Real Options and Game-Theoretic Value

• The presentation discusses real options and game-theoretic value in the context of investment decisions.

Three Value Drivers

• Managers create economic value by increasing revenues, reducing costs, and/or decreasing risks
• Revenues, costs, and risks are the three value drivers accounted for in the Net Present Value (NPV) formula
• NPV is calculated as the initial investment plus the sum of net cash flows divided by (1 + weighted average cost of capital) to the power of time

Static Value: "Static" Net Present Value

• Static NPV does not account for managerial flexibility, intertemporal spillovers, interproject spillovers, and strategic interactions with rivals and partners

Basic Factors Determining C/S Market Value

• Amount of expected cash flows
• Timing of expected cash flows
• Risk of expected cash flows

Real Options Value

• Firms invest capital to make profits which can be viewed as rights, but not obligations, to take some action in the future.
• A financial option gives the right, but not the obligation, to buy or sell a security at a specified price at or before a specified date
• A real option is the firm's right but not an obligation, to take an action with respect to underlying assets
• Real options = physical or human assets (not financial securities)

Types of Options

• Defer: wait before acting until more is known or timing is better (e.g., introducing a new product)
• Expand/Contract: increase or decrease the scale of an operation in response to demand (e.g., adding or subtracting memory to a computer)
• Abandon: discontinue an operation and liquidate assets (e.g., discontinuing a research project)
• Stage Investment: commit investment in stages, creating valuations and abandonment options (e.g., staging research and development projects)
• Switch Inputs/Outputs: alter the mix of inputs or outputs in response to market prices (e.g., telephony/internet/cellular services)
• Grow: expand the scope of activities to capitalize on new opportunities (e.g., extending brand names)

Strategic Flexibility vs Commitment

• Strategic flexibility vs. commitment is a key tradeoff for firms when considering investments
• Strategic flexibility is like "having options," while commitment is like "exercising an option" by proceeding with investment
• The greater the uncertainty a firm faces, the more important it is to improve standard NPV analysis by including real options analysis

Strategic Flexibility Matters

• Strategic flexibility matters for managers to address uncertainty (demand and/or technological) and irreversible investment (sunk costs)

Option to Wait

• With high uncertainty and irreversible investments, firms can defer investment until more information reduces the level of uncertainty
• Firms can invest when market conditions become favorable or back out if conditions are adverse
• The value of the option to wait increases with uncertainty if waiting reduces uncertainty or the firm learns new information that mitigates uncertainty
• If static NPV is positive and waiting won't decrease the level of uncertainty, the firm should invest immediately
• The option to wait allows managers to invest when conditions are favorable and reduces the downside risk should conditions be unfavorable.

Option to Abandon/Exit and/or Switch

• When a firm invests in assets that can be resold or put to another use, it has an option to abandon or switch
• Investments can be fully recovered or redeployed, allowing the firm to abandon/switch if conditions worsen, limiting economic loss
• Investments/real assets are often irreversible, limiting redeployment
• If sunk costs are low and assets can be redeployed, the value of exit/abandonment increases

Growth Option

• Investments are made for both immediate cash flows and follow-on investment opportunities
• These follow-on investment opportunities are growth options
• First-stage investments create growth options
• Subsequent investments exercise/implement these options

Game Theoretic Value

• NPV is substantially influenced by actions competitors and potential market entrants
• Competitive interactions with rivals and preemption add complexity to the Commitment vs Flexibility tradeoff
• Real options analysis generally favors flexibility but does not account for rivals/partners
• Game-theoretic analysis can change the optimal investment timing suggested by real options, prioritizing commitment

Example: Preemption and NPV

• A firm decides whether to invest in a plant/new product now or wait 1 year, facing substantial sunk costs
• The firm's rival plans to invest in a similar plant/product in 6 months
• If the rival introduces its product first, it will take almost the entire market share
• Investing now yields a $600 NPV
• Waiting one year, with no preemption, yields NPV of $773 ($173 is the value of the option to wait)
• Investing in 1 year but being preempted by the rival yields a -$1455 NPV