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

III. Investment Timing Strategy and Economic Rents

A crucial strategic choice for competing in emerging industries is the timing of investment in capacity. We next utilize a simple numerical example to illustrate the timing strategy, first under perfect competition, and then under monopoly. The firm in this example has invested in a pilot project to get an early foothold in the market. If the market opens up and creates expansion opportunities, the firm will increase capacity significantly by investing in a follow-up project. This pioneering strategy involves high risk, but also involves low competition in the early stage of the market leading to substantial expected economic rents. Here we assume:

(i) An industry portfolio is traded in the financial market with exactly the same risk characteristics as the project, yielding an expected return of 16%. The dynamics in the present value of the follow-up project imply a 25% increase (u = 1.25) or a 20% decline (d = 0.8) per year. This represents a standard deviation in project present value of 22.315% per year. The real rate of interest is five percent per year (r = 1.05).

(ii) The expected economic rent of the follow-up project in the first year is 10. Due to anticipated entry, the cash inflows will decline exponentially at a 30% annual rate until the project earns the opportunity cost of capital of 16%.

(iii) The production facility has an infinite physical life. The required investment outlay is 500.

Given the declining expected economic rents and the opportunity cost of capital of 16%, the present value of the expected operating cash inflows from the production facilities is estimated to be 524.(2) The net present value (NPV) therefore is 524 - 500 = 24. Based on the net present value rule, management should invest immediately.

However, when we consider the option to defer capacity expansion and wait to see how the market develops further, management should postpone. The dynamics of market demand for the product result in a series of possible project values over time. Based on the binomial option pricing model, the value of the deferred project may increase by a factor of u(1 - ||Delta~.sub.t,s~) per period if market demand turns out to be favorable, or it may decrease by a factor of d(1 - ||Delta~.sub.t,s~) per period if market demand tums out to be unfavorable, i.e.,

The net value (inside the parentheses) at each state is equal to the maximum of:

|V.sub.t,s~ - I invest 0 stop |C.sup.t,s~ = p|C.sup.t 1, u~ (1 - p)|C.sup.t 1, d~/r defer

where p = r - d/u - d is the risk-neutral probability.(3)

The value of the option to invest in the follow-up project is 28, which is greater than the net present value of 24. The optimal strategy, therefore, is to defer the follow-up project until the market develops favorably.

If we consider a project with the same economic rent, |ER.sub.1~, in a monopoly, the expected net operating cash inflows are constant. The present value of the production facilities is now 563, and the NPV equals 563 - 500 = 63. When we consider the option to defer capacity expansion, management should invest immediately: