STRATEGY AND SHAREHOLDER VALUE CREATION: THE REAL OPTIONS FRONTIER

The current interest in real options reflects the dramatic increase in the uncertainty of the business environment. Viewed narrowly, the real options approach is the extension of financial option pricing models to the valuation of options on real (that is, nonfinancial) assets. More broadly, the real options approach is a way of thinking that helps managers formulate their strategic options—the future opportunities that are created by today's investments—while considering their likely effect on shareholder value. But if the real options framework promises to link strategy more closely to shareholder value creation, there are some major challenges on the frontier of application. In the first part of this paper, the authors tackle the question, “What is really new about real options, and how does the approach differ from other wellestablished ways to make strategic decisions under uncertainty?” This article provides a specific definition of real options that relies on the ability to track marketpriced risk. Using examples from oil exploration and pharmaceutical drug development, the authors also show how specific features of the industry and the application itself determine the usefulness of the real options approach. The second part of the paper addresses the question: Given the many differences between real and financial options, how should a real options application be framed? The authors examine the use of real options in the valuation of Internet companies to demonstrate the required judgment and tradeoffs in the framing of real options applications. The case of Webvan, an online grocer, is used to illustrate the inter‐action between strategy, execution, and valuation.     

BANKING ON REAL OPTIONS

This article discusses why many companies use committed bank facilities to finance their real options. The pace of change in the current economic environment has increased the value of financial flexibility. If and when companies choose to exercise their real options, they often require capital to finance these initiatives. Committed bank facilities meet this requirement by providing the assurance of funding (subject to explicit conditions), or at least a starting point for raising the new capital.
Raising the capital necessary to finance very large real options is so critical that many companies use a single financial advisor to evaluate M&A transactions and raise the funds. In the case of ClubCorp, Bank of America provided M&A advice and an interim loan to finance an acquisition that exceeded the company's committed bank capacity. Later that year, Bank of America "agented" a new deal to refinance this acquisition debt. In a second case, Ferrellgas hired Bank of America to evaluate, help negotiate, and finance its acquisition of Thermogas. Financing this transaction required a bridge loan and synthetic lease as well as monetizing $175 million of equity securities.     

REAL OPTIONS: STATE OF THE PRACTICE

In the mid‐1980s, financial economists began building option‐based models to value corporate investments in real assets, laying the foundation for an extensive academic literature in this area. The 1990s saw several books, numerous conferences, and many articles aimed at corporate practitioners, who began to experiment with these techniques. Now, as we approach the end of 2001, the real options approach to valuing real investments has established a solid, albeit limited, foothold in the corporate world. Based on their recent interviews with 39 individuals from 34 companies in seven different industries, the authors of this article attempt to answer the question, “How is real options being practiced, and what impact is it having in the corporate setting?” The article identifies three main corporate uses of real options—as a strategic way of thinking, an analytical valuation tool, and an organization‐wide process for evaluating, monitoring, and managing capital investments. For example, in some companies, real options is used as an input into an M&A process in which rigorous numerical analysis plays only a small role. In such cases, real options contributes as a qualitative way of thinking, with little formality either in terms of analytical rigor or organizational procedure. In other firms, real options is used in a commodity trading environment where options are clearly specified in contracts and simply need to be valued. In this case, real options functions as an analytical tool, though generally only in specialized areas of the firm and not on an organization‐wide basis. In still other companies, real options is used in a technology or R&D context where the firm's success is driven by identifying and managing potential sources of flexibility. In such cases, real options functions as an organization‐wide process with both a broad conceptual and analytical core. The companies that have shown the greatest interest in real options generally operate in industries where large investments with uncertain returns are commonplace, such as oil and gas, and life sciences. Major applications include the evaluation of exploration and production investments in oil and gas firms, generation plant investments in power firms, R&D portfolios in pharmaceutical and biotech firms, and technology investment portfolios in high‐tech firms. While the approaches to implementation are quite varied, there appears to be a common path to the successful adoption of real options. The key steps of the adoption process are: (1) conducting pilot projects; (2) getting buy‐in from senior‐level and rank‐and‐file managers; (3) codifying real options through expert working groups, specialist training, and customization; and (4) institutionalizing and integrating real options firm‐wide. After citing best practices for each of these four steps, the authors close by predicting that a “network” effect and acceptance by Wall Street will serve as catalysts for more widespread corporate use of real options.     

THE PROMISE OF REAL OPTIONS

In recent years, both practitioners and academics have argued that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. This paper shows how option pricing models used in valuing financial assets can be used to value three kinds of real options that are often built into corporate projects: the option to delay, the option to expand, and the option to abandon. As a number of examples in this paper suggest, corporate investments that would be rejected using conventional DCF analysis can sometimes be justified by the value of the strategic options they provide. As the illustrations also show, however, the pricing of real options is considerably more difficult than the pricing of financial options and adjustments must often be made to capture the complexity of real investments.     

CONVERTIBLE BONDS: MATCHING FINANCIAL AND REAL OPTIONS

For companies whose value consists in large part of “real options”‐ growth opportunities that may (or may not) materialize‐convertible bonds may offer the ideal financing vehicle because of the matching financial options built into the securities. This paper proposes that convertible debt can be a key element in a financing strategy that aims not only to fund current activities, but to give companies access to low‐cost capital if and when their real investment options turn out to be valuable. In this sense, convertibles can be seen as the most cost‐effective solution to a sequential financing problem‐how to fund not only today's activities, but also tomorrow's growth opportunities (some of them not yet even foreseeable). For companies with real options, the ability of convertibles to match capital inflows with corporate outlays adds value by minimizing two sets of costs: those associated with having too much (particularly equity) capital (known as “agency costs of free cash flow”) and those associated with having too little (“new issue” costs). The key to the cost‐effectiveness of convertibles in funding real options is the call provision. Provided the stock price is “in the money” (and the call protection period is over), the call gives managers the option to force conversion of the bonds into equity. If and when the company's investment opportunity materializes, exercise of the call feature gives the firm an infusion of new equity (while eliminating the debt service burden associated with the convertible) that enables it to carry out its new investment plan. Consistent with this argument, the author's recent study of the investment and financing activities of 289 companies around the time of convertible calls reports significant increases in capital expenditures starting in the year of the call and extending three years after. The companies also showed increased financing activity following the call, mainly new long‐term debt issues (many of them also convertibles) in the year of the call.     

REAL OPTIONS AND CORPORATE RISK MANAGEMENT

By formulating an integrated strategy that combines the creation and exercise of real options together with other risk management techniques, management can reduce risk and thereby increase firm value. For example, a company that is in a position to delay investing without losing its competitive edge, to abandon a project that becomes unprofitable, or to adjust its operating strategy at low cost can avoid risks and exploit profitable opportunities. But, even when real options are used in this way to limit the risk profile of the firm, financial derivatives can help to hedge any residual risk that would otherwise affect the value of the real options and the overall firm.
An integrated risk management approach requires a careful process of diagnosing a company's risk exposure. First, management must decompose the company's risk exposure to understand the fundamental sources of risk. Second, the company's capacity to bear risk must be determined, which requires an understanding of why individual risks (if left unmanaged) would reduce the value of the firm. Third, different approaches for addressing risk should be explored, ranging from diversification to use of financial derivatives and other contracts to investing in (or exercising) a wide array of real options. Fourth, the firm must properly integrate the different risk management solutions to optimize its strategy.     

REAL OPTIONS PRIMER: A PRACTICAL SYNTHESIS OF CONCEPTS AND VALUATION APPROACHES

Strategic capital investment decisions are being made every day in an increasingly uncertain world. While the traditional NPV approach does a reasonable job of valuing simple, passively managed projects, it does not capture the many ways in which a highly uncertain project might evolve, and the ways in which active managers will influence this evolution. In cases where managerial flexibility is a major source of strategic value, companies will want to use real options valuation methods.
This article serves as a managerial tutorial on this newer, less understood approach. It uses simple examples to illustrate the essence of four basic categories of real options—timing, growth, production, and abandonment. The examples begin by taking a "binomial" approach to option valuation, in which the value of an investment initiative is allowed to take on two possible future values. Besides being used to illustrate the distinctive features of a real option, the binomial approach also serves to help the reader understand the alternative Black-Scholes valuation approach (though without requiring the reader to master the complex mathematics underlying Black-Scholes). Basic instructions for implementing both approaches are provided, along with a discussion of how to set appropriate discount rates and the important role of volatility assessment in the valuation process.     

TRACKING STOCKS AND THE ACQUISITION OF REAL OPTIONS

Despite their wellpublicized conflict of-interest problems, tracking stocks can be a superior alternative to equity carveouts in a particular, though increasingly common, set of circumstances—namely, when companies launch highrisk, capitalintensive startups that are expected to have valuable future synergies with their main operating divisions. Like equity carveouts, tracking stocks reduce the well-known conglomerate discount by exposing the startups directly to capital market discipline and incentives. But, in contrast to carveouts, tracking stocks leave strategic and operating control in the hands of single board of directors and management team. This feature of tracking stocks is likely to add significant value by reducing the eventual cost of integrating the startup operation into the firm's core operations. The author supports this view by comparing the different approaches taken by two telecommunications companies, BCE and Sprint, in financing (and later integrating) their wireless communications services.     

FIRST-MOVER (DIS) ADVANTAGE AND REAL OPTIONS

Fear of losing first-mover advantages has caused many corporate strategists to ignore real options analysis and simply go ahead with any project that they think is expected to have a positive net present value. But first-mover advantages are not nearly as valuable as most strategists tend to assume. This article weighs the expected value of first-mover advantages against the benefits of the real option arising from delay and flexibility. The real options model recognizes the value of delaying projects until important sources of uncertainty and risk can be resolved.
After reviewing two well-known cases of successful second movers—the triumph of VHS over Betamax in VCRs and Microsoft's remarkable late software entries—the authors go on to present more broadly based historical evidence for their view that first-mover advantages often fail to confer lasting value. The article closes with an assessment of first-mover advantages in the new economy, including a brief look at recent developments in the Internet and telecom sectors.     

MATCHING FINANCIAL AND REAL INVESTMENT OPTIONS: EVIDENCE FROM WARRANT CALLS

We provide new evidence on the sequential financing explanation for the use of warrants. Consistent with sequential financing, capital spending starts increasing in the year of the call and peaks three years after the call. In addition, both equity and debt financing increase significantly in the year of the call and remain at high levels. Warrant contract features—the exercise price and the presence or absence of a price condition for callable warrants—are also consistent with the sequential financing hypothesis.     

OPTION EXERCISE GAMES: THE INTERSECTION OF REAL OPTIONS AND GAME THEORY

While the real options approach has proven useful in providing an analytical framework for analyzing the timing of investment decisions, a notable failure of the approach has been an almost complete lack of strategic considerations. In standard real options models, invest-ment (and exercise) strategies are for-mulated in isolation, without considering the potential impact of other firms' exercise strategies. This paper illustrates how the intersection of real options and game theory provides powerful new insights into the behavior of economic agents under uncertainty.
Introducing strategic considerations into the real options framework can lead to a rethinking of standard real option analysis. For example, one of-ten cited conclusion of the real options literature is the overturning of the standard capital budgeting rule of in-vesting immediately in any project with a positive NPV. Because the fu-ture value of the asset is uncertain, there may be significant benefits to deferring the investment until condi-tions prove even more favorable. But this result clearly depends on the lack of competitive access to the project. If firms fear preemption, then the option to wait becomes less valuable. For example, while the standard real op-tions models suggest that a real estate developer should wait until the devel-opment option is considerably "in the money," competition and the fear of preemption will likely force develop-ers to build much earlier.     

ESTIMATING THE VALUE OF DELIVERY OPTIONS IN FUTURES CONTRACTS

We analyze the effect various delivery options embedded in commodity futures contracts have on the futures price. The two embedded options considered are the timing and location options. We show that early delivery is always optimal when only a timing option is present, but not so when joint options are present. The estimates of the combined options are much smaller than the comparable estimates for the timing option alone. The average value of the joint option is about 5% of the average basis on the first day of the maturity month. This suggests that joint options can increase deliverable supplies while potentially having only a small effect on basis behavior.