Young Li, Barclay James,Ravi Madhavan, & Joseph Mahoney

2007

Advances in Strategic Management

REAL OPTIONS: TAKING STOCK AND

LOOKING AHEAD

A concentrated report on developments in ‘real options theory’ and how ‘real options’ ideas can effectively be used

A discussion on the past, present, and potential future of Real Options Theory research and literature

Real Options Defined –

A Real Option is the right to undertake some action or decision in the future (i.e. the option to ‘make’, ‘abandon’, or ‘contract’, etc.)

ARTICLE OVERVIEW

Investment Decisions Implications of common real options on investment

strategies

Investment Mode Choices The effects of real options on governance and

organization

Performance Implications How real options analysis and understanding affects

valuation and performance

REVIEW OF CURRENT REAL OPTIONS LITERATURE

APPLICATIONS OF REAL OPTIONS THEORY

Wait-to-invest In cases of uncertainty and high irreversibility of

investment, a firm may choose to invest later rather than immediately

Allows firm to wait for favorable conditions

Abandon and switch Real Options theory proposes that the value of a put option

increases with salvage value and future uncertainty Adds divestment considerations to NPV analysis

Corporate growth Decisions made not necessarily for immediate cash flows,

but for value derived from potential future benefits and returns

INVESTMENT AND DIVESTMENT

Option Interactions Additional options increase the value of investment projects Substitutable options add flexibility to investments,

increasing value ‘Dueling’ options take place of each other but have differing

value

Options Portfolios Strategic decisions can be viewed as bundles of real options R&D project portfolios can be viewed as a portfolio of options Alliances can be viewed as ‘exploratory investments in real

options’

INVESTMENT AND DIVESTMENT

Competitive Dynamics Investments are made with the industry as a whole in mind Options are weighed with first-mover advantage,

competitive entry, sector monopoly/dominance, etc.

Uncertainty and Learning In general, uncertainty increases the value of real options Two types:

Exogenous – resolved with time, encourages waiting prior to investing

Endogenous – reduced by strategic investments, reveals learning opportunities and can encourage investing

Investments can be made by a firm to influence uncertainty to their advantage

INVESTMENT AND DIVESTMENT

Choice of Investment Modes Real options can affect a firm’s choice in investment modes Real options weigh heavily on the ‘make or buy’ decision Example - Exogenous technological uncertainty leads to a

preference for equity collaboration over acquisition

Collaborative Ventures Trading of real options between partners can create joint

gains Optimal equity shares of a joint venture can be determined

by the real options each partner holds

ORGANIZATION AND GOVERNANCE

Valuation Risk-neutral probabilities of success are smaller for early-

stage ventures & positively related to the number of prior financing rounds

Implied volatility is larger for early-stage ventures and are negatively related to the number of prior financing rounds

Performance Implications Option pricing models may not readily apply to real

investments (because of differences between real and financial options)

Businesses that link small options with large strikes will perform better than those who stay small or large

Firms with greater exit value and less specialized assets are worth more to investors

VALUATION AND PERFORMANCE

Investment Real options/learning and resources and capabilities Investment decisions from a real options perspective Exit/abandonment decisions Interactions between real options and option-like projects

Investment Mode Choices Governance choice and contractual issues

Performance Implications Real options theory and organizational performance Cost of real options creation and exercise Firm and industry-level influences on investment performance

THE FUTURE OF REAL OPTIONS RESEARCH