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.     

INCENTIVES AND THE RESOLUTION OF BANK DISTRESS

Unlike prudential regulations that are put in place prospectivelyto develop banks, procedures for dealing with banks in distressare generally determined on an ad hoc basis. Often the lackof clarity in the policy framework creates incentives for bankmanagers, shareholders, depositors, and regulators that undercutprompt resolution of financial distress. The result is ofteninaction, the accumulation of bad debts, and ultimately theassumption of losses by the state. This article argues thatgovernment intervention to relieve financial distress shouldbe institutionalized in a set of regulations that forces theauthorities to comply with reporting and decisionmaking processes.Only in this way can inherent disincentives for dealing withdistress be curtailed.      

CREATING VALUE AT A CONGLOMERATE: THE CASE OF THE GODREJ GROUP

This discussion with the chairman of the Godrej Group, a well-known India-based conglomerate, begins by exploring the issue of diversification versus a single-industry focus, particularly in developing countries. Mr. Godrej observes that the capital and managerial talent provided by a corporate parent can be invaluable resources in a developing economy, where such commodities are likely to be in relatively short supply. On the other hand, he notes, a conglomerate must have some underlying strategic rationale in order to create value, and a diversified company will work only "when each of its businesses is run with clear and focused accountability."
To that end, the Godrej Group recently instituted the EVA performance management framework in six of its key businesses. In particular, the management teams running those businesses are rewarded according to the terms of an EVA-based incentive plan. Each business has since seen significant improvements in capital efficiency, market share, and overall performance. The stock price of the Godrej Group's publicly held entity has more than doubled (in a flat market), and the vast majority of the employees believe that the EVA implementation has been the company's most important recent initiative. Management teams are said now to look much more carefully at options for outsourcing, contract manufacturing, eliminating bottlenecks, and even reusing old equipment at new facilities.
Perhaps the most significant change, however, is that the "improved rigor and discipline of our EVA-based capital allocation system" has permitted Godrej family members to move from operationsoriented, owner-manager functions to a broader leadership role. The EVA system has allowed them to feel more comfortable in decentralizing day-to-day decision-making because they are confident that managers and employees are all working in the shareholders' interests.     

THE DANGERS OF DECENTRALIZATION

Demand for decentralization is strong throughout the world.But the benefits of decentralization are not as obvious as thestandard theory of fiscal federalism suggests, and there areserious drawbacks that should be considered in designing anydecentralization program. An analysis of these dangers makesit easier to understand some of the real choices. These choicesare not so much whether to decentralize in general, but ratherwhat functions to decentralize, in which sectors, and in whichregions. In many cases the problem is not so much whether acertain service should be provided by a central, regional, orlocal government, but rather how to organize the joint productionof the service by the various levels. In many—if not most—cases, such measures have anenormous potential and could, if properly designed and implemented,significantly improve the efficiency of the public sector. Decentralizationmeasures are like some potent drugs, however: when prescribedfor the relevant illness, at the appropriate moment and in thecorrect dose, they can have the desired salutary effect; butin the wrong circumstances, they can harm rather than heal.This article looks at some of the negative effects of decentralizationin the hope that a better understanding of its dangers willcontribute to a wiser application of potentially desirable decentralizationprograms.      

EVA® FOR BANKS: VALUE CREATION, RISK MANAGEMENT, AND PROFITABILITY MEASUREMENT

This article presents a complete ranking of America's 100 largest bank holding companies according to their shareholder value added. This research, the first of its kind for the banking industry, defines an EVA measurement for banks and presents evidence of EVA's stronger correlation with bank market values than traditional accounting measures like ROA and ROE. Besides developing EVA and MVA as analytical tools for viewing the economic performance of the organization from a shareholder perspective, the authors also present a framework for calculating EVA at all levels of the organization, including lines of business, functional departments, products, customer segments, and customer relationships. The implementation of an EVA profitability measurement system at the business unit (or lower) level requires methods for three critical tasks: (1) transfer pricing of funds; (2) allocation of indirect expenses; and (3) allocation of economic capital. Although solutions to the first two are fairly straightforward, the allocation of capital to business units is a major challenge for banks today. In contrast to the complex, “bottom-up” approach used by a number of large banks in implementing their RAROC systems, the authors propose a greatly simplified, “top-down” approach that requires calculation of only the volatility of a business's operating profit (or NOPAT). The advantage of using NOPAT volatility is that it allows EVA analysis at any level of the organization in a way that captures the volatility effects from all sources of risk (credit, interest rates, liquidity, or operations). While such a top-down approach is clearly not meant to take the place of a comprehensive, bottom-up RAROC analysis, it is intended to provide a complement–a high-level “check” on the detailed, bottom-up risk management procedures and controls now in place at most banks. Moreover, for those banks that have developed extensive funds transfer pricing, cost allocation, and RAROCstyle capital allocation systems, the EVA financial management system can either be integrated with those systems or serve as an independent economic assessment of the bank's business risks and returns.