complete dissertation article (may 24)

8/7/2019 Complete dissertation article (May 24)

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CHAPTER 1

INTRODUCTION TO THE STUDY

I. INTRODUCTION

An important ingredient in todays business environment is undoubtedly the ever

increasing degree of uncertainty firms face. To account for this uncertainty, scholars

developed the real options approach to better deal with the stochastic nature of future

monetary flows. During the past two decades, an important number of studies have

appeared that not only enhanced the standard real options approach but provided empirical

applications as well. However, these studies are mostly based on the assumption of either

perfectly competitive environments or under monopolistic assumptions, and thus, they do

not take into account the strategic implications of many investment projects.

Most competitive settings in todays business environment are imperfect. In order to

incorporate oligopolistic assumptions that integrate strategic behavior by participants in an

industry, recent work on strategic investments merged the standard real options approach

with the analytical and mathematical tools of game theory. During the past few years,

several studies have emerged that utilize this real options game theoretic approach. Most

of this recent literature is based on the assumptions of duopolistic competition with

identical firms and perfect information flows.

Nevertheless, the reality of the business environment seems to demand more general

models, which account for the asymmetry that exists amongst firms and that stems from

several sources, like different access to technology, differing organizational and learning

capabilities, and disparate regulatory frameworks. A few studies have appeared in the

financial economics literature in order to better deal with the asymmetric nature of firms


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(e.g. Pawlina and Kort, 2006). Additionally, another element of todays business

environment is imperfect or asymmetric information. In this case, firms operating in an

oligopolistic setting may have different access to information about several important

variables, such as project costs, or potential revenue flows. Again, only a few studies have

emerged that deal with strategic projects under imperfect information (e. g. Thijssen et al,

2003).

The purpose of this study is to develop a general model that takes into account,

within a strategic real options framework, both the asymmetric nature of firms and the

informational imperfections that permeate a real business environment. Furthermore, this

study will provide theoretical extensions that are applicable to specific kinds of strategic

investment projects.

The rest of this introductory chapter is organized as follows. In the next section, an

introduction to the research problem will be delineated. In this part, the main ingredients

and sources for the proposed study will be outlined. The third section will present the

significance and limitations of the proposed study. Finally, the introductory chapter will

evolve into the main set of research questions and their extensions.

II. STATEMENT OF RESEARCH PROBLEM

The most utilized tool in investment projects analysis is the DCF (discounted cash

flows) valuation methodology. However, it is well documented in the finance and

economics literature that this technique tends to be insufficient, since it provides essentially

static results (i.e.it does not account for dynamics of any sort). Todays business

environment is full with sources for uncertainty. Uncertainty may stem from demand,


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technology (which may result in cost uncertainty), product market, or even systematic risk

such as risky political or macroeconomic environments.

The real options methodology was developed in order to account for the perceived

flaws in DCF valuation. Financial options deal with volatility in financial markets, and in a

similar manner, real options treat uncertainty on real investment projects. The literature

dedicated to studies that utilize the real options approach has multiplied in the past two

decades. Several fields of study have used this technique to improve both the understanding

of real investment projects and their valuation as well. Table 1 shows some examples of

different studies in different areas.

The origin of the real options approach can be traced to Myers (1977). The analogy

is that holding a real investment project under uncertain prospects is formally similar to

holding a financial call option. It involves the right, but not the obligation, to spend

resources at some future time in order to obtain an asset whose value is stochastic. Thus,

the use of real options accounts for the flexibility that firms confer to managers to

undertake an investment at a present or future time; it involves the options to wait for the

investment, to abandon the project later on, or to disinvest from it at a later date.

The analysis of investment projects must also account for another form of option: a

growth option. This growth option involves the opportunity that is created, by completing a

certain investment project, to undertake further related growth projects at future dates. For

example, buying land may give a firm or individual the right to build a new estate

development at a future date. But furthermore, it may be the case that, by having

undertaken the investment, it may have also acquired the opportunity to buy more adjacent

land to complete further investment projects. This

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Table 1: Real Option Topics and Areas of Aplication

Topic or Area ReferencesNatural resources Tourinho (1979), Brennan and Schwartz (1985,

1985b), Siegel, Smith and Paddock (1987), Paddock,

Siegel, and Smith (1988), Trigeorgis (1990),

Schwartz (1997, 1998), Smit (1997), Tufano (1998),

Cortazar, Schwartz and Casassus (2000), Moel andTufano (2000)

Competition and corporate strategies Bandwin (1982, 1989, 1991), Trigeorgis (1991,

1996), Kulatilaka and Perotti (1992), Smit and

Trigeorgis (1995), Grenadier and Weiss (1997),

Farzin, Huisman, and Kort (1998), Busby and Pitts

(1997), Economides (1999)

Manufacturing Kulatilaka (1984, 1988, 1993), Baldwin and Clark

(1994, 1996), He and Pindyck (1992), Kamrad and

Ernst (1995), Mauer and Ott (1995)

Housing and real estate Stulz and Johnson (1985), Titman (1985), Capozza

and Li (1994), Grenadier (1995, 1996), Childs,Riddiough, and Triantis (1996), Sirmans (1997),

Downing and Wallace (2000)

International Baldwin (1987), Dixit (1989), Kogut and Kulatilaka

(1994), Bell (1995), Buckley and Tse (1996), Capel

(1997), Schich (1997), Buckley (1998)

R & D Morris, Teisberg, and Kolbe (1991), Newton and

Pearson (1994), Childs, Ott, and Triantis (1995),

Falulkner (1996), Ott and Thompson (1996), (Herath

and Parkm (1999), Carter & Edwards (2001), Perlitz,

Peske, and Schrank (2001)

Regulated firms and utilities Mason and Baldwin (1988), Teisberg (1990, 1993,

1994), Edleson and Reinhardt (1995)

M&A and corporate governance Hathaway (1990), Smith and Triantis (1994, 1995),

Hiraki (1995), Vila and Schary (1995), Ikenberry and

Vermaelen (1996),

Interest rates Ingersoll and Ross (1992), Ross (1995), Lee (1997)Inventory Chung (1990), Stowe and Gehr (1991), Stowe and Su

(1997)

Labor force Kandel and Pearson (1995), Bloom (2000)

Venture capital Sahlman (1993), Willner (1995), Gompers (1995),

Zhang (1999)

Advertising Epstein, Mayor, Schonbucher, Whalley, and Wilmott

(1998)

Law Triantis and Triantis (1998)

Hysteresis effects and firm behavior Pindyck (1991), Dixit and Pindyck (1994)

Environmental compliance and conservation Purvis, Boggess, Moss, and Holt (1995), Wiebe,Tegene, and Kuhn (1997)

Industrial organization Imai (2000), Huisman and Kort (2000)

Patents and innovation, high technology pricing Schwartz and Moon (2000), Kellogg and Charnes

(2000), Bloom and Van Reenen (2001), Boer (2000),

McGrath and MacMillan (2000)

Source: Lander and Pinches (1998)


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potential for further investing in related projects constitutes a growth option. Nevertheless,

this simple analysis does not take into consideration the possibility of rivals entering the

land market for this case.

There are several kinds of investment projects that may require an analysis based on

strategic considerations. When firms undertake an investment, a key element is the

potential reaction by competitors to this event. Most studies that are based on real options

methodologies fail to recognize this fact, and are based on either monopolistic or perfectly

competitive environments. In the first case, it is not significant to take competitors

reactions into account since there is none under a monopoly assumption, and in the second

case, any reaction taken by rivals does not affect the industry since under perfect

competition the number of firms is so large that no single firms actions affects an industry.

However, most investment projects actually occur within the confines of imperfectly

competitive or oligopolistic settings (Smit, 2002). Under these circumstances, investment

projects must be seen as strategic. They affect the competitive environment and may be

affected by it. Due to their magnitude or their nature, rival firms are affected by particular

investment decisions. In turn, these events may induce specific reactions by these rival

firms that have to be accounted for in order to better assess the whole valuation process.

These investments result in the possibility of firms gaining a strategic advantage over its

rivals.

The talk of strategic value emerges from the imperfect nature of oligopolistic

competitive environments. The strategic value of investments is interpreted as the

acquisition of growth opportunities relative to competitors (Kulatilaka and Perotti, 1998).

The preferred tool appearing in the literature with regards to strategic analysis is game

theory. In order to account for the perceived gap in the finance and economics literature


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with regards to the analysis and valuation of strategic investment projects, the uncertainty

analysis tools provided by the real options approach have been combined with the

analytical tools for strategic considerations that game theory contains. This merging of

analytical approaches has produced several important studies with regards to investment

projects under uncertainty and strategic considerations.

What follows briefly outlines the importance and limitations of these studies. To

facilitate the exposition, the studies have been clustered according to similarities and/or

extensions.

a. Strategic Growth Options

Kulatilaka and Perotti (1998) introduced the term strategic growth options. They

refer to this term as an investment that results in the acquisition of a capability that allows

a firm to take better advantage of future growth opportunities and that helps it gain a

strategic advantage. Compared to standard real options analysis, strategic growth options

are allowed to affect both prices and market structure, since they take into account rivals

reactions to strategic investment projects. This particular study deals with an investment in

technology that may confer a firm a cost advantage versus its rivals under future demand

uncertainty.

In addition to the study by Kulatilaka and Perotti (1998), several studies have

appeared in the literature extending the use of real options under strategic considerations

and the notion of strategic growth options. Kulatilaka and Perotti (1999), Weeds (2002),

Grenadier (2002), Lambrecht and Perraudin (2003), Pawlina and Kort (2006), Huisman et

al (2001), Bouis et al (2006), Imai and Watanabe (2005) are some examples of studies that


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have integrated real options and strategic analysis to account for the different twists in

strategic investments. All of these studies are based on one key assumption: firm symmetry.

However, it is very rare to oversee processes where competing firms are actually identical.

b. Strategic Growth Options under Asymmetric Conditions

Several sources ofasymmetry arise in industries competitive environments. Among

potential sources of asymmetry, we can cite the following: cost asymmetry, revenue

asymmetry, and information asymmetry. Cost asymmetry may be obtained by way of

different scales, different technologies or simply different regulatory environment. Revenue

or demand asymmetry may be had by having different reaction capabilities to market

conditions. In other words, firms may have similar cost structures buy may react differently

to changing market conditions stemming from learning capabilities. Finally, informational

asymmetry may occur because firms may have differing access to economic or financial

information crucial for specific investment projects. Only until very recently have a few

studies appeared in the strategic real options literature that deal with investment projects

under competitive settings and some sort of asymmetry amongst firms.

Pawlina and Kort (2006) extend the strategic growth options literature and develop

a theoretical model, based on the investment models proposed by Dixit and Pyndick (1994),

in order to incorporate investment cost asymmetry. In this study, cost asymmetry is treated

as an exogenous process in which firms enter the market with cost asymmetry stemming

from different access to capital markets, different degrees of organizational flexibility or

quite simply, as a consequence of different regulatory conditions. Another feature of this

study is the intent to produce a more general framework for strategic real options


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contributions. By incorporating ex-ante asymmetry between firms, the case of firms gaining

a strategic advantage as a result of investments, is generalized. Kong and Kwok (2006) go a

step further by accounting for asymmetry in both investment costs and revenue flows.

Thus, they develop a richer set of strategic interactions.

A key assumption that is present in the above mentioned studies is that of complete

information. According to Lambrecht and Perraudin (2003), this approach has two

limitations. First, the assumption of complete information may very well be unrealistic,

since beliefs about competitors behavior often prove to be wrong. Second, if information is

complete and an optimal cooperative equilibrium may be achieved, why is it that it very

seldom occurs? Thijssen et al (2003) investigate the role of information on strategic

investments imposing either a Stackelberg advantage or a follower advantage as potential

gains from a first-mover or an information spillover advantage, respectively. However, this

study is more focused on the welfare effects of information imperfection. Smit et al. (2004)

develop a model that treats acquisitions under asymmetrical information as a bidding

contest game. They recognize the fact that imperfect information and information

asymmetry play a key role in the valuation process in acquisitions. Nevertheless, the

departure point is that of two identical bidders.

Efforts have been recently put in to try to develop a more general framework that

encompasses the different studies that have appeared in the financial economics literature.

On one hand, there are studies that try to deal with the asymmetric nature of firms by

extending the strategic options models to account for asymmetry. On the other hand, a few

studies have tried to incorporate imperfect or asymmetric information to a strategic options

framework. However, to our knowledge, no model has been developed in order to deal with

both of these elements. This is precisely the main driver for this study. The importance of it

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resides in the acknowledgement of both asymmetry and imperfect information as two key

issues that are present in todays business environment.

c. Applications to Mergers and Acquisitions

Different kinds of strategic investment projects have unique features that confer a

special character because of their relative importance to their field. In fact, the real options

methodology has been applied to a multiplicity of investment projects in different areas of

the business environment. Table 1 shows some of the research areas where this approach

has been undertaken.

Mergers and acquisitions (M&A) can be seen as an interesting case. In the last few

years, and among other causes, due to economic liberalization and global openness, the

business world has seen an increasing wave of mergers and acquisitions (The Economist,

2006). There appears to be a growing appetite for consolidation in a large variety of

industries. Among them, the financial services industry, the cement industry, and the

pharmaceutical industry serve as examples of this M&A wave.

However, studies have demonstrated that between 55 and 75% of mergers and

acquisitions actually destroy at least some part of shareholder value (Paulter, 2002). Thus,

there is a need to better understand this phenomenon using different perspectives. From the

financial economics point of view, there is a need for better valuation processes that take

into account both the uncertain nature of future flows, as well as the strategic

considerations embedded in an imperfect oligolopolistic environment. A few studies have

recently tried to undertake this task. Smith and Triantis (1995) conceptually developed the

idea of M&As as a set of corporate options. However, th is work does not take strategy into


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consideration. Smit (2002) refines the concept of strategic growth options developed by

Kulatilaka and Perotti (1998) in order to account for industry reaction in an acquisition

environment. In particular, it views acquisitions as the purchase of further growth options

into new and related markets. Thus, it helps to conceptually explain why firms may be

willing to overpay for acquisitions as a strategic tool to gain footholds into new and

potentially large markets.

Nevertheless, there is a need to develop a theoretical framework which is applicable

to these types of events in order to gain a better understanding of their dynamics. Smit et al.

(2004) treat acquisitions as bidding games under uncertainty and they take into account the

strategic nature of bidding games. Under their assumptions, the bidders behave as identical

firms under imperfect information.

As stated before, it is a rare occurrence where firms participating in an imperfectly

competitive environment are actually symmetrical, and where information flows in a

perfect way. Therefore, there is a need to study the M&A process using a more general

framework, one that takes into account the asymmetry present in firms true nature, the

imperfection embedded in potential targets information flows, the potential reaction by

rivals to a merger or acquisition, and the uncertain nature of todays business environment.

d. Applications to International Joint Ventures

An analysis of international joint ventures provides interesting insights into

investment decisions as real options. It is often beyond the resources of a single firm to

purchase the right to expand in all potential market opportunities. Joint ventures are

investments that provide firms with the opportunity to expand in favorable environments,


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but avoid at least partially the losses from downside risk (Kogut, 1988). Under the real

options setting, firms may engage in a joint venture, where the potential exists in the future

for either of the participating firms to acquire or divest from the others stake according to

some contractual agreement.

Kogut (1991) derived a model that is concerned with the timing of exercise of the

acquisition options that develop with joint ventures. With this model, they provide

empirical support to the treatment of joint ventures as real options. This study recognizes

that the most common option in a joint venture is the option to acquire the partners stake.

Chi (2000) developed a theoretical model for international joint ventures under a

real options perspective where each partner treats the ventures valuation as a stochastic

variable. This model extends the previous work by taking asymmetry between the partner

firms into account. An application of this model may be made to the case of joint research

and development, where there may exist asymmetry in the value of results to the partner

firms. In this sense, one firm may find the results from the investments more valuable than

the other due to differentiated capabilities, scope economies, or learning processes. Folta

and Miller (2002) study equity partnership in the context of partner buyouts under

competitive assumptions. Under the empirical framework developed in this study, strategic

considerations exist. Partner buyouts may be exercised as a tool to preempt rivals from

entering into an industry by completing the acquisition or a partner firm. This empirical

work is mainly based on the strategic growth options concept of Kulatilaka and Perotti

(1998). Tong et al (2005) also provide empirical support to the existence of real options

features in joint ventures. However, they limit this support to specific types of joint

ventures, such as minority and diversifying ventures. Nevertheless, none of these studies


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provides a suitable theoretical model for international joint ventures on neither asymmetric

conditions or in the context of imperfect information.

Gilroy and Lukas (2005) develop a suitable theoretical model for strategic alliances

and international joint ventures. In this study, an optimal threshold where firms decide

whether to conclude their partners buyout or to divest from the venture is found. The

results are based on the standard assumptions of perpetual options, and more importantly

with regards to this particular work, they are based on the assumptions of perfect

information flows.

As is the case for mergers and acquisitions, it is sensible to think of informational

imperfections. In a joint venture environment, there may be informational asymmetries

between partner firms. These asymmetries may stem from the degree of partnership

between the firms in a venture, or may emerge from asymmetric managerial behavior. This

study intends to provide a more general model that may further advance the real options

approach in joint ventures setting by incorporating imperfect information into its modeling.

e. Summary

Investment projects need to be studied in a more comprehensive way to take better

account of the changing conditions present in todays business environments. These studies

should also incorporate the strategic considerations stemming from imperfectly competitive

industries. Firms actions affect not only their own future flows but also rivals behavior.

Finally, information flows are often not perfect. Some firms participating in investment

projects may have better information than others with regards to future revenue flows, and

therefore informational asymmetries occur.


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The purpose of this study is to extend the work done in analyzing investment

projects as strategic real options and thus to provide a more general model that takes the

above factors into consideration. This more general model will then be extended to the

cases of acquisitions and international joint ventures, where the concerns described in the

above paragraphs, have actually been raised in the financial economics literature.

III. SIGNIFICANCE OF THE STUDY

The study of investment projects as strategic real options is a relatively recent event

in the financial economics literature. However, there is a need to further deepen this

analysis stemming from the imperfections that exist in the competitive environment. Some

of these imperfections have been studied in the strategic real options context. Among them,

we can cite the work by Pawlina and Kort (2006) on strategic real options under cost

asymmetry by firms, and Smit et al (2004) who have modeled acquisitions as an options

game with asymmetric information.

This study contributes to the generalization of the strategic growth options model

by combining both the asymmetric nature of firms and the imperfect information

environment in which investment projects occur. Evidence has been found about the merits

of real options as a valuable tool in valuation processes. Nevertheless, this technique by

itself fails to explain the intricacies of strategic behavior under an oligopolistic setting with

imperfect but realistic conditions, such as asymmetric firms and imperfect information.

Only by developing new models, such as the one proposed in this study, will we be able to

better understand the underlying processes that may result in better valuation for strategic

projects.

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Moreover, the growth in importance of specific kinds of strategic investment

projects merits the existence of suitable models to analyze them. Mergers and acquisitions

have overseen an important increase in their occurrence in the past few years. As stated

before, the majority of M&As actually result in financial failure. Therefore, the need for

better models to study this phenomenon clearly appears. A straightforward application of

the theoretical model developed in this study is to analyze the acquisition process from the

strategic real options approach. In this case, the contribution is to extend the general model

to provide a specific and suitable model for imperfect information to the case of

asymmetric firms competing for an acquisition project.

Another extension of the model is the application to international joint ventures.

This is another area of important growth in the business world. Although in nature, there

are similarities with acquisitions as investment projects, there are also important

differences. While acquisitions may be treated as one-sided options where a firm

undertakes an investment and therefore a call option for future growth, international joint

ventures offer a two-sided option. Under these assumptions, a firm purchases two

options, an acquisition call option to buy its partners shares at a future date, or a

divestment put option where it can abandon the project by selling its own stake to its

partner. Thus, with the elements provided by this study, a suitable model that takes into

consideration strategic behavior and asymmetry by participants will be developed.

It is important to acknowledge that in order to provide support for the conceptual

and theoretical models developed in this work, empirical support must follow. Furthermore,

the need appears to develop models that are appropriate for other strategic projects, such as

R&D investment, technology adoption, greenfield investment in international markets, etc.


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In these strategic investment projects, the main characteristics of the competitive

environment proposed under the above assumptions, seem to exist.

IV. RESEARCH QUESTIONS

As stated before, the analysis and valuation of strategic investment projects needs

further refinement. The intent of this study is to answer to the following question: Can a

more general and comprehensive model for valuing strategic investment projects be

developed such that it considers the following factors: uncertain revenue flows, strategic

behavior by other participants in an industry, the asymmetric nature of rival firms, and

imperfect information flows?

It is evident that not all investment projects may be treated under the above assumptions.

Nevertheless, it appears that several types of investment projects actually fall into this

category. What kind of applications can be derived from such a general model? In

particular, may a suitable model be developed in order to obtain better valuation processes

for strategic acquisitions? May the same be replicated for the case of international joint

ventures? The model developed in this study and its extensions to acquisitions and

international joint ventures will help to clarify these questions and suggest new and related

avenues of research.

V. DELIMITATIONS AND LIMITATIONS OF THE STUDY

Even though the goal of this study is to advance the strategic real options literature

towards more general modeling, it must be acknowledged that not all investment projects

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lend themselves to be analyzed by this model. Plenty of investment projects affect the

actions and flows of the investing firm and are not affected and do not affect their

competitive environment. Such may be the case of estate development or energy

exploration. Other projects are present in unique competitive environments, such as the

case of investment by monopolistic or state controlled firms. On the other hand, the case of

industries where a very large number of small firms participate, approximate the perfectly

competitive scenario. Finally, a number of scenarios may be thought of where no

asymmetric information exists, such as perfect auction bidding. Nevertheless, several

applications such as the ones discussed above seem to have the characteristics alluded to in

this introductory chapter.

VI. ORGANIZATION OF THE DISSERTATION

The rest of this study is organized as follows. Chapter 2 will provide an overview of

the current state of the literature on strategic options. This literature review will provide

both the path that strategic options studies have taken to date, as well as the main sources

behind this studys development. Chapter 3 will portray a proposed general model that may

help to deal with the issues of imperfect information and the asymmetric nature of firms for

strategic growth options. Two applications are proposed for this model. Chapter 4 will

provide a suitable theoretical model for the case of strategic acquisitions under both cost

asymmetry and imperfect information. Chapter 5 will extend the model to the case of

international joint ventures. Finally, some concluding comments, as well as suggestions for

future research, will be presented in the final part of this work.


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CHAPTER 2

LITERATURE REVIEW

I. INTRODUCTION

In this chapter, an overview of the relevant literature is presented. Three main

sections are contained in this chapter. The first section consists of an overview of the real

options approach after its introduction in the financial economics literature two decades

ago. This overview will center in the main models that have been developed within the

strategic options context. This overview will trace the evolution of strategic real options in

order to provide support for the development of the more general model proposed in this

study. As stated before, this model incorporates both asymmetry amongst firms, as well as

the notion of imperfect or asymmetric information flows.

Section 2 of this chapter consists of a review of the studies that have related the real

options approach to the case of acquisitions. Smith and Triantis (1995) were the first to

suggest that strategic acquisitions in the context of uncertainty must have clear real options

features. Several studies have emerged since then that have tried to operationalize this

notion. This second section will lead to the extension of the proposed model under a

strategic acquisition setting.

Finally, section 3 of this chapter provides the necessary background to extend the

general model to the case of international joint ventures. Particularly, this section deals with

ventures that provide the option to the involved parties to acquire or divest their venture in

the future. Although few studies have actually dealt in a specific manner with this

phenomenon, it must be acknowledged that international joint ventures have increasing

occurrence in todays business world.


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II. THE REAL OPTIONS APPROACH

At the heart of standard real options reasoning there are two concepts that this

methodology incorporates. The first concept is uncertainty. Uncertainty may stem from

several sources. Among these sources, we may cite demand uncertainty, technological

uncertainty, revenue flows uncertainty, and informational uncertainty. However,

uncertainty by itself does not justify the use of real options. The second and more important

concept that the real options approach is able to deal with is managerial flexibility.

Managerial flexibility provides firms with options to invest and act. It is important to

note that traditional DCF analysis is not able to incorporate the flexibility that managers

have to operate. Trigeorgis (1995) enumerates several types of options that managerial

flexibility confers firms with. Table 2 is based on this work.

It is beyond the scope of this study to incorporate the reasoning behind all different

types of options. Among the different types of options that firms possess as part of their

investment schedule, this study is primarily concerned with growth options. Any

investment that is undertaken in order to provide future growth opportunities for firms may

be thought of as a growth option. Under real options reasoning, an early investment may be

equivalent to purchasing the right (but not the obligation) to make further investment at a

later date. Examples of growth options may be R&D investment, strategic acquisitions,

strategic alliances or international joint ventures, technology adoption, etc. Several studies

have been developed to cope with each issue using the real options approach. Table 3

provides some examples of growth options examined using the real options approach.

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Table 2: Real options categories

Category Description

Option to defer Management holds a lease on resources. It

can wait some time until demand signals

justify new construction.

Staged investment Undertaking stage investments creates the

option to abandon without incurring all

the costs. Each stage may be viewed as an

option.

Option to alter operation scale If market conditions are favorable, the

firm can expand. If conditions are

negative, it can reduce its scale of

operations.

Option to abandon If market conditions decline severely,

management can abandon operations

permanently and realize the salvage value.Option to switch Either product flexibility (management

can change the output mix of the facility),

or process flexibility (same outputs using

different types of inputs).

Growth options An early investment is prerequisite for the

opening up of future growth opportunities.

Among these, we can cite strategic

acquisition, R&D, lease on undeveloped

land.

Multiple interacting options Real-life projects often involve both

upward-potential and downward

protection options, where their combined

value differs from the sum of separateoptions (when they interact).

Source: Trigeorgis (1995)


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The actual marketplace is characterized by change and uncertainty, and these factors

are captured by the above studies. However, a third element that is inherent to todays

business environment is strategic interaction (Trigeorgis, 1995). The studies that are

presented in Table 3 fail to capture this important issue. Indeed, they are either based on the

assumptions of monopoly or founded on the idea of

perfectly competitive industries. In either case, the actions of a firm are not affected by its

rivals reactions.

Table 3: Growth options studies

Type Description StudiesResearch and development An R&D investment may

entail a firm to a

competitive advantage on

new product development

Weeds (2002)

Schwartz (2003)

Strategic acquisition An acquisition may

provide access to new

markets

Smith and Triantis (1995)

Smit (2002)

Smit et al (2004)

Joint ventures Equivalent to the purchase

of a right to complete

acquisitions at later dates

or to gain footholds in new

markets for later

investments

Kogut (1991)

Gilroy and Lukas (2005)

Technology adoption Investment in new

technologies may provide

strategic growth

opportunities by way of

first mover or cost

advantage

Kulatilaka and Perotti

(1998)

Land development Lease on new land may be

similar to acquisition of

rights for later growth

opportunities (real estate,

mining, natural resources)

Moel and Tufano (2003)

Capacity building Capacity may signal a

commitment for future

aggressive strategy, andviewed as an opportunity to

take advantage of future

positive demand

Kulatilaka and Perotti

(1999)


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However, these assumptions are strong and inappropriate in the majority of

industries. Most industries have several participants that often behave in response to rivals

actions. Under a strategic investment context, decisions are often affected by the perceived

response of rivals, or are aimed at affecting them. Therefore, the need arises to deal with

project valuation and analysis in a more comprehensive manner.

a. Strategic Behavior of Firms

In order to deal with imperfect competition, the economics literature, and

particularly, modern industrial organization studies, provide plenty of cases that utilize

game theory to undertake strategic analysis. The purpose of this sub-section is to provide a

brief overview of the main studies that have been used to consider the strategic behavior of

firms involved in oligopolistic competition with regards to the kind of investment projects

that have been discussed above. Reviewing the IO literature on strategic behavior is beyond

the scope of this work and thus this review is selective.

One of the main considerations present in strategic behavior in the industrial

organization context is related to the effects of entry or potential entry by

rivals into an industry. Dixit (1980) analyzes the role of investment in entry deterrence. In

this study, investment in capacity is utilized by firms as a signal of their commitment to

stay in the marketplace and thus to prevent entry by rivals. A key element in this analysis is

the fact that investments are irreversible and thus act as sunk costs. The irreversibility of

investments is a key element in the growth options reasoning as well, since if it were not

Comentario [U7]: Poor sentence.please redo.


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the case, any number of firms would be willing to participate on any given investment

project.

Dixits model was extended by several studies in order to deal with uncertainty.

Among them, Maskin (1986) found that under the assumptions of quantity or capacity

competition, the incumbent firm chooses a higher capacity to deter entry than it would

under a deterministic setting. In turn, this makes entry deterrence less likely by increasing

its cost. Another interesting extension that is also related to this work may be seen in

Rasmussen (1987). This study holds that under the assumptions of perfect information, zero

transaction costs, and no legal impediments to mergers; in a duopolistic setting, firms

always have the incentive to merge and thus form a monopoly, since they can always do at

least as well as the aggregate profits of the firms under duopolistic competition. Finally,

Fudenberg and Tirole (1985) use a spatial model to formalize the equilibrium strategies in

preemption games. In this deterministic setting, several equilibrium strategies may be

observed under different conditions in the preemption game by an incumbent and a

potential entrant. Either sequential entry or preemption are the outcomes of this preemption

game. These studies have provided the necessary support to incorporate the strategic

reasoning into the real options methodology.

b. Strategic Growth Options

Under oligopolistic competition, investment opportunities are exercised under the

acknowledgement of competitive reaction by rivals. In these conditions, a strategic

investment no longer represents an internal value optimization problem against nature

(uncertainty) but it involves a strategic game against both nature and competition. Whereas


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a simplification of standard real options modeling is an extended net present valuation

consisting of the sum of the traditional DCF method plus the managerial flexibility value

(real option), it now must incorporate as another element the strategic value stemming from

competitive interactions (game theory) (Smit and Trigeorgis, 2003).

Smit and Ankum (1993) developed a theoretical model to account for the difference

in economic rents under different competitive assumptions. In order to analyze the case of

oligopolistic competition, they utilized game theoretic tools, and came up with several

interesting propositions, depending on the importance of project values and the intensity of

competitive rivalry: when there is low project value it may be attractive for both firms to

defer investment; however, as soon as one of the firms invest, the other will follow suit. If

competitive rivalry is intense, both firms will invest immediately, which may be

suboptimal. When there is asymmetric market power among firms, investment may result

in a credible threat of complete preemption. Even though this study proposes a conceptual

model to better deal with strategic investments and deals with the very general idea of

economic rents, it has helped to set the foundations of strategic options thinking.

Kulatilaka and Perotti (1998) derive a model for a specific investment project. In

this study, a firm may decide to undertake a project (potentially some kind of technology

adoption) that confers the firm with a strategic cost advantage versus its competitors. In

tune with Dixit (1980) and his view of irreversible investments as a strategic threat to

competitors, strategic investment under uncertain conditions can be viewed as a

commitment to a more aggressive future strategy. The acquisition of this strategic cost

advantage endogenously leads to the capture of a greater market share, either by dissuading

entry or by inducing competitors to take an accommodating stance and make room for the

stronger competitor. An important result emerging from this study is that the effect of


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uncertainty on the relative value of the strategic growth options is ambiguous under

imperfect competition. This stems from the fact that in an oligopoly, profits are convex in

demand, since oligopolistic firms respond to better demand signals by increasing output

and prices, and thus expected cash flows increase with volatility. The main factor affecting

the valuation of such an investment is whether or not the project possesses a strong

preemptive effect. This result is different from the standard real options model, which

predicts an unambiguous correlation between the project (and the option) value and the

degree of uncertainty. Main and important assumptions that are present in this model are

those of linear demand and symmetric Cournot competition, as well as a discrete time

framework. In this context, and under the assumptions of sequential entry, the strategic

investment confers the competitor a higher entry threshold, which if high enough, may

result in preemption altogether.

In a follow-up study, Kulatilaka and Perotti (1999) analyze the impact of another

investment project: the decision to invest in distribution capabilities that allow the firm to

deliver a product faster than competitors under Cournot competition. The most intriguing

result is that greater uncertainty unambiguously favors the early commitment to invest. The

standard real options literature concludes that in a context of perfect competition the value

of the option to wait increases with uncertainty. When strategic considerations are taken

into account, the value of this time-to-market option always increases more than the value

of not investing. This stems again from the fact that profits are convex in demand due to the

oligopolistic market structure. The assumptions are the same than in the previous study;

however, there is an important difference. This particular framework allows only for a

situation when the time-to-market option may only be acquired today and thus there is no

option to wait. These two studies provide ample support to the fact that early investment


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has a different market impact in an imperfectly competitive environment. However, they

are suitable models for specific investment situations and are based on fairly strong

assumptions and developed under the less general ideas of discrete time.

Grenadier (2002) presents a tractable approach to derive equilibrium investment

strategies in a continuous-time Cournot framework. The main tool that appears in this

study is that, by transforming the industry demand curve, it can approximate an

oligopolistic setting to an artificial perfectly competitive industry. In this manner the

author is able to provide closed form solutions in a continuous time model.

One of the key assumptions that appear in this study is that related to the existence

of any number of symmetrical firms, and that the cost of increasing output is linear. While

other studies assume specific stochastic processes and demand functions, this study

provides a general result for different functions. As the main result of this study, the author

is able to explain why empirical results that provide evidence of firms behaving in a way

closer to the standard NPV rule than to standard real options predictions actually do so.

Under this proposed scenario, increasing competition unambiguously leads firms to

exercise their options sooner, as the fear of preemption diminishes the value of their options

to wait. Thus, the option premium that emerged from the real options literature is in effect a

function of the intensity of competition and the number of participants. This is a result that

differs from the predictions of Kulatilaka and Perotti (1998) which attribute this

relationship to the degree of the strategic advantage that may be captured with an

investment and not to the amount of participants. Again, it must be reiterated that a key

ingredient for the transformed demand curve is that of symmetrical firms.

Weeds (2002) extends previous studies in the industrial organization literature in

two respects: it introduces both uncertainty about future profits as well as technological


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uncertainty over the success of R&D investments. Fudenberg and Tirole (1985) developed

the theoretical background to analyze games of entry and exit in a deterministic framework.

This extension also incorporates the insights developed in previous studies (such as Dixit,

1988) about technological uncertainty with deterministic returns, and combines both

branches with the real options treatment of uncertainty to extend both branches of the IO

literature to a stochastic environment. Once again, the setting is a duopoly and the

assumption is that of symmetrical firms. An important feature of this study is that it

considers the benchmark case of two firms planning their investments cooperatively. It is

important since it may be similar to the case of a strategic alliance or a joint venture. The

main result that is evident from this study is that, contrary to Grenadier (2002), competition

between a small number of firms does not necessarily undermine the option to delay. In this

particular R&D setting, the fear of creating a patent race may further raise the value of

delay and increase the time before any investment takes place. In the case of two symmetric

firms, the identities of the leader and the follower in R&D are indefinite, while an extension

to asymmetry would provide a unique definition.

Huisman and Kort (1999) also extend the model developed by Fudenberg and Tirole

(FT) by incorporating the treatment of profit uncertainty. The framework is a duopoly with

identical firms. Three scenarios are identified. In the first one, which holds when first

mover advantages are large, a preemption equilibrium occurs where the moments of

investment of both firms are dispersed. In the second one, there is simultaneous investment

when demand is relatively large, and the result is similar to collusion. Finally, in the third

scenario the preemption equilibrium is appropriate to environments with low uncertainty,

while the simultaneous investment occurs with large uncertainty at the moment of a high

level of demand.


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Huisman et al (2001) base their methodology on the above mentioned work by

Fudenberg and Tirole (1985). Based on the assumption of duopolistic competition with

identical firms, they develop a continuous time model for investment timing under

uncertainty when firms may gain an advantage by being a leader. Under this scenario,

previous studies have ruled out the existence of a simultaneous equilibrium since this result

is suboptimal for both firms (low payoffs). However, if both firms want to be the first to

invest and thus become a leader, each firm will want to preempt the other from investing

first and a coordination problem arises. This problem is solved with the use of the mixed

strategy approach appearing on Fudenberg and Tiroles work. The main result is that under

this scenario, the simultaneous outcome exists with positive probability, which may help to

explain the investment waves that exist in certain industries.

Pawlina and Kort (2002) study another specific investment decision in the face of

uncertainty and strategic interactions: the decision to replace a production facility. This

model is again based on the assumption of duopolistic competition with identical firms

under linear demand, and is in fact another extension of Fudenberg and Tiroles with the

use of mixed strategies. The results are different than in Huisman and Kort (1999). In this

case, the type of equilibrium (preemptive or simultaneous) depends on the sunk investment

costs. If the investment cost is high enough a simultaneous equilibrium will occur, whereas

if this cost is low enough, a preemptive equilibrium is the dominant outcome. The intuition

is the following: if the advantage of being the leader and investing first is large enough (low

cost), firms have an incentive to make the early investment; if this advantage is small (cost

is high), firms will make the replacement simultaneously. The optimal threshold for

replacing the facility has two major components in this model, the waiting effect, which is

Comentario [U8]:


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analogous to the option to defer the investment, and the strategic effect, which incorporates

the value of being the leader in this setting.

Kort et al (2005) study the effect of uncertainty on the choice between different

degrees of flexibility in proceeding with investment. In this scenario, a firm may be able to

choose between two alternative strategies: investing in one lump or investing in small

increments gradually over time. While intuition may suggest that increased uncertainty

unambiguously favors sequential investment, the authors find that under strategic

considerations growth being uncertain actually favors the scale economies provided by a

single large investment. Some applications that are suggested by this study are related to

the adoption of new technologies, whether to invest in an intermediate (and cheaper)

technology or to leapfrog to a more expensive next generation one; or the takeover decision

of firms that have to decide whether to acquire blocks of shares of the entire target

company. The model itself is a variation of prototype models of irreversible investment

under uncertainty. This kind of models may be found in Dixit and Pyndick (1994).

Bouis et all (2006) extend the basic strategic option model, which is set under the

assumption of duopolistic competition, to a three firm scenario. In this symmetrical 3 firm

context, the results are quite different than those for the 2 firm case. Whereas the two firm

case results on a preemption equilibrium as its only solution, the three firm setting allows

for two types of equilibria. In the first one, all firms invest sequentially and in the second

one, the first two firms invest simultaneously while the third one invests at a later moment.

They also found the accordion effect, which is the term that they used to describe that

exogenous demand shocks affect the timing of entry of the odd numbered investors in the

same qualitative way, while the entry time of the even-numbered firms is affected in


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exactly the opposite qualitative way. If a delay is observed for the odd firms, then the

even investors will invest sooner.

The purpose of this brief overview has been to put in perspective the current state of

the art in the strategic options literature. A key factor that is present in all of these studies is

the fact that two strong assumptions are made: the existence of symmetric firms in

competition, and perfect information flows. As it was stated before, competition often

exists between firms with different size, different learning capabilities, or different access

to technology, and thus to recreate this realistic environment, a few studies have been made

in order to deal with the asymmetric nature of firms in the context of strategic investments

under uncertainty.

c. Strategic Growth Options with Asymmetric Firms

It has been stated before that the analysis of strategic options needs further

refinement, by taking into account the asymmetric nature of firms participating in the

marketplace. Few studies have extended the main models to incorporate this factor. The

following lines will provide a brief overview of these studies.

Smit and Trigeorgis (2003) develop a conceptual model to analyze an innovation

race game in which a firm has an advantage in developing a particular technology. In the

context of this study, the advantageous firm has limited resources. There are two games to

be studied: a simultaneous investment game and a sequential investment scenario, in which

the powerful firm chooses its R&D strategy before the other firm. The equilibrium

outcomes are radically different. Whereas the dominant strategy for the P firm is a low

effort strategy for the simultaneous investment case, its dominant strategy is a high effort


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one for the sequential investment scenario, since by doing so, the firm signals a credible

commitment to gain a strategic advantage, and therefore the weak firms dominant

strategy is a low effort one. There are two elements in the valuation of this kind of strategic

option, a flexibility value and a strategic commitment effect. The signs for these two effects

are opposite and its relative valuation affects the strategic behavior of firms.

Huisman et al (2003) develop a model to extend the prevailing Industrial

Organization deterministic models to better account for uncertainty. They utilize a mixed

strategies solution to what they call the existing market model developed by Smets

(1991). In the new market model that appears in Dixit and Pyndick (1994), two firms battle

to enter a new market, while in this studys model, two existing firms have the opportunity

to place a new investment (potentially R&D or technology adoption) to gain a strategic

advantage. Under this model, depending on where the optimal joint investment curve lies,

either a preemption equilibrium exists or a tacit collusion one, in which all firms refrain to

invest until they get a strong enough signal from the market. This model is extended to

allow for asymmetric firms. In this extension, there is investment cost asymmetry among

firms. Contrary to the previous predictions, there exist now three types of equilibria. A

preemption equilibrium occurs when both firms have an incentive to become the leader

(when the cost advantage is relatively small). The result is that the strong firm invests at the

weak firms investment threshold. A sequential equilibrium occurs when the weak firm has

no incentive to become the leader and thus the strong firm simply maximizes its own

process as if it had a monopoly on the investment opportunity, although with its payoffs

affected by competition. Finally, a simultaneous investment equilibrium is achieved with

positive probability. A crucial contribution that this study provides is that the factors

affecting the actual outcome are two key elements: the relative first mover advantage and


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the degree of investment cost uncertainty. When the investment cost asymmetry is

relatively small, and with no significant first-mover advantage, the firms invest jointly.

When first-mover advantage is significant, the strong firm prefers to become the leader, and

thus the preemption equilibrium occurs. Finally, if the asymmetry among firms is large

enough, the result is sequential investment.

Pawlina and Kort (2006) provide the most thorough study to date on the impact of

asymmetry on strategic real options. Its main conclusions are indicated in the above study,

which in part emerges from Pawlina and Kort. However, this study fully characterizes the

different equilibria and the conditions under which each occur. This characterization is

achieved by use of Monte Carlo simulation. Furthermore, this study analyzes the

implications of the results for economic policy and welfare. An interesting result for

welfare analysis is that it is possible that a preemptive or sequential equilibrium under

asymmetry is more socially desirable that the same results for symmetric firms.

Finally, Kong and Kwok (2006) extend the study by Pawlina and Kort to

incorporate two kinds of asymmetry: investment cost asymmetry and revenue flows

asymmetry. Their results contradict the results of both Huisman et al (2003) as well as

Pawlina and Kort (2006). In this study, the simultaneous equilibrium can never occur under

cost asymmetry alone, and in their context, it can only occur under both cost and revenue

flows asymmetry. The authors utilize the same existing market model than both of the

above studies while incorporating revenue flow (or profit) asymmetry.

All of the above studies provide significant contributions towards generating a more

general model that may help to gain better understanding of the strategic options processes.

However, a tacit assumption that all of these studies employ is that of perfect information.


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A more realistic environment usually deals with imperfect or asymmetric information

flows.

d. Strategic Options under Imperfect Information

The assumption of complete information is often unrealistic. Grenadier (1999)

develops a model in which private information is conveyed through the revealed exercise

strategies of market participants. A suitable scenario for this model is oil exploration. In

this case, it is frequent to find two or more firms leasing adjacent tracts of land for oil

exploration. A firm may take advantage of being the first to drill or wait until its rival has

done so and thus conveys the information about the success of the drilling, in which case

there may be a follower advantage. In equilibrium, as the potential benefits from option

exercise become greater, firms will trade off the benefits of early exercise with the benefits

of waiting for information to break through the actions of others. Equilibrium strategies in

this context are sequential, with the least informed firms free-riding on the information

conveyed by the most informed agents. In this setting, agents may find their own private

information overwhelmed by the others signals and simply jump on the bandwagon. This

may help to explain the occurrence of overinvestment in some industries. However, the

model assumes the existence of n symmetric firms.

A significant event for many firms is that their conjectures about competitors

behavior often prove to be incorrect. Lambrecht and Perraudin (2003) introduce a model in

which firms take into account for their strategic investment decision their rivals trigger

threshold. However, this trigger point is unknown to a firms rival, and their beliefs are

constantly updated by the realization of the stochastic variable. Thus, the optimal


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investment strategy for each firm depends on the level of the implied fear of preemption

and on the distribution of competitors costs from which a firm updates its beliefs. This

optimal strategy may lie anywhere between the zero net present value trigger and the

optimal strategy for a monopolist. Limit cases exist for a large number of firms (perfectly

competitive scenario) and for the case of perfect information, whose results are well known

in the strategic options basic literature..

Martzoukos and Zacharias (2001) develop a model to analyze option games with

incomplete information and spillovers. Under their proposed setting, learning may be

achieved in a variety of ways: by acquiring information, exploration or marketing research.

Spillovers are also allowed resulting in a scenario where firms may decide to free ride on

their rivals investments. There are two decisions for the firms to make: the optimal level of

coordination in a joint investment context, and the optimal effort for a given level of

spillover effects. Nevertheless, in order to generate a more tractable analysis, the study is

based on the strong assumption that firms do not affect each other in the marketplace (they

either have a monopoly over the investment decision or prices are determined

exogenously). As it has been well commented, these are strong and often unreal

assumptions.

Thijssen et al (2003) study the effect of imperfect information on strategic

investment. Whereas Lambrecht and Perraudin (2003) study the effect of imperfect

information over their rivals actions, this study is concerned with imperfect information

over the success of the investment project. In this framework, signals arrive over time that

can either mean a low revenue or a high revenue project. As it is often the case in strategic

real options modeling, two opposite effects arise in this context. A first mover advantage

(Stackelberg) can be created, as well as a second mover (follower) advantage stemming


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from information spillovers. Thus, two different situations arise from the relative weight of

these effects: a preemption equilibrium for the case of a more valuable Stackelberg

advantage, or a war of attrition case where no firm is willing to invest first since

information spillovers will provide an advantage for the rival firm. It is important to

distinguish between uncertainty and imperfect information in this setting. The main

difference stems from the fact that signals do not guarantee a successful outcome for the

project under the imperfect information scenario, and the relative number of positive

signals is compared to the existence of a symmetric prior belief on the investment trigger

threshold.

The above models provide some discussion on strategic real options models under

imperfect information. However, all of them are based on the assumptions of symmetric

firms. This study intends to provide a more general model that accounts for both

asymmetry and incomplete information. This study intends to build on the conceptual work

of Smit and Trigeorgis (2003), by using a similar approach to Pawlina and Kort (2006) who

in turn built on an existing market model, and combining it with the insights provided by

basic signaling games present in the informational game theory literature (e.g. Fudenberg

and Tirole, 1991). Figure 1 provides an approximation to the path that strategic option

studies have followed, as well a graphic indication of this studys general goals. A more

extended discussion and development of these models will appear in the next chapter.

Another aim of this study is to provide applications for the proposed general model.

Particularly, two applications are proposed, one related with the issue of strategic

acquisitions and the other to international joint ventures. A brief overview of the work that

has been done with regards to strategic real options in both contexts (acquisitions and

IJVs) will follow.


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III. ACQUISITIONS AS STRATEGIC GROWTH OPTIONS

Smith and Triantis (1995) were the first to observe that acquisitions as an economic

phenomenon possess a lot of the features present on the real options reasoning. They

offered a rationale for a treatment of strategic acquisitions in a real options setting since

they possess several characteristics that are inherent to this

Figure 1: Path for strategic option analysis

DCF Analysis

(Deterministic)

Real options

(Uncertainty)

Perfect competition

Strategic options

Symmetry

Perfect information

Asymmetric strategicoptions

Strategic optionsImperfect information

Proposed generalmodel

Industrial Organization

Imperfect competition

Deterministic


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methodological perspective: They are undertaken under uncertainty and therefore, in a

strictly economic sense, a strategic acquisition should be viewed as the purchase of a right

to enter new markets or to make further acquisitions in related markets or industries at a

later date. Even though this study has been very useful in arousing the interest on real

options and acquisitions, it fails to capture the importance of strategic considerations under

the acquisitions umbrella.

Several empirical studies have been a part of the M&A literature that have given

support to the notion of the real options approach to valuing M&As (e.g. Pereira and

Rocha Armada, 2002, Dapena and Fidalgo, 2003). However, these studies fail to address

the strategy issue that is adhered to this process.

Smit (2002) captures in a conceptual study the importance of strategic behavior in an

acquisitions context. It is evident that most acquisitions are undertaken as future growth

opportunities, in order for firms to gain a strategic advantage over its rivals via economies

of scale, as footholds to new and potentially more profitable markets, or as a way to

preempt potential rivals. As such, the author suggests that the interaction between the real

options methodology and the game theoretical tools is the proper way to analyze strategic

acquisitions. Several questions arise in this study: How valuable are the growth

opportunities created by an acquisition? How is the industry likely to respond and how will

this response affect in turn the acquisition value? Thus, it sets the tone to provide

theoretical models that operationalize the conceptual reasoning in this study.

Lambrecht (2004) utilizes a real options approach to provide a theoretical

explanation for the pro-cyclicality of merger waves. Particularly, the study concentrates on

mergers that are motivated by economies of scale. Empirical evidence has shown that

merger waves tend to increase with economic expansion while they are slowed during


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recessions. The model is based on the assumption of merging firms behaving as price takers

and under complete information markets. Under these assumptions, the author finds

theoretical support for the timing of mergers being pro-cyclical. By relaxing the assumption

of perfect competition, and assuming a different motive for the merger (that duopolistic

firms merge to become a monopoly), the study also shows that mergers that are motivated

by an increase in market power are also pro-cyclical. Finally, this work analyzes the case

for hostile takeovers and argues that while mergers are efficient, takeovers take place

inefficiently late, and thereby decrease total value.

Betton and Moran (2004) model the negotiation process between target and bidding

firms as a Stackelberg game with complete information. In the first stage the target defines

its reservation premium, and in the second stage, the bidder decides the optimal acquisition

time. The model predicts a positive relation between target growth and volatility, as well as

a positive relation between the premium and the expected wealth creation. It must be noted

that this model fails to consider potential competition for the target in the acquisition

process, and therefore, it does not fully capture the strategic implications of this

phenomenon.

Carow et al (2004) acknowledge the fact that despite the relatively wide acceptance

of first mover advantages, few empirical studies examine whether being an early mover

affects performance. They develop an empirical model that gives support to the hypothesis

that first-mover advantages are significant in industry acquisition waves. Acquiring a first-

mover advantage or dissuading entry are key elements of strategic behavior by firms and

managers, and are a key element in the strategic acquisition process. The study finds that

strategic pioneers, those acting in manners consistent with having superior information,


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capture significant advantages. This superior information may be due to experience or

learning capabilities.

Finally, Smit et al (2004) develop a model that helps to treat acquisition as real

options bidding games. This model deals with strategic interactions and another key

element in the strategic acquisition process: imperfect information. The main contribution

of this study lies in the fact that this study shows the influence of asymmetric and imperfect

information about firms resources on targets valuation. Under a two-player setting, a

bidder may decide to make a preemptive or accommodating bid at the first stage.

Depending on the type of the bid and the similarity of the bidders (approximated by their

correlation), the second player decides to undertake a due diligence (if the initial bid is

accommodating) or abstain from it. When the second player abstains, the initial bidder

completes the acquisition at the preemptive bid. A double effect emerges from this setting.

When firms are similar, the opening bid signals high target value for the rival, and thus

induces it to undertake the due diligence. On the other hand, acquisition prices will be high,

inducing the second player to be less inclined for the investment. Another interesting result

is that value appropriation (for the winning bid) increases with uncertainty and thus the

likeliness of a bidding contest. Finally, value appropriation of the first bidder increases with

higher information costs.

As it can be inferred from the above paragraphs, there have been limited studies on

acquisitions as strategic growth options. Nevertheless, it seems that acquisitions as an

economic phenomenon possess the necessary ingredients for a deeper understanding under

a strategic options framework: uncertainty in future cash flows, an important strategic

component that arises from industry wide and rivals reactions, the asymmetric nature of

participating (acquiring) bidders due to size and technological differences, and finally,


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imperfect information flows that arise in a global context due to regulatory differences,

agency problems or other sources. In this context, the purpose of this study is to extend the

proposed general model in order to produce a suitable theoretical proposal that helps to

better understand the strategic acquisitions phenomenon.

IV. INTERNATIONAL JOINT VENTURES AS STRATEGIC GROWTH

OPTIONS

Quite often, the task of building a market position and/or entering new markets

requires resources that are beyond a single firms capabilities. Thus, a strategic partner may

be sought in order to share the costs of obtaining the necessary capabilities to achieve the

proposed goals, and to share the inherent risk that comes along with investment in risky

projects. Thus, joint ventures serve as an attractive way to invest in future growth

opportunities. Furthermore, joint ventures often result in contracts that give the firms an

opportunity to complete the acquisition if the market conditions turn favorable or to divest

from it if conditions are deemed negative. In fact, Chen (2005) finds empirical support to

the notion that acquisition joint ventures are better analyzed under real options

considerations, as opposed to transaction costs analysis. Furthermore, Tong et al (2005)

find that joint ventures confer partner firms valuable growth options, but limited by certain

conditions. Specifically, they find that minority and diversifying IJVs contribute to growth

value, but other types of IJV do not.

Kogut (1991) explores this issue and assigns real options features to it. The main

concern in this study is related to the timing of the exercise of acquisitions under a joint

venture context. Under its empirical modeling, the author finds support to the notion that


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acquisitions are completed when market signals regarding demand are favorable, and that

no divestment is undertaken as long as the signals are not that negative. The study finds

support to the main hypothesis that ventures will be acquired when their valuation exceeds

the base rate forecast underlying the valuation of the business.

Chi (2000) develops a theoretical model in order to discuss the nature of the

acquisition decision by partners in an international joint venture. Under this model, each

partners valuation of the venture assets evolves stochastically over time. The assessments

of the two parties have some kind of correlation index, and the level of uncertainty falls

over time due to the learning that occurs about the ventures outcome. An important

assumption throughout this study is that bargaining power is equal among the partner firms.

The results indicate that the option to acquire (divest) is more valuable to the two partners

when their valuations are less correlated, when there is any divergence between partners

growth expectations, and when the volatility expectations diverge.

Folta and Miller (2002) examine the issue of buyouts and equity purchases of

partner firms subsequent to initial minority equity stakes. In an analogous way to Kogut

(1991), they characterize minority investments as two-stage compound options. Exercising

the first stage buyout results in the purchase of the right to exercise a second stage growth

option, which in turn involves future investments. This study takes strategic considerations

into account by acknowledging that early exercise decisions may be warranted in order to

preempt rivals or gain a learning advantage. The main results state that increased partner

valuation and less uncertainty make partner buyouts more likely and that when buyout

options are more proprietary (fewer partners associated with the target firm), partner buyout

is more likely. Maybe more important with regards to this study, when there are fewer

rivals in the marketplace, partner buyout is more likely.


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In general, real option theory suggests that foreign direct investment (FDI) is a

platform utilized by multinational enterprises (MNEs) to carry further investments abroad.

Thus, international joint ventures may be seen as investments that may have an intrinsic

negative value but that carry a high option value due to possible subsequent investment

opportunities. Gilroy and Lukas (2005) develop a two phase market entry model in order to

incorporate this reasoning behind FDI. The first phase serves as a platform and is in fact a

close collaboration project with a partner. The second phase is essentially divided in two

options: to acquire the remaining equity and transform the alliance into a merger or to

divest the venture by selling out to the partner. The authors utilize a simulation process and

find that the choice of investing in the first stage is not only driven by the growth option,

but also driven by the degree of flexibility to abandon the venture. It must be noted that this

study is based on the assumptions of a monopoly over the investment opportunities, and as

such, it does not take into account strategic considerations.

Juan et al (2007) focus their research in international joint ventures on the treatment

of compensation options present in joint venture agreements as non-standard real options.

They develop a suitable model to deal with this atypical real options based on two case

studies and provide support to the notion of the compensation clauses as the purchase of

real options for future growth.

Finally, Savva and Scholtes (2006) depart from the mainstream literature on

strategic real options and merge cooperative game theory with the real options

methodology in order to incorporate the real options approach into the analysis of

partnerships, such as IJVs. They introduce the idea of a cooperative option under a

complete markets assumption, which includes the assumption of perfect information and

perfectly tradable assets. The authors provide comparative results between cooperative and


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non cooperative game theoretical analysis. The results provide some interesting managerial

insights. Partners with divergent risk attitudes gain more synergies with highly uncertain

environments; non cooperative options in this context must be carefully analyzed, since

there are two opposite effect to account for: on one hand, they are valuable for individual

partners since they cut off lower utility edges, but they can result in empty ventures

when partners are too greedy in their non cooperative clauses. This study provides an

interesting framework to analyze strategic alliances and joint ventures, but is still limited in

its development due to the strong assumptions of complete markets.

The purpose of this study is to extend the proposed model to include international

joint ventures where there is an embedded acquisition option for the partners. By utilizing

the proposed general model, and building on the existing work of strategic joint ventures,

particularly on the work by Girloy and Lukas (2005), this study intends to make further

advances in the development of a suitable model for this phenomenon.

V. SUMMARY

During the introductory chapters, this study has tried to introduce the research

problem. The notion of strategic options as an analytical tool towards a better

understanding and valuation of strategic investment projects is in its early stages. The

models that have been developed to date utilizing the tools provided by both a real options

approach and game theoretical tools has helped to shed light on the intrinsic valuation of

strategic projects under uncertainty. Both theoretical and empirical models have provided

support to the existence of strategic options embedded in the context of certain kinds of

investment projects. However, in order to deal with important features present in real world


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scenarios, there is a need to produce more sophisticated theoretical and empirical models.

This study intends to provide a more general framework to analyze strategic investment

projects and their valuation, by incorporating two elements that are present in todays

business environment: asymmetry among firms and imperfect information. It is important

to note that asymmetry may have several sources and information imperfections may be

studied in different ways. This study intends to concentrate in investment cost asymmetry

as the main source for studying asymmetry and in informative signals as a way to

approximate imperfect information. The next chapter will provide the necessary steps to

create this general framework.

Some investment projects clearly present the features that this study intends to

portray. Strategic acquisition projects and international joint ventures are surrounded by

both uncertainty and strategic considerations related to rivals reactions to them. They

occur in a world with firms operating under asymmetric costs potentially due to the

changing environment of technology and the learning processed that accompany it. Both

strategic acquisitions and IJVs, as strategic investments, are surrounded by imperfect and

sometimes asymmetric information. This may be due to regulation, agency problems, or

imperfectly informative signals about the feasibility or profitability of investment projects.

This study intends to extend the proposed general framework in order to find suitable

applications in these phenomena. Chapters 4 and 5 develop these models to the case of

strategic acquisitions and international joint ventures, respectively.


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CHAPTER 3

STRATEGIC GROWTH OPTIONS UNDER ASYMMETRY AND IMPERFECT

INFORMATION: THE MODEL

I. INTRODUCTION

The previous chapters have provided the reasonin

complete dissertation article (may 24)

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