A real options and game-theoretic approach to corporate investment strategy under competition - includes appendices - Topics in Real Options and Applications

Financial Management (Financial Management Association), Autumn, 1993 by T.J. Smit, L.A. Ankum

An investment strategy encompasses a sequence of tactical investment projects, of which several may yield a low return when considered in isolation. Often the value of such an investment consists of the option to invest in the future growth of the firm. For example, the value of a pilot project or an R&D investment does not derive so much from the expected cash inflows, but rather from the option to invest in future commercial exploitation. Standard forecasting of the expected cash inflows implicitly assumes investing in the follow-up project. Therefore, the traditional discounted cash flow (DCF) method has serious shortcomings in analyzing projects when information concerning future investment decisions is not yet known. The application of option theory can be used as an analytical tool to evaluate such projects and to support the overall operating and investment strategy. Brennan and Schwartz |1~ examine the operational policy of a copper mine. Myers |9~, Trigeorgis |12~, McDonald and Siegel |8~, Majd and Pindyck |10~, and Myers and Majd |10~ provide other examples of flexible investment strategies.

We consider the option to defer investment in production facilities analogous to a call option on a dividend-paying stock. In this investment strategy, decisions involving the creation of capacity may be postponed so that management can decide not to invest if market demand turns out to be unfavorable. On the other hand, deferral also has disadvantages since during the postponement period the firm misses the net operating cash inflows. The analogy with a call option, of course, is not exact. One difference between financial call options and future investment possibilities is the exclusiveness of the latter. Kester |5~ and Trigeorgis |12~ have shown that competition in the market may force the company to invest early, which may erode the flexibility value of a deferred investment strategy.

This paper casts the real options approach for project timing in a microeconomic framework. We use microeconomic tools to analyze aspects of competition in the investment strategy in forecasting the cash inflows. In this connection, we focus particularly on the concept of economic rents, i.e., the excess profit above the opportunity cost of capital. Economic rents attract new entrants to the market so that if the investment opportunity is not exclusive new entrants will diminish returns until expected and required returns are equal. Under rivalry, economic rents only exist if the firm has a specific competitive advantage in the realization of the project. The firm, therefore, needs to identify those markets in which it has a temporary or permanent competitive advantage and concentrate investment in these areas. If the competitive advantage is temporary, expected economic rents will decline over time and postponement will erode the value of the project. Based on the firm's strength in relation to its competitors and the value of the project in relation to market uncertainty, we develop various investment tactics.

The paper is organized as follows. Section I discusses the options approach to investment timing. Section II studies the concept of economic rents for strategic planning purposes, as well as the influence of competition on the expected economic rents over time. In Section III, we use an options approach for timing investment strategy in different microeconomic market contexts. Finally, Section IV provides some concluding remarks and directions for further research.

I. The Option to Defer Investment

Some investment projects can actually be seen as the first links in a chain of subsequent investment decisions. With projects of this type, the firm essentially acquires an option to invest in a potential follow-up project. For example, an R&D project, the development of a new technology, or entry into a new geographical market may create future investment opportunities. In strategy, these projects are often compared with options for future company growth (e.g., see Myers |9~). We consider the option to defer a project (see Kester |5~ for a qualitative approach, and Trigeorgis |12~ or Kemna and Vorst |4~ for a quantitative treatment). The deferment of a capacity expansion program caused by uncertain market demand is seen to create flexibility for management. The timing of investment in a production facility is analogous to the timing of exercising of a call option on a dividend-paying stock.

Exhibit 1 illustrates this analogy. The underlying value is the present value of the net operating cash inflows, |V.sub.t~. The (present value of the) investment outlay in the plant, I, is equivalent to the exercise price. If, in time, market demand develops favorably, the firm would invest and the net value of the project would equal its NPV = |V.sub.t~ - I. If the project does not prove to be lucrative and the net present value turns out to be negative, management may decide not to invest and the value is zero. Besides this advantage to wait and see, deferment also has disadvantages. For example, if we consider a project with an infinite life, management misses the net operating cash inflows when the plant is not operative. The missed net operating cash inflow during the deferment period is equivalent to a dividend.