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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
Comentario [U1]: Once you cite aTable, you need to place it on thepage that follows.
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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
Comentario [U2]: It is not clearwhat you want to say in thissentence and paragraph. I believthis is where you interject whatthe gap is in this area. Rethink thparagraph.
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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.
Comentario [U3]: What aboutapplying it to the issue of jointventures?
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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
Comentario [U4]: This is the firsttime you mention internationaljoint ventures. If the focus is oninternational joint ventures thenyou need to go back to the sectioon joint ventures and talk aboutthem as well.
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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.
Comentario [U5]: See comment iChapter I. The table goes on thenext page once it is mentioned othe text.
Comentario [U6]: See commentabove.
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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
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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
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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
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