REAL OPTIONS ANALYSIS AND STRATEGIC DECISION

MAKING

Authors:

Edward H. Bowman and Gary T. Moskowitz

Made by Cheng (Orange) Wang

Modified by Minjae Lee

Edward H. Bowman

Professor of MIT, Sloan

PhD, Ohio State University

Deceased, 1998

Gary Moskowitz

Professor of SMU, Cox

PhD, Wharton School

INTRODUCTION - MOTIVATIONS

Despite the theoretical attractiveness of the real options approach, its use by managers appears to be limited.

Illustrate some of these problems using Merck's recent real options calculation as an example how the results of strategic analysis can differ from the

assumptions of a typical options model the use of a standard options model in a strategic

analysis could lead to poor strategic decisions.

VALUING A STRATEGIC REAL OPTION

Corporate decisions can be viewed through strategic options lens Termination of joint ventures, Venture Capital investment,

R&D programs, Capital Budgeting decisions

The common theme in these decisions – two stage process

First stage: the company made a small investment; it gives the company the right to participate in the projects (the purchase of the option)

Second stage: the company make a decision whether or not to make a larger investment in the project (the exercise the option)

VALUING A STRATEGIC REAL OPTION:THE PROJECT

Merck used the real options to justify an investment in an R&D project – Project Gamma

The biotech company Gamma has patented its technology but has not developed any commercial applications from it.

Merck wants to enter a new line of business but needs the new technology from Gamma.

If Merck licenses the technology, it will take 2 years of R&D; but it is uncertain whether the new tech product was commercially feasible or not;

If after 2 years, the new product is commercially feasible, it will take another year to do the start-up, e.g. build plants, marketing, working capital, etc.

The Proposed Gamma Agreement – resembles a call option Merck pays Gamma $2 million license fee over 3 years period Merck will pay Gamma Royalty fee if the product is commercially feasible Merck can terminate the agreement anytime if Merck is dissatisfied with the

process The theoretical value should compare to the actual cost of the option: Σ(license

fee + R&D cost) Merck expects the start-up costs to be independent of the future value of the

new tech.

VALUING A STRATEGIC REAL OPTION:MERCK’S ANALYSIS

Important parameters in Black Scholes Model

(Black and Scholes 1973)

Value of the option: CIt is on the left side of the equation. Stock price: S Exercise price: K Time to expiration: t Volatility: N

Use standard normal dist Risk-free interested rate: r

VALUING A STRATEGIC REAL OPTION:MERCK’S ANALYSIS USING THE BLACK-SCHOLES MODEL

Option Value Parameter Stock price(=Value of the project) The DCF value from the project,

assuming project successful; Exercise price: Cost of start-up cost including building

plant if decides to commercialize the technology.

Time to expiration: Based on expected time to develop

product and build the factory Volatility: Based on annual standard deviation of

returns of the biotechnology company Risk-free interested rate: Based on the then-prevailing yield on

2- to 4-year treasury bonds.

Cost of buying option= costs of licensing + Costs of R&D=$2.8mil

LIMITATIONS OF THE QUANTITATIVE APPROACH TO REAL OPTIONS

There are implementation problems when using quantitative model to value strategic real options

Finding a model whose assumptions match those of the project being analyzed;

Determining the inputs to the selected model; Mathematically solve the option pricing algorithm

This paper discuss the first two problems in Merck case

Modeling assumptions Determining the inputs

LIMITATIONS OF THE QUANTITATIVE APPROACH TO REAL OPTIONS: MODELING ASSUMPTIONS

Making the use of financial option valuation models problematic for real

options since strategic options often lack some of the explicit features of

exchange-traded options.

The Black-Scholes’ model assumes lognormal distribution of underlying stock price

with constant volatility:

But, lognormal assumption may be inappropriate for a strategic option since

standard techniques ignores the product life cycle

In the Merck example, the use of the Black-Scholes model is problematic .

BS model shows the longer Merck could wait to exercise its option, the more

valuable the option is since (1) The increase in value is due to the lognormal

assumption where price has more time to move to higher values and (2) The

present value of the exercise price is lower for a longer option.

However, the longer Merck waits to exercise the option, the lower the value

of the option:

(1) The bulk of the value of the project comes from the patent protection and the

patent has expiration date.

(2) Exercise prices could be adjusted for the additional inflation factors.

LIMITATIONS OF THE QUANTITATIVE APPROACH TO REAL OPTIONS: DETERMINING THE INPUTS

Stock price:

In contrast to exchange-traded option, for real options, the analogous stock price

may be unknown and/or unactionable.

Regarding sensitivity cases, Merck did not attempt to assess the likelihood of the

different downside scenarios that it created.

Exercise price:

Option valuation model assumes that the exercise price is fixed in advance

Many strategic investments do not have fixed exercise price

Merck use start-up costs as exercise price; but on the date to exercise, Merck could

license the tech to another firm or to build a plant of a smaller or larger size, etc.

Time to expiration:

There is often no set time to expiration for real option

Interaction of the time to expiration and the stock price distribution assumptions

can produce severe problems

Volatility:

For strategic option, there are no publicly traded instruments whose risk profile

matches that of the proposed investment

CONCLUSIONS: THE ROLE OF OPTION ANALYSIS IN STRATEGIC PLANNING

Real options presents planners a Dilemma Theoretically, good way to think about flexibility inherent in investment

proposals; Practically, many difficulties in making accurate calculations; and the errors

are hard to find; Create more advanced and customized valuation models that better matches

the characteristics of the investment proposal A formal quantitative valuation model is a part of strategic planning

and capital allocation process Firm need both financial and strategic analysis; Use multiple models to check on each other; DCF relies sole on financial

analysis while strategic analysis does not provide information of returns Potential advantage of using the real option: It may change the type of investment proposals that are reviewed; An option perspective inverts the usual thinking about uncertainty absorption

in the organizational literature (Kogut and Kulatilaka 2001) An option approach encourages experimentation and the proactive

exploration of uncertainty.