Home  BADM449  Handout #12 Joseph T. Mahoney

College of Business
Department of Business Administration
BADM449  Strategic Management/Business Policy

Valuing Strategic Flexibility

Investment under Uncertainty: The Strategic Options Approach to Investment

As business persons, we are constantly presented with the opportunity to enter new businesses or launch new products. Often these proposals involve large commitments to capital, organizational effort, and managerial talent which are difficult to reverse once undertaken. Even more typically these decisions are made under conditions of great uncertainty. Will demand for the product fail to materialize? Will prices be lower or higher than we expect? Will the product be more expensive to launch than we plan? When faced with such dilemmas, the best response for management is often to "wait and see." That is, rather than commit yourself to a course of action that you can't back away from, a good rule of thumb is often to "keep your options open" and remain flexible.

While such a decision rule seems intuitively obvious, this position presents a dilemma to us. In this course in strategic management we have placed a great deal of emphasis on the idea of commitments. Commitments being defined as irreversible (sunk cost) investments. We have been arguing that sustainable competitive advantage is created by influencing the behavior of (potential) competitors through committed, irreversible action. The idea that there would be value to remaining strategically flexible seems to conflict with the idea that strategic commitment is the key to sustainable competitive advantage.

In order to deal with this posed dilemma, we should try to deal with two different questions:

1) When is strategic flexibility more important than strategic commitment?; and

2) How does one value "strategic flexibility?"

As it turns out, the answers to these questions are quite interesting and they have great practical value to us when making strategic decisions.

[For a more detailed discussion of the example that follows as well as strategic flexibility and options in general, see Avinash Dixit and Robert Pindyck, Investment under Uncertainty.)

How should we decide whether or not to enter into a business? If we refer to the literature on finance, the traditional approach is to use cash flow analysis using a net present value criterion. For example, let us imagine a situation in which we are considering entering the business of making "widgets." Assume that it costs $1600 to build a widget factory and that our current cost of capital is 10 percent. In addition, we sell only one widget per year, and the current price of a widget is $200. While we know the current price for widgets, we are somewhat uncertain about the future prices. Marketing forecasts indicate that there is a 50% chance that prices will go up to $300 next period (and remain there forever), however, there is also a 50% chance that prices will go down to $100. This forecast implies that the expected price of widgets in the future is $200 (= .5 * $300 + .5 * $100).

Using these numbers, we can evaluate this "project" with a standard cash flow analysis. The expected cash flow from entering the widget business appears in the first column of Table 1 (at the top of the following page). In period 0, we build the plant (-$1,600) and begin production, receiving $200 in revenues (-$1,600 + $200 = -$1,400). From that period on, we have positive expected cash flow of $200. We can use this cash flow series to arrive at the net present value (NPV) for the project, which is $600. Based upon this analysis, we would then proceed with the project since the NPV is greater than zero.

However, what if we wait a period, and find out whether the price goes up or down? That is, what if we choose to keep our options open and remain flexible in our decision. Two different scenarios could occur. The first possibility is that the price goes up to $300, in which case we would experience the cash flow under Scenario 1 in Table 1. The second possibility is that the price goes down to $100; in which case, we obtain the cash flows under scenario 2. Now, one will notice that under scenario 1, the NPV (in period 0) is positive (i.e., NPV = $1,545); however, under scenario 2, the NPV is negative (i.e., NPV is -$455). Thus, if we waited a period and the price went up to $300, we would proceed with the project; while if it went down, we would not. Thus, under the second scenario, the actual NPV would be $0. What does this tell us about the value of waiting, or remaining strategically flexible?

One way of answering this question is to reframe our cash flow analysis. Instead of taking the NPV of the expected cash flows, let us calculate the expected NPV of the two scenarios combined. That is, we have a 50% chance of the price going up and getting an NPV of $1,545, and a 50% chance of the price going down and getting $0. The expected combined NPV is therefore $773 (= .5 X $1,545 + .5 X 0). The NPV where we wait, find out the true price, and then make the decision is larger (by $173) than going right ahead right now. There is (an option) value to waiting. Thus, we can increase our expected returns by waiting a year and then deciding whether to undertake the sunk cost investments in a new plant.

In this strategic management note, we consider three common and important strategic options found in capital investment projects. Strategic options allow managers to add value to their firm by acting to amplify good fortune or to mitigate loss. Managers often do not use the term "option" to describe these opportunities; for example, managers may refer to "intangibles" rather than to puts or calls. But when managers review major investment proposals, these option "intangibles" are often the key to their decisions.

(1) The option to wait (and learn) before investing. The above example illustrates that even when the narrow (positive) NPV calculation suggests a "Go," when the options value of flexibility is taken into account, the top-level manager should wait. The option to wait is equivalent to a call option on the investment project. The call is exercised when the firm commits to the project. But often it is better to defer a positive-NPV project in order to keep the call option alive. Deferral is most attractive when uncertainty is great and immediate project cash flows -- which are lost or postponed by waiting -- are small.

(2) The option to make follow-on investments if the immediate investment project succeeds. In some cases, even if the first plant does not make sense on a stand-alone basis, the experience gained could substantially improve the economics of any subsequent plants. Thus, the first plant could merely be the "price of admission" representing a necessary learning curve. Thus, when the narrow (negative) NPV calculation suggests a "NO GO" the growth options may tip the scale to "GO." Companies often cite "strategic" value when taking on negative-NPV projects. A close look at the project's payoffs reveals a call option on follow-on projects in addition to the immediate project's cash flows. Today's investments can generate tomorrow's opportunities.

(3) The option to abandon the project. Even if the CSP fails, that component of the mill could be potentially replaced by another technology; the bulk of the mill, such as electric arc furnace and rolling mills, may be useable even with another thin-slab technology. Thus, when the narrow (negative) NPV calculation suggests a "NO GO" the options value of abandonment may tip the scale to "GO." The option to abandon a project provides partial insurance against failure. This is a put option; the put's exercise price is the value of the project's assets if sold or shifted to a more valuable use.

An interesting side note to this analysis is that it suggests that the traditional narrow NPV analysis is incorrect. When there is ongoing uncertainty of the economic environment in which irreversible investment decisions are made, the "Strategic Options" perspective recognizes the option value of waiting for better information. The traditional "net present value" rule (i.e., accept positive NPV projects), which is taught to virtually every business school student can give very wrong answers. The reason for the shortcoming of the narrow NPV rule is that this rule ignores irreversibility and the option value of delaying an investment. A narrow NPV analysis fails to account for all of the costs associated with forgoing the option to build later.

Three important characteristics of "strategic" investments:

  1. Irreversible (i.e., sunk cost)
  2. Uncertainty (over the future rewards from the investment)
  3. You have some leeway about the TIMING of the investment.

These three characteristics interact to determine the optimal decisions of the investors.

The net present value rule, however, is based on some implicit assumptions that are often overlooked. Most important, it assumes that either the investment is reversible, that is, it can somehow be undone and the expenditures recovered should market conditions turn out to be worse than anticipated, OR, if the investment is irreversible, it is a now or never proposition, that is, if the firm does not undertake the investment now, it will not be able to in the future.

Although some investments meet these conditions, most do not. Irreversibility, and the possibility of delay are very important characteristics of most investments in reality. The ability to delay an irreversible investment expenditure can profoundly affect the decision to invest. It also undermines the simple net present value rule. The reason is that a firm with an opportunity to invest is holding an "option" analogous to a financial call option -- it has the right but not the obligation to buy an asset at some future time of its choosing. When a firm makes an irreversible investment expenditure it exercises, or "terminates," its option to invest. It gives up the possibility of waiting for new information to arrive that might affect the desirability or timing of the expenditure; it cannot disinvest should market conditions change adversely. This lost option value is an opportunity cost that must be included as part of the cost of investment. As a result, the NPV rule "invest when the value of a unit of capital is at least a large as its purchase and installation cost" must be modified. The value of the unit must exceed the purchase and installation cost, by an amount equal to the value of keeping the investment option alive.

A few concluding points on strategic flexibility:

  1. When the uncertainty about the payoffs increases the value of waiting increases.

  2. If by waiting there is no decrease in the level of uncertainty, then if the narrow NPV is positive, you should go now.

  3. We have so far ignored other players in the market. In academic terms, we have been analyzing the problem as decision theoretic. However, we now are going to move on to considerations where the timing of investments also depends on how other players will respond. Thus, strategic management must take into account both decision theoretic problems and game-theoretic problems (e.g., as the number of potential competitors increases, our incentives for acting now will typically increase).