Complete summary of the course Economics of Strategy (FEM11059). It includes all the lectures, important parts of the book and examples.
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Summary Economics of Strategy
Session 1: Real Options as a concept to value a firm’s strategic options
(Extra: ST chapter 1 + paper sessie 1)
§ Market value
- Market capitalization (P) = net present value (NPV) of earnings from assets in place + present
value of growth opportunities (PVGO)
- Merely looking at current earnings multiples underestimates firm’s market value. It especially
cannot account for high stock prices of growth stocks.
- Estimate of option value:
Tobin’s Q = P / book value of equity
® If Tobin’s Q is high, then market value is much greater than the book value, so investors
expect a lot from opportunities a firm has.
® Higher uncertainty leads to more opportunities. If firm’s can limit the downward loses,
then higher uncertainty would give you higher option value. Tobin’s Q will be higher.
§ Differences between NPV and real option approach
- NPV approach = FCF/(1 + r) − I
® Don’t invest as NPV < 0 Invest as NPV > 0
- NPV: All Uncertainties
Option Analysis
Difference is that we avoid the negative outcomes. We will only invest/continue if the
outcome is Excellent.
,§ Real options
- Options are rights, not obligations, to undertake some action in the future.
® Actions should be conditional on outcomes (based on the outcome decide what to do).
® The greater the uncertainty, the more extreme the range of outcomes.
- Two examples of real options:
1. Timing option (Oil field)
Example: we can develop an oil field at a cost of $10mn. PV from investing today is
$11mn. We can invest now or next year. The oil price is very volatile, so waiting and invest
next year give: $9mn with probability 50% and $13mn with 50%.
® NPV of investing today: NPVToday = PVTODAY – I = 1.000.000
® Option value of waiting to invest: Option value = (0.5 x $0 + 0.5 x 3mn)/(1+disc))
Waiting to invest is beneficial if disc < 50%, so if the discount rate is not to high we should
wait to invest (wait for more information).
® The investment project competes with itself over time. Investing now means giving up
the opportunity to invest later.
® Higher uncertainty implies greater option value. When the uncertainty is lower, for
example $10mn with 50% and $12mn 50%, then immediate investment is optimal.
® Investment rule: Invest when value exceeds cost by option value of waiting
Example: Consider the following values of a developed oil field. The oil field can be
developed at three different periods, t=1,2,3. The cost of development equals $100mn.
There is no discounting
It is a timing option as development of an oil field is an irreversible investment for which the
payoffs vary over time. As the current value of V is lower than the investment cost, you will
certainty not invest now. If the current value of V decreases to $70, you will still not invest. If the
current value increases to $110, you can either invest and receive a payoff of $10 or you can wait.
The expected value of waiting equals 15 (0.5*30+0.5*0). As the expected value of waiting is
higher than immediate investment, it is optimal to postpone investment to time t=3.
2. Growth option (R&D)
Example: R&D creates an option to invest at a later stage. Suppose the cost of a market
launch is $10 mn. Suppose the revenues are uncertain: $8mn with probability of 50% and
$12mn with 50%. Successful R&D takes 1 year. Suppose cost of R&D is $0.5mn.
NPV = - $0.5mn <0 à NPV would tell you that you should not invest and it ignores the
fact that we can ignore the bad outcome of 8mn.
Net option value = -$0.5mn + (0.5x$2mn)/(1+disc) à Net option value > 0
- When can we use the NPV method?
(i) When there is no uncertainty
(ii) When investment is reversible.
,§ Irreversibility
- Irreversibility means that you can’t undo an investment. This means that you will not get the
full amount back that you paid. Investment is irreversible when there are sunk costs involved.
- Almost all investments are at least partially irreversible.
§ Real option analogy with financial options
® Dividend yield: if you don’t hold the stock but only the option, you don’t receive the dividend.
® Main difference: for stocks we have historical data, so we have a good estimate of the stock
volatility. With new projects we don’t have historical data, so no good estimate of the project
volatility. (We saw that high volatility leads to high option value, so researchers often estimate a
high volatility in order to show a good research project that should be financed)
§ Black Scholes option pricing formula
- Black and Scholes created an option pricing formula
® Call option: right to buy the underlying asset
® Put option: right to sell the underlying asset
® European: No exercise possibility before maturity date of the option.
- Formula for the European call option (hoef je niet uit je hoofd te leren):
Option value =
- Example:
• Market introduction is not possible unless R&D is complete (European)
• The value of introducing the good in the market (S) is estimated at $8mn.
• Market Introduction costs (X) are $10mn.
• R&D of new drug development takes 3 years (T-t=3) to complete.
• The risk-free rate of interest (r) equals 4% (=the yield on a bond with same maturity)
• Nothing is lost by waiting to invest (no competitors): d=0
• Standard deviation is the annual deviation of returns for comparable stocks: s=40%.
- Summary
® S (project value) >> X (cost of investment): Option is deep in the money
This means that the NPV is very positive (NPV>>0). In this case it is not necessary to do an
option analysis (an option analysis takes much more resources), because it is clear that you
should go ahead with the project.
® S << X: Option is deep out of the money
This means that the NPV is negative. The NVP would tell you not to invest. The option value
would be zero, because you will not invest.
, ® S close to X: Option is at the money
This means that NPV close to 0. In this case option analysis is worth while.
- Pros and cons of Black-Scholes
Cons:
ü Underlying asset of the option is not traded on financial markets (in financial markets the
stock is traded and with real options we created the underlying ourselves.)
® Real options are proprietary, so main assumption of the derivation violated.
ü Managerial blackbox: not easy to explain to top management.
Pros:
ü Is able to deal with managerial flexibility and irreversibility
ü Can incorporate competitive behavior
ü There is a standard calculation method available
§ Different levels of analysis
- Cost and benefit when firm is viewed in isolation (NPV-analysis)
- Flexibility value when firms can adjust to changes in the market (option value)
- Strategic position in the market (IO/game theory)
Session 2: Corporate real options
(Extra: ST chapter 3)
§ Overview of common real options
- Timing option: the option to delay an investment until more market information becomes
known (e.g. when to start with the exploration of an oilfield)
- Growth option: the option to grow by making a small investment now in order to make a
larger investment in the future (e.g. market introduction options derived from R&D)
- Operating: the option to abandon, to temporarily shut down, contract and expand capacity
or to switch input and/or output factors (e.g. the option to shut down production if price
drops below variable costs)
§ Timing option
- Example: option the develop an oil field. When will we decide to develop the oil field?
• We will not develop the oil field when the NPV is zero. We wait until more information is
available.
• If there is no uncertainty, the value would be zero until P=I and if P>I it will be 45° line.
• If uncertainty increases (decreases), the line will go up (down), the flexibility value
increases (decreases) and expanded NPV will go up (down).
The flexibility value is highest when P=I (at the money, so we don’t really know if it is a
good investment decision or not).
• When the flexibility value becomes zero (V is very high) you don’t want to wait anymore.
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