing is expected to be more favorable

To increase or decrease the scale of an operation in response to demand

To discontinue an operation and liquidate the assets

To commit investment in stages giving rise to a series of valuations and abandonment options

To alter the mix of inputs or outputs of a production process in response to market prices

Stage investment

To expand the scope of activities to capitalize on new perceived opportunities

ExamplesDescriptionOption

Adding or subtracting to a service offering, or adding memory to a computer

When to introduce a new product, or replace an existing piece of equipment

Discontinuation of a research project, or product/service line

Staging of research and development projects or financial commitments to a new venture

The output mix of telephony/internet/cellular services

Extension of brand names to new products or marketing through existing distribution channels

Real Options

Nucor Steel Mini-mill

•Stand-alone investment: NPV = -$50 million

– Abandonment Option: High (Low sunk cost)

– Growth Option: High (Follow-on investments

Commitment Versus Flexibility -The Value of Time

Cost to Build Plant = $1600 Cost of Capital = 10%

Price(t=1) = $100

Price(t=0) = $200

Price(t=1) = $300.5

.5

Price = $100

Price = $300

Commitment Versus Flexibility -The Value of Time

Time Expected Cash Flow(Traditional NPV)

Expected Cash Flow(Scenario 1)

Expected Cash Flow(Scenario 2)

0 $ (1,400) $ - $ -1 $ 200 $ (1,300) $ (1,500)2 $ 200 $ 300 $ 1003 $ 200 $ 300 $ 1004 $ 200 $ 300 $ 1005 $ 200 $ 300 $ 1006 $ 200 $ 300 $ 1007 $ 200 $ 300 $ 1008 $ 200 $ 300 $ 100

Infinity $ 200 $ 300 $ 100

NPV $ 600 $ 1,545 $ (455)

Build now (classic NPV) versus value of waiting

NPV calculation ($1400) in year 0 .5($300) + .5($100)

= $200 for each year after

Value of $200 perpetuity=$2000

Expected NPV ($1400) + $2000=$600

Waiting Year 0 = $0 Scenario 1 (price = $300)

Yr. 1=($1300) Perpetuity of $300 NPV =$1545

Scenario 2 (price = $100) Yr. 1=($1500) Perpetuity of $100 NPV =($455)

NPV of waiting: .5($1545) + .5(0) = $773

Value of waiting one period

Expected value of building the plant in period 0 = $600

I f the firm waits a year, the uncertainty is resolved, and the firm will undertake the investment only if the price is $300

By waiting a year, the firm’s expected value is (1545*0.5 + 0* 0.5) =$773, as opposed to $600

Value of the option = 773 – 600 = $173

Competencies and Strategic Flexibility

Strategic flexibility is analogous to “having options” and commitment is analogous to the “exercise of an option.”

The greater the uncertainty the firm faces, the more valuable are its real options.

The resolution of uncertainty over time is the catalyst which induces a manager to make (sunk cost) commitments.

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Example of Real Options The SuperCom Project:

A large telecommunications company faces an opportunity to invest in an R&D project that will revolutionize the way consumers use telephones, internet, and TV.

Real Options in the SuperCom Project

R&D Stage Commercialization Stage

0 (Years) 3 5 7 T = 15

I1

Ic

Defer( up to 1 year)

IE

I3

ExpandSwitch Use

(Abandon for salvage) Contract( save Ic )

I2

Abandon(forgo I2)

I1: Required investment in the R&D project.

I2: Required investment in the commercial-scale plant, marketing, and distribution - if the R&D effort is successful, and if market conditions are favorable..

I3: Final investment in the project; can be decreased by Ic if the market is weak.

IE: Flexibility in the design of the production process allows for output expansion with an outlay of IE.

V: Gross present value of the completed project’s expected operating cashflows.

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Sources

Baldwin, C., and L. Trigeorgis, 1995, “Real Options, Capabilities, TQM, and Competitiveness,” Harvard Business School Working Paper.

Capozza, D., and Y. Li, 1994, “The Intensity and Timing of Investment: The Case of Land,” American Economic Review.

Dixit, A., and R.S. Pindyck, 1994, Investment Under Uncertainty, Princeton University Press.

Kogut, B., and N. Kulatilaka, 1994, “Operating Flexibility, Global Manufacturing, and the Option Value of a Multinational Network,” Management Science.

Kulatilaka, N., 1995, “The Value of Flexibility: A general model of Real Options,” Real Options in Capital Investments, Praeger.

Trigeorgis, L., 1996, Real Options, MIT Press.