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This chapter attempts to demystify the concepts of real options. Specifically, it attempts to answer several basic questions: what are real options, how are companies using real options, what types of options exist, why are real options important, who uses real options, where are real options most appropriately used, and what are the experts saying about real options? The chapter starts by reviewing the basic concepts of real options as a new paradigm shift in the way of thinking about and evaluating projects. The chapter reviews several business cases in different industries and situations involving pharmaceutical, oil and gas, manufacturing, IT infrastructure, venture capital, Internet start-ups, and e-business initiatives. The chapter then concludes with some industry "war stories" on using real options as well as a summary of what the experts are saying in journal publications and the popular press.
A PARADIGM SHIFT
In the past, corporate investment decisions were cut-and-dried. Buy a new machine that is more efficient, make more products costing a certain amount, and if the benefits outweigh the costs, execute the investment. Hire a larger pool of sales associates, expand the current geographical area, and if the marginal increasein forecast sales revenues exceeds the additional salary and implementation costs, start hiring. Need a new manufacturing plant? Show that the construction costs can be recouped quickly and easily by the increase in revenues it will generate through new and improved products, and the initiative is approved.
However, real-life business conditions are a lot more complicated. Your firm decides to go with an e-commerce strategy, but multiple strategic paths exist. Which path do you choose? What are the options that you have? If you choose the wrong path, how do you get back on the right track? How do you value and prioritize the paths that exist? You are a venture capital firm with multiple business plans to consider. How do you value a start-up firm with no proven track record? How do you structure a mutually beneficial investment deal? What is the optimal timing to a second or third round of financing?
Real options are useful not only in valuing a firm through its strategic business options but also as a strategic business tool in capital investment decisions. For instance, should a firm invest millions in a new e-commerce initiative? How does a firm choose among several seemingly cashless, costly, and unprofitable information technology infrastructure projects? Should a firm indulge its billions in a risky research and development initiative? The consequences of a wrong decision can be disastrous or even terminal for certain firms. In a traditional discounted cash flow model, these questions cannot be answered with any certainty. In fact, some of the answers generated through the use of the traditional discounted cash flow model are flawed because the model assumes a static, one-time decision-making process while the real options approach takes into consideration the strategic managerial options certain projects create under uncertainty and management's flexibility in exercising or abandoning these options at different points in time, when the level of uncertainty has decreased or has become known over time.
The real options approach incorporates a learning model such that management makes better and more informed strategic decisions when some levels of uncertainty are resolved through the passage of time. The discounted cash flow analysis assumes a static investment decision, and assumes that strategic decisions are made initially with no recourse to choose other pathways or options in the future. To create a good analogy of real options, visualize it as a strategic road map of long and winding roads with multiple perilous turns and forks along the way. Imagine the intrinsic and extrinsic value of having such a strategic road map when navigating through unfamiliar territory, as well as having road signs at every turn to guide you in making the best and most informed driving decisions. This is the essence of real options.
The answer to evaluating such projects lies in real options analysis, which can be used in a variety of settings, including pharmaceutical drug development, oil and gas exploration and production, manufacturing, e-business, start-up valuation, venture capital investment, IT infrastructure, research and development, mergers and acquisitions, e-commerce and e-business, intellectual capital development, technology development, facility expansion, business project prioritization, enterprise-wide risk management, business unit capital budgeting, licenses, contracts, intangible asset valuation, and the like. The following section illustrates some business cases and how real options can assist in identifying and capturing additional strategic value for a firm.
EXPANSION AND COMPOUND OPTIONS: THE CASE OF THE OPERATING SYSTEM
You are the Chief Technology Officer of a large multinational corporation, and you know that your firm's operating systems are antiquated and require an upgrade, say to the new Microsoft Windows XP series. You arrange a meeting with the CEO, letting him in on the situation. The CEO quips back immediately, saying that he'll support your initiative if you can prove to him that the monetary benefits outweigh the costs of implementation-a simple and logical request. You immediately arrange for a demonstration of the new operating system, and the highly technical experts from Microsoft provide you and your boss a marvelous presentation of the system's capabilities and value-added enhancements that took in excess of a few billion dollars and several years to develop. The system even fixes itself in times of dire circumstances and is overall more reliable and stable than its predecessors. You get more excited by the minute and have made up your mind to get the much-needed product upgrade. There is still one hurdle, the financial hurdle, to prove not only that the new system provides a better operating environment but also that the plan of action is financially sound. Granted, the more efficient and sophisticated system will make your boss's secretary a much happier person and hence more productive. Then again, so will an extra week's worth of vacation and a bigger bonus check, both of which are a lot cheaper and easier to implement. The new system will not help your sales force sell more products and generate higher revenues because the firm looks state-of-the-art only if a customer questions what version of Windows operating system you are using-hardly an issue that will arise during a sales call. Then again, when has using the latest software ever assisted in closing a deal, especially when you are a contract global-freight and logistics solutions provider?
You lose sleep over the next few days pondering the issue, and you finally decide to assemble a task force made up of some of your top IT personnel. The six of you sit in a room considering the same issues and trying to brainstorm a few really good arguments. You link up the value-added propositions provided in the Microsoft technician's presentation and come up with a series of potential cost reduction drivers. Principally, the self-preservation and self-fixing functionality will mean less technical assistance and help-desk calls, freeing up resources and perhaps leading to the need for fewer IT people on staff. Your mind races through some quick figures, you feel your heart pounding faster, and you see a light at the end of the tunnel. Finally you will have your long-awaited operating system, and all your headaches will go away. Wait-not only does it reduce the help-desk time, but also it increases efficiency because employees will no longer have to call or hold for technical assistance.
Your team spends the next few days scouring through mountains of data on help-desk calls and issues-thank God for good record-keeping and relational databases. Looking for issues that could potentially become obsolete with the new system, you find that at least 20 percent of your help-desk calls could be eliminated by having the new system in place because it is more stable, is capable of self-fixing these critical issues, can troubleshoot internal hardware conflicts, and so forth. Besides, doesn't employee morale count? Satisfied with your analysis, you approach the CEO and show him your findings.
Impressed with your charts and analytical rigor in such a short time frame, he asks several quick questions and points out several key issues. The cost reduction in technical assistance is irrelevant because you need these people to install and configure the new system. The start-up cost and learning curve might be steep, and employees may initially have a tough time adjusting to the new operating environment-help-desk calls may actually increase in the near future, albeit slowing down in time. But the firm's mission has always been to cultivate its employees and not to fire them needlessly. Besides, there are five people on staff at the help desk, and a 20 percent reduction means one less full-time employee out of 5,000 in the entire firm-hardly a cost reduction strategy! As for the boss's secretary's productivity, you noticed two first-class air tickets to Maui on his desk, and you're pretty sure one of them is for her. Your mind races with alternate possibilities-including taking a trip to Hawaii with a high-powered digital-zoom camera but deciding against it on your way out. He notices your wandering eyes and tries to change the subject. You still have not sufficiently persuaded your boss on getting the new operating system, and you are up a tree and out on a limb. Thoughts of going shopping for a camera haunt you for the rest of the day.
Sound familiar? Firms wrestle with similar decisions daily, and vendors wrestling with how to make their products more marketable have to first address this financial and strategic issue. Imagine you're the sales director for Microsoft, or any software and hardware vendor for that matter. How do you close a sale like this?
Performing a series of simple traditional analyses using a discounted cash flow methodology or economic justification based on traditional analyses will fail miserably, as we have seen above. The quantifiable financial benefits do not exceed the high implementation costs. How do you justify and correctly value such seemingly cashless and cash-flow draining projects? The answer lies in real options. Instead of being myopic and focusing on current savings, the implementation of large-scale servers or operating systems will generate future strategic options for the firm. That is, having the servers and system in place provides you a springboard to a second-, third-, or fourth-phase IT implementation. That is, having a powerful connected system gives you the technical feasibility to pursue online collaboration, global data access, videoconferencing, digital signatures, encryption security, remote installations, document recovery, and the like, which would be impossible to do without it. Hence, the value of upgrading to a new system provides the firm an expansion option, which is the right and ability, but not the obligation, to invest and pursue some of these value-added technologies. Some of these technologies such as security enhancements and global data access can be highly valuable to your global freight company's supply chain management. You may further delineate certain features into groups of options to execute at the same time-that is, create a series of compound options where the success of one group of initiatives depends on the success of another in sequence. Notice that using an extrapolation of the traditional analytic approaches would be inappropriate here because all these implementation possibilities are simply options that a senior manager has, and not guaranteed execution by any means. When you view the whole strategic picture, value is created and identified where there wasn't any before, thereby making you able to clearly justify financially your plans for the upgrade. You would be well on your way to getting your new operating system installed.
EXPANSION OPTIONS: THE CASE OF THE E-BUSINESS INITIATIVE
The e-business boom has been upon us for a few years now, and finally the investment bank you work for has decided to join the Internet age. You get a decree from the powers that be to come up with a solid e-commerce initiative. The CEO calls you into his office and spends an hour expounding on the wisdom of bringing the firm closer to the electronic Web. After hours of meetings, you are tasked with performing a feasibility analysis, choosing the right strategy, and valuing the wisdom of going e-commerce. Well, it sounds simple enough, or so you think.
The next two weeks are spent with boardroom meetings, conference calls with e-commerce consulting firms, and bottles of Alka Seltzer. Being a newly endowed expert on the e-business strategies after spending two weeks in Tahiti on a supposedly world-renowned e-commerce crash course, you realize you really still know nothing. One thing is for certain: the Internet has revolutionized the way businesses are run. The traditional Sun Tzu business environment of "know thy enemy and know thyself and in a hundred battles you will be victorious" hadn't met the Internet. The competitive playing field has been leveled, and your immediate competitors are no longer the biggest threat. The biggest threat is globalization, when new competitors halfway around the world crawl out of the woodwork and take half of your market-share just because they have a fancy Web site capable of attracting, diverting, and retaining Web traffic, and capable of taking orders around the world, and you don't. Perhaps the CEO's right; it's a do-or-die scenario. When a 12-year-old girl can transform her parents' fledgling trinket store into an overnight success by going to the Internet, technology seems to be the biggest foe of all. You either ride the technological wave or are swept under.
Convinced of the necessity of e-commerce and the strong desire to keep your job, you come up with a strategic game plan. You look at the e-commerce options you have and try to ascertain the correct path to traverse, knowing very well that if you pick the wrong one, it may be ultimately disastrous, for you and your firm, in that particular order. In between updating your curriculum vitae, you decide to spend some time pondering the issues. You realize that there are a large number of options in going e-commerce, and you have decided on several potential pathways to consider as they are most appropriate to the firm's core business.
Excerpted from Real Options Analysis by Johnathan Mun Excerpted by permission.
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|List of Figures|
|Ch. 1||A New Paradigm||9|
|Ch. 2||Traditional Valuation Approaches||55|
|Ch. 3||Real Options Analysis||77|
|Ch. 4||The Real Options Process||93|
|Ch. 5||Real Options, Financial Options, Monte Carlo Simulation, and Optimization||99|
|Ch. 6||Behind the Scenes||139|
|Ch. 7||Real Options Models||171|
|Ch. 8||Advanced Options Problems||241|
|Ch. 9||Real Options Analysis Toolkit Software (CD-ROM)||277|
|Ch. 10||Results Interpretation and Presentation||317|
|Case Studies and Problems in Real Options||345|
|Answers to Chapter Questions||355|