Strategic Investment: Real Options and Games Book

List of Figures xi
List of Tables xvii
List of Boxes xix
Acknowledgments xxi
Introduction: Strategic Investment as Real Options and Games xxiii
I.1. Introduction: About This Book xxiii I.2. Real Options and Games: Linking Corporate Finance and Strategy xxiv
I.3. An Overview of the Book xxviii
Part I: Approaches to Strategic Investment
Chapter 1
Corporate Finance and Strategic Planning: A Linkage 3
1.1. Introduction 3
1.2. The Market Value of Growth Opportunities 5
1.3. From NPV to an Expanded (Strategic) NPV Criterion 8
1.4. Value Drivers of NPV, Flexibility Value, and Strategic Value 13
1.4.1. Value Drivers of NPV 14
1.4.2. Drivers of Flexibility or Growth Option Value 21
1.4.3. Drivers of Strategic Value and Strategic Moves 24
1.5. Value Creation in Strategic Planning 32
1.6. Conclusions 33
Chapter 2
Strategic Management: Competitive Advantage and Value Creation 35
2.1. Introduction 35
2.2. Views of Value Creation of the Firm 38
2.2.1. Industry and Competitive Analysis 40
2.2.2. Strategic Conflict and Game Theory 43
2.2.3. Internal, Resource-Based View of the Firm 45
2.2.4. Dynamic Capabilities 49
2.2.5. Options and Games: A Linkage Approach 51
2.3. Competitive Advantage and Industry Evolution 53
2.3.1. Competitive Advantage in the Early and Growth Stages 54
2.3.2. Competitive Advantage in Mature Businesses 58
2.3.3.Creative Destruction and Adaptation as Source of Advantage 60
2.4. Portfolio Planning of Growth Opportunities 68
2.4.1. Boston Consulting Group Matrix 70
2.4.2. Exercise Timing of Options: The Tomato Garden Analogy 72
2.4.3. Real-Options Growth Matrix 76
2.5. Conclusions 90
Chapter 3
Corporate Real Options 93
3.1. Introduction 93
3.2. Options Valuation 94
3.2.1. Basic Nature of Options 98
3.2.2. From Financial to Real Options Valuation 100
3.3. Overview of Common Real Options 106
3.3.1. The (Simple) Option to Defer 110
3.3.2. Options to Expand or Contract 114
3.3.3. The Option to Abandon for Salvage or Switch Use 116
3.3.4. The Option to Temporarily Shut Down 119
3.3.5. Options to Switch Inputs or Outputs 122
3.4. Prototype Examples: Valuing an R & D Program and a Mining Concession 123
3.4.1. Valuing a Research and Development Program 124
3.4.2. Valuing a Mine Concession (License) Using Certainty-Equivalent Valuation 127
3.5. An In-Depth Case Application: Valuing Offshore Oil Concessions in the Netherlands 134
3.5.1. Stages of Offshore Petroleum Development on the Dutch Continental Shelf 134
3.5.2. Valuation Based on Replication in Financial Markets 138
3.5.3. Main Insights 149
3.6. Summary and Conclusions 154
Appendix 3.1. Binomial Option Valuation 156
Chapter 4
Games and Strategic Decisions 163
4.1. Introduction 163
4.2. The Rules of the Game 171
4.3. A Taxonomy of Basic Games 181
4.3.1. Time to Launch under Competition (Symmetric Innovation Race) 184
4.3.2. Asymmetric Innovation Race and Preemption 186
4.3.3. Simultaneous Innovation Race When the Opponent's Capabilities Are Unknown 189
4.4. Competitive Reactions in Quantity versus Price Competition 191
4.4.1. Quantity Competition 191
4.4.2. Price Competition 198
4.4.3. Type of Competitive Reaction: Strategic Substitutes versus Complements 200
4.5. Two-Stage Games: Strategic Value of Early Commitment 202
4.5.1. Direct versus Strategic Effects of Investment Commitment 203
4.5.2. Strategic Effect, Tough or Accommodating Positions, and Type of Competition 205
4.6. Summary and Conclusions 208
Appendix 4.1. A Chronology of Game Theory Developments 210
Part II: Competitive Strategy and Games Chapter 5
Simple Strategic Investment Games 217
5.1. Introduction 217
5.2. A Road Map for Analyzing Competitive Strategies 218
5.3. One-Stage Strategic Investments 222
5.4. Two-Stage (Compound) Options: The Case of Proprietary R & D 226
5.5. Two-Stage Investments with Endogenous Competition 229
5.5.1. Competition in Last (Production) Stage: Contrarian versus Reciprocating Competition 229
5.5.2. Competition in Innovation Investment: Time-to-Market Races and Strategic Alliances 242
5.6. Cooperation in the First Stage: Joint R & D Ventures 247
5.7. Summary and Conclusions 251
Chapter 6
Flexibility and Commitment 255
6.1. Introduction 255
6.2. The Basic Two-Stage Game 258
6.2.1. Equilibrium Quantities, Prices, and Payoff Values 260
6.2.2. Valuation of Competitive Strategies 262
6.3. Numerical Examples of Different Competitive Strategies under Contrarian versus Reciprocating Competition 268
6.3.1. Competitive R & D Strategies under Quantity Competition 268
6.3.2. Goodwill/Advertising Strategies under Price Competition 278
6.4. Summary and Conclusions 285
Appendix 6.1. Reaction Functions, Equilibrium Actions, and Values in Different Market Structures under Quantity or Price Competition 289
Chapter 7
Value Dynamics in Competitive R & D Strategies 295
7.1. Introduction 295
7.2. Literature on R & D Options 296
7.3. The Basic Two-Stage R & D Game 298
7.4. Critical Demand Zones/Sensitivity 300
7.5. Technical R & D Uncertainty, Stochastic Reaction Functions, and Asymmetric Information with Signaling 309
7.5.1. Technical R & D Uncertainty (under Symmetric Information) 309
7.5.2. Imperfect/Asymmetric Information and Stochastic Reaction Functions 311
7.5.3. Signaling Effects 313
7.6. Learning Experience Cost Effects 315
7.7 Competition versus Cooperation in R & D 319
7.8 Summary and Conclusions 322
Part III: Applications and Implications Chapter 8
Case Applications 329
8.1. Introduction 329
8.2. Strategic Games in Consumer Electronics 346
8.2.1. Winner Takes All versus Strategic Alliances in the Launch of Video Recorder Systems 346
8.2.2. The Competition versus Coordination Game of the High-Density Disk 350
8.3. Buy-and-Build Platform Acquisition Strategies 352
8.3.1. Classifying Acquisitions Based on Options and Games 353
8.3.2. Growth Option Value in a Buy-and-Build Strategy 356
8.3.3. Competition in a Buy-and-Build Strategy 360
8.4. Infrastructure Investment: The Case of European Airport Expansion 366
8.4.1. Infrastructure Investment and Aviation Developments 367
8.4.2. Infrastructure Valuation as an Options Game 370
8.4.3. Implementation in the Case of Schiphol Airport 382
8.5. Conclusions and Implications 389
Chapter 9
Continuous-Time Models and Applications 393
9.1. Introduction and Overview 393
9.2. Continuous-Time Version of Smit-Trigeorgis Framework 396
9.2.1. Equilibrium Output and Values 397
9.2.2. Strategic Entry Decisions 401
9.2.3. Equilibrium Entry and Critical Demand Thresholds 405
9.2.4. Benchmark Cases: Symmetric Competition and Monopoly 408
9.3. Strategic Investment Timing under Uncertainty 408
9.3.1. Strategic Interactions and the Timing of Investment 408
9.3.2. Innovation with Uncertainty over Completion and Time Delays 411
9.4. Exercise Strategies under Incomplete Information with Applications 414
9.4.1. Entry and Preemption under Incomplete Information 414
9.4.2. Applications 416
9.5. General Equilibrium Investment Strategies under Imperfect Competition and Asymmetric Information 419
9.5.1. Equilibrium Investment Strategies under Imperfect Competition 419
9.5.2. Investment Strategies under Asymmetric Information 421
9.6. Conclusions 423
Appendix 9.1. Derivation of Option-Pricing Differential Equation 425
Appendix 9.2. Discounted Profit Flow and Value Function 427
Appendix 9.3. Sequential Stackelberg Leader-Follower Entry 428
Chapter 10
Overview and Implications 429
10.1. Introduction 429
10.1.1. Linking Corporate Finance and Strategic Planning 429
10.1.2. An Expanded Valuation Framework to Capture Flexibility and Strategic Value 431
10.2. Implications of the Strategic Options and Games Framework 439
10.2.1. Timing Games for Simple Commercial Options 440
10.2.2. Investment Games Involving Strategic Options 442
10.3. Empirical Implications 445
References 447
Index 461