A real options approach for entrepreneurs making decisions under uncertainty.

Sale, R. Samuel ; Atinc, Guclu

COMMON ANALYSES

Net Present Value Analysis

NPV analysis seeks to determine the present value of a stream of future cash flows by discounting them based on a discount rate and the timing of the cash flows. These discounted cash flows are then summed together. If this summation is positive, NPV analysis suggests that a project should be undertaken. Conversely if the value is negative, NPV analysis suggests that the project not be undertaken.

Two fundamental ideas behind the discounting of a stream of cash flows are that more money is preferred to less money and that receiving money sooner is preferred to receiving money later. Because a rational person would rather have a dollar today than a dollar tomorrow, that person would only find an investment opportunity appealing if he or she expects to receive more than one dollar tomorrow in exchange for the investment of one dollar today.

The amount of the additional return, above the one-dollar initial investment, required to make an investment appealing varies from situation to situation based in part on the financial status of the investor. This discount rate is often set equal to the weighted average cost of capital (WACC). An entrepreneur's WACC is essentially the interest that he or she is charged on an "average" dollar. In order for an investment to be appealing, each dollar invested should have an expected return greater than the amount of interest that the entrepreneur pays on his or her debt. Otherwise, the entrepreneur would be better off to "invest" in the lowering of debt rather than invest in the project in question. The calculation of the WACC is concerned not only with interest paid on debt, but equity as well. The above explanation can be extended to consider dividend payments on equity, but the result is the same: Regardless of the source of capital, positive expected returns less than the WACC are not generally considered appealing.

Net Present Value Analysis, Uncertainty, and Risk

Critics of NPV state that it is inappropriate for use under uncertainty situations. Before this criticism is addressed, it is important to distinguish between uncertainty and risk. When a decision maker "lacks knowledge of what all the alternatives are, what the outcomes associated with each alternative are, or cannot assign probabilities to each of the possible outcomes," then the decision maker is facing uncertainty. When a decision maker "faces more than one alternative but knows all of the possible outcomes associated with each of the alternatives, and can assign probabilities to each possible outcome," then the decision maker is facing risk (Kroll, 2007, p4).

Critics of NPV analysis use two main arguments stating its inappropriateness for use in uncertainty situations. The first concerns how uncertainty is captured in the model. In NPV analysis, this is addressed using the discount rate. A firm's WACC is often used as the discount rate, but this is still more appropriate for decision making under risk than decision making under uncertainty. By definition, in uncertainty situations it may not be possible to estimate all potential cash flows and the probabilities of each of the cash flows occurring. Gilbert (2004, p49) makes this point and also points out that the discount rate is based on the variance of the cash flows and thus ignores skew and kurtosis.

The second, and more common, argument against the use of NPV analysis under uncertainty concerns the ability of management to respond to uncertainty over time. NPV analysis does not normally consider learning on the part of management or the impact of changes to the environment during the life of a project. This includes management's reaction to changes as uncertainties are resolved, as well as major changes to the business environment (Afuah, 2003, p231).

Because NPV analysis inappropriately models uncertainty and ignores the ability of the entrepreneur to respond to uncertainty over time, it systematically undervalues investment opportunities where there are high levels of uncertainty and management has the ability to respond to this uncertainty throughout the life of the project (Kogut and Kulatilaka, 1994, p52; Afuah, 2003, p231; Gilbert, 2004 p49-50; Wu and Tseng, 2006, p314; Wang and Hwang, 2007, p247). In other words, when management has considerable flexibility, NPV analysis consistently underestimates the value of a project because it ignores this flexibility.

Valuation of investment projects is a challenging activity for all types of businesses. NPV analysis does not adequately consider the value of flexibility, a key to the logic behind real options. In today's dynamic environment, uncertain situations require rapid reaction to sudden changes. This makes NPV analysis increasingly inappropriate for decision-making under uncertainty.

Options, Real Options Pricing, and an Explanation of the Negative Bias

Options exist whenever a person has the right but not the obligation to engage in some activity. For example, a stock option gives a person the right but not the obligation to buy stock at a particular price. Real options are so named because they are concerned with real as opposed to financial assets. Real options are associated with the flexibility that management has in dealing with uncertainty. All else being equal, an entrepreneurial venture is more valuable if it does not limit the entrepreneur's flexibility. Real options pricing is the name of a collection of techniques that seek to determine the value of the flexibility that is associated with real options.

Any valuation method that ignores management flexibility implicitly assigns all real options a value of zero. This leads to a definite negative bias when there are high levels of uncertainty and management has the ability to respond to this uncertainty throughout the life of the project (Kogut and Kulatilaka, 1994, p52; Afuah, 2003, p231; Gilbert, 2004 p49-50; Wu and Tseng, 2006, p314; Wang and Hwang, 2007, p247). Valuation methods, such as the internal rate of return and the Black-Scholes option pricing method, share this limitation. In order for a methodology to be appropriate for use under uncertainty, it must more adequately address flexibility.

LITERATURE REVIEW

The following literature review is divided into three sections. The first section discusses NPv analysis and other methods that are appropriate for decision-making under risk. The second section presents a real options approach that is appropriate for decision-making under uncertainty. The final section presents a review of several recent conceptual and theoretical studies that are related to the use of real options pricing and entrepreneurial decision-making.

Pricing Methods Appropriate under Risk

one example of decision-making under risk is the management of a retirement fund designed for slow and steady growth. Here the investor has a wealth of historical data with which to predict the probabilities of various outcomes and takes on a rather passive role as manager. Such risk situations are not entirely confined to financial investment but may be found in real investment as well. For example, imagine a contractor who is about to begin construction on his twentieth McDonald's. Although the contractor was probably making decisions under uncertainty when he began construction of his first McDonald's, it could be argued that he is working under risk now.

One popular technique for valuing assets under risk is NPV analysis. In a pure risk situation, numbers can be assigned to potential outcomes and probabilities can be assigned to the likelihood of each outcome. NPV requires the decision maker to know all cash flows, the timing of these cash flows, and the discount rate. NPV analysis assumes that the amount and timing of all cash flows are known with certainty. The discount rate is used to account for risk. All else being equal, a higher discount rate will result in a reduction in the present value of distant cash flows. This is the mechanism by which NPV analysis models the time value of money.

Another valuation method suitable for use under risk is the internal rate of return (IRR) method. The IRR method uses the same basic arithmetic function as NPV analysis. The difference between these two methods is which variable is unknown. In the NPV method, the discount rate is given and the NPV calculated. In the IRR method, the NPV is set equal to zero and the discount rate determined. Gould (1972) compares NPV to IRR methods and discusses the relative benefits of NPV. The major drawback of the IRR method relative to NPV is that IRR can sometimes generate multiple solutions to the same problem.

Another valuation method is the Black-Scholes option pricing method. It is probably the most well known method of valuing financial options. The Black-Scholes option pricing method was developed to determine the value of European call options. A European option can only be exercised on a particular date as opposed to an American option that can be exercised at any time up to a particular date. A call option gives one the right to buy a stock at a particular predetermined price regardless of the market price of the stock. The Black-Scholes option-pricing method is valuable for pricing European call options but requires several assumptions to be made which are seldom justified when trying to determine the value of real options (Gilbert, 2004, p51). Despite the fact that it is an options-pricing method, the Black-Scholes method is more appropriate for risk situations than uncertainty situations. In this way, it is more closely related to NPV and IRR than it is to real options pricing methods. This is not surprising because the Black-Scholes option pricing method was designed to value financial options as opposed to real options.

NPV, IRR, and the Black-Scholes method are powerful financial tools. However, they are tools that are appropriate for use under risk, not uncertainty. They also more appropriate when the decision maker is a passive investor rather than an entrepreneur (Afuah, 2003, p231). Here a passive investor is one who can choose to buy or sell an asset but who has no control over the management of the asset. This is opposed to an entrepreneur who assumes managerial responsibility over the asset and thus can actively manipulate events in an effort to maximize his or her wealth.

Unfortunately, there are many examples of NPV being used to assess values under uncertainty. Remer et al (1993) report results of a survey on Fortune 500 companies about their use of valuation techniques. These results show that 97% of the companies used NPV method for investment decisions in 1991. Johnson, Smythe and Fulmer (2000, p60) describe NPV as "an extremely accurate and useful tool" for use in selecting projects in an uncertain environment. There is no doubt that NPV and the other valuation methods are useful. However, the assumptions of these methods are that decision makers have far better information than is realistic for entrepreneurs. The methods discussed above are appropriate for use under risk, not uncertainty.

Real Options Analysis under Uncertainty

If NPV analysis is inappropriate for use under uncertainty, what methods are appropriate? The answer to this question is important to entrepreneurs who face uncertainty every day. There are several real options analysis methodologies present in the literature. The purpose of this section is not to exhaustively review these methods. Instead, most of the real options pricing methods are discussed only in general terms. In addition, a recommended method is discussed in detail.

Some real options analysis methodologies are based on economic models. Two examples are Dixit (1992) and Wu and Tseng (2006). Dixit (1992) examines the value of the option to wait to invest by developing an economic model that relates investment hurdle values to the options associated with waiting to invest. Wu and Tseng (2006) use an economic model to examine the value of patents as options. Another approach that is sometimes used for real options analysis is game theory. Grenadier and Wang (2007) use a game theory approach to investigate time inconsistent preference of entrepreneurs. Another technique that has been used is fuzzy logic. Wang and Hwang (2007) develop a fuzzy logic methodology for determining whether to invest in a particular venture. One problem that all of these methodologies share to a greater or lesser degree is that their results depend on the particular structure or assumptions of the model and are not likely to be generalizable.

Seppa and Laamanen (2001) use what is essentially a combination of NPV analysis and decision trees. The authors describe this as a binomial lattice of risk free hedge portfolios that are discounted using the risk free rate of return. A binomial lattice for a particular investment is similar to a decision tree where every period the asset's value has a certain chance of increasing and a certain chance of decreasing. A risk free hedge portfolio for a particular asset contains that asset as well as financial options whose value varies inversely with the value of the asset in such a way that the value of the portfolio as a whole does not depend on which state of nature occurs. Seppa and Laamanen use data from 421 Us venture capital transactions to compare the predictive ability of traditional NPV analysis to that of their binomial model. They find that the binomial model generates risk return profiles that are more accurate than traditional methods.

Cave and Minty (2004) present a more in-depth methodology that consists of nine activities. These activities are as follows: think strategically, value risk exposure, identify major milestones, identify decisions and uncertainties in each phase, calculate passive NPV, identify available real options, obtain additional data as necessary, determine the expanded NPV, and perform sensitivity analysis. Six of these activities are classified as real options thinking. The other three are classified as real options analysis. The activities, as well as the goals to be attained by each are included in Figure 1.

Conceptual and Theoretical Studies:

This section describes articles that discus current conceptual and theoretical issues surrounding real options pricing. The purpose of this section is to make the reader more familiar with real options thinking, a critical component of Cave and Minty (2004)'s method.

Kogut and Kulatilaka (1994) point out that although many real options are inherent in an investment--for example an investor generally has the right to delay the start of an investment or abandon an investment--some of the most valuable options are not inherent. These options must be designed into a project. Kogut and Kulatilaka term this type of proactively generated options as "platform investments." An example of a platform investment is when a process is designed with more flexibility than is currently required. The authors describe platform investments as future oriented options. They argue that in many industries competitive forces require the speedy incorporation of new methods, techniques, and infrastructure in order for a firm to remain competitive. They further point out that many of these new practices would be rejected if decisions were based on NPV analysis. This seeming contradiction is based on the idea that investments are often required so that firms are able to react competitively when opportunities arise. The authors suggest that part of the problem with current practices is that managers are often judged by short-term performance and thus are more inclined to be myopic and that this myopic viewpoint leads to under-investment in truly innovative products and processes.

According to Cassiman and Ueda (2006, p262), "entrepreneurs in small innovative firms tend to come from large established firms in the industry." They go on to state that these entrepreneurs unusually conceive of their innovations while they are working for an established firm and only start their own firms after the parent organization decides not to develop the innovation. Cassiman and Ueda investigate why established firms may choose not to commercialize an innovation while entrepreneurial start-up companies choose to do so. They make two important assumptions. First, it is assumed that a firm has a limited capacity for commercializing innovations. Second, it is assumed that the transfer of an innovation from an established firm to a start-up firm is frictionless. When these assumptions hold, an established firm may choose not to commercialize an innovation even if it is likely to be profitable. Essentially, an established firm may choose not to commercialize an innovation that is expected to be profitable because it does not fit with the existing capabilities of the firm. This does not occur for start-up companies because they are assumed to have equal fit with all potential new innovations. The assumption of frictionless transfer implies that, in this case, the established firm will forego commercializing the innovation because the total profit across both firms is greater if they allow the start-up to commercialize the ill-fitting innovation while they concentrate on innovations with better fit (p263). Based on these assumptions, they make the following generalizations: the innovations commercialized by established firms tend to exhibit greater fit, higher levels of cannibalization of existing demand, and lower profits than innovations commercialized by start-up firms.

Dixit (1992) discusses a phenomenon faced by foreign investors in the US during the 1980s. At the beginning of 1980s, American currency appreciated tremendously and foreign firms rapidly invested in US. These firms were not that fast to react when dollar depreciated at the end of the decade. Dixit relates hurdle rates required for investment in a project to the value of the option to wait to invest. In doing so, Dixit suggests that the slowness of a market to move to equilibrium may be a rational response to uncertainty. This investment in the US can be thought of as a platform as described by Kogut and Kulatilaka (1994).

Lee et al (2007) approaches a different conceptual issue. They use a real options perspective to discuss the impact of entrepreneur friendly bankruptcy laws. They make the argument that when bankruptcy laws are less harsh, entrepreneurs are more willing take risks and invest. They state that this increases economic development and diversity, and benefits society in general. In order to stimulate this development they make five suggestions. They recommend against automatic firing of management after filing for bankruptcy. They recommend a reorganization option. They recommend the opportunity for an automatic stay of assets. They recommend that owners have the opportunity of a fresh start in the case of liquidation. Finally, they recommend that the bankruptcy procedure be handled in a timely manner.

Grenadier and Wang (2007) discuss time inconsistent preference of entrepreneurs. They cite several studies that when payoffs are far away, people are more patient than they are when they are closer in. They suggest that there are two opposing forces that impact the timing on any investment. The first is the desire to wait for uncertainty to resolve itself. This is associated with the value of the option to wait to invest. They say that the second force is the desire to invest early, which is driven by time inconsistent preferences. The authors make a conceptual distinction between naive and sophisticated entrepreneurs. The authors describe naive entrepreneurs as believing (falsely) that, in the future, they will make decisions in order to obtain optimality as defined by their preferences today. The authors describe sophisticated entrepreneurs as recognizing that, in the future, they will make decisions in an attempt to obtain optimality as defined by their preferences in the future.

McGrath (1996) uses options theory to explain how successful entrepreneurs counter the "twin liabilities of newness and smallness." The author describes starting entrepreneurs as using social capital to obtain required resources. The authors point out that this use of personal relationships to obtain resources at reduced costs results in asset parsimony. They further point out that asset parsimony is a key element in flexibility. Flexibility and the limitation of loss are, in turn, key elements of real options theory.

Leslie and Michaels (1997) begin by discussing the importance of thinking in terms of options rather than strictly in terms of NPV. They relate the six variables used by the Black-Scholes method to six levers that can be used to manipulate the value of real options. The authors define the value of the real options as being positively related to the time to expiration, uncertainty of expected cash flows, present value of expected cash flows, and the risk free interest rate. They define them as being negatively related to the present value of fixed costs and the value lost over the duration of the option. The authors then present advice for managing options proactively so as to increase their value. This advice is included in Figure 2.

Cave and Minty (2004) describe the real option valuation process as including nine broad activities. Six of these activities are conceptual in nature (real options thinking) and the other three are computational (real options evaluation). This methodology is a framework that subsumes some of the other methods discussed. For example, the advice given by Leslie and Michaels (1997) concerning proactive management of options is very similar to some of the objectives of the first two activities (think strategically, value risk exposure) of Cave and Minty's method. The next to last step of Cave and Minty's method is to determine the strategic NPV. One method of calculating the strategic NPV is presented by Seppa and Laamanen (2001). This holistic consideration of both options thinking and options analysis is very important.

CONCLUSIONS AND RECOMMENDATIONS

While there is no real question that entrepreneurs should consider the real options associated with the deferment of an investment, O'Brien et al (2003) investigate whether or not entrepreneurs actually do consider these real options. Their study is not concerned with the particulars of the real option pricing techniques used by members of the sample, but rather is concerned with whether or not the decisions (however they were arrived at) agree with the stated theory. In this respect, O'Brien et al appear to be testing what Cave and Minty (2004) would call real options thinking. Overall, O'Brien et al find that entrepreneurs do behave in accordance with real options pricing theory. In particular, they find a negative relationship between uncertainty and entry, and find that this relationship is moderated by the level of irreversibility of the project. In other words, if all else is equal entrepreneurs are less likely to invest if uncertainty is higher and this relationship is stronger when in the investment requires a large sunk cost. These effects are statistically significant after controlling for various industry, firm, and individual characteristics.

Cave and Minty (2004) use a series of hypothetical situations to empirically investigate how closely entrepreneurs follow a real options approach when making decisions. They also compare and contrast the entrepreneurs' decision-making processes with that of administrators by presenting the same set of hypothetical situations to a sample from each group. Both sets of subjects were able to identify real options but neither was consistently able to calculating the strategic NPV. This suggests that entrepreneurs do not understand real options analysis or are not able to integrate it effectively into their real options thinking.

Cave and Minty (2004) present a method that structures real options thinking and incorporates real options analysis into this framework. Please refer to Figure 1. The ability to think in terms of real options is critically important to entrepreneurs. Therefore, our first recommendation is that entrepreneurs should use the method presented by Cave and Minty or a similar method for decision making under uncertainty. Two of the real options thinking activities described by Cave and Minty are think strategically and value risk exposure. In their discussion of ways of proactively managing options, Leslie and Michaels (1997) discuss these activities at length. These two articles are recommended to interested entrepreneurs.

There is evidence that successful entrepreneurs understand the importance of real options thinking (O'Brien et al, 2003). This understanding may be instinctive or learned over time, because many business curricula devote more time to NPV than real options. This is demonstrated by evidence that entrepreneurs are unable to calculate the value of real options (Cave and Minty, 2004). Therefore, it is recommended that business curricula for all business majors should place greater emphasis on teaching the basics of real options thinking. Also, curricula for management, finance, and entrepreneurship students should place greater emphasis on teaching real options analysis and the incorporation of real options analysis in real options thinking.

APPENDIX--AN ILLUSTRATIVE EXAMPLE

The conceptual issues discussed above may be more understandable if accompanied by an illustrative example. The example problem follows the method recommended by Cave and Minty (2004). The first step of the process is think strategically. In this step, the decision maker must assess the general environment, identify opportunities, and determine the feasibility of any opportunities that are identified as well as any threats to implementation.

This appendix relates the real options pricing method suggested by Cave and Minty to the decision of the SG Corporation to globalize. The SG Corporation is a fictitious construction chemical producer located in Orlando, Florida. The company is specialized in production of cement additives, mortars and grouts. The product line consists of seven types of cement additives, three types of mortars for floor and wall insulation, and two types of grouts for tile and ceramic floor covering. Concrete chemicals is roughly a six billion dollar industry, and the SG Corporation holds eighth position in the market in terms of revenue with $200 million in annual revenues and $12 million profit in 2006. Although the SC Corporation has been profitable since its formation in 1979, recent developments in the US construction industry are causing the executives some concern. CEO Jack Vanegor constantly argues with Board of Directors about the rapid decreases in profits. The board is not happy with the current situation and is seriously considering the sale of the company to a larger competitor. Mr. Vanegor on the other hand insists that the temporary slump in US construction industry can be mitigated by turning the SG Corporation into an international firm.

The competition has already penetrated markets in Europe and Asia, but the CEO is confident that market in the Middle East is large and growing sufficiently to make the investment in globalizing the SC Corporation worthwhile. Currently, members of his staff are scouting Egypt and Kuwait for a viable location to build a factory. Mr. Vanegor wants them to learn about all aspects of the investment opportunities in these two countries including labor, energy, legal environment, infrastructure, and taxation. The Executive Vice Presidents of Finance and Production have been working in this direction for the past three months. Figure 3 comes from their feasibility study.

Management has performed a SWOT analysis to identify internal strengths and weakness and external opportunities and threats to the globalization strategy. They find that the major strength of SG Corporation is the ability to react to sudden changes due its size. On the other hand, the major weakness is the lack of support from the shareholders due to recent developments. Vanegor is well aware of the arising opportunities in Middle East construction industry; however, the Middle East is known as the boiling point of the world where there are strong anti-American sentiments. As an American company, this is the biggest threat to the SG Corporation expanding there. Competition in the region is light, and the CEO is confident about the decision to globalize.

In any decision-making process, the ability to identify risks is a key to success. The entrepreneur's level of influence and control over the identified risk is also important for assigning values to the risks the company faces. Cave and Minty (2004) identify this as the second step in the real options pricing methodology. Leslie and Micheals (1997, p.16-17) suggest four ways of applying real-options to investments. They recommend that entrepreneurs emphasize opportunities, enhance leverage, maximize rights, and minimize obligations. Management has to identify the several potential risks associated with the globalization project. These are listed in Figure 4. Many of these risks are beyond the control of management. However, Mr. Vanegor has reminded management that some of the risks can be influenced by the decisions of management.

Identification of the major milestones is the third step suggested by Cave and Minty (2004). In order to divide the projects into separate phases, management has identified the critical phases of the investment opportunity. The team came up with these critical phases of the project: legal formation of the entity in the specific country, acquisition of land for the factory, preparation of the factory construction project, collection and evaluation of bids for the construction, construction, acquisition of the factory equipment, formation of a distribution channel in the region, organization of marketing activities in the region, consideration of quality control issues, and, launch.

Identification of decisions, events, and uncertainties in each of these steps is the fourth step in the process. The first phase of the project is the legal formation of the entity in the specific country. Both countries are willing to attract foreign investments so risks in this phase are considered minimal. Management has not identified any options in this phase of the project.

The second phase of the project is the acquisition of land for the factory. Management has some concern that once a facility location is selected, the company may become a target for terrorist attack. Management has decided that the risk of terrorist attack is something that they have no control over. Because they have no ability to respond to this uncertainty, management has no real options associated with this phase.

The third phase of the project is the preparation of the factory construction project. This preparation includes the development of blueprints and schedules for the construction project. The SG Corporation can either have the project prepared by a US firm or use one of the construction companies from the Middle East that offer this service. The use of a local company from the region may lead to goodwill. Recall that the construction companies are the potential customers of the SG Corporation. This goodwill may reduce the risk of not being accepted by local companies. However, Mr. Vanegor is concerned with management's ability to assess the credentials and determine if a Middle Eastern construction company can do a credible job on such an important (to the SG Corporation) project. Mr. Vanegor has expressed concerns that using a regional preparer would increase the risk of delays in construction. Management has the option of using a Middle Eastern company to prepare the project, but it is decided that the increased risk of delay outweighs the decreased risk of acceptance so this option is foregone.

The fourth phase of the project is the collection and evaluation of bids for the construction project. Uncertainty concerning the qualifications of the regional companies influences decisions in the fourth phase as well. Normally, open bidding is used on construction contracts and the lowest bidder is selected. Using a local company would likely to decrease the risk of not being accepted by local companies but management is concerned that use of the lowest local bidder may increase the risk of delays in construction if the company does not have a reasonable chance of staying on schedule and on budget. Management has the option of changing their bidding process and using a selective bidding process that only solicits bids from some of the most experienced local companies. Management has decided that since the project will be properly prepared by a known firm in the US, an experienced local construction company should have little trouble executing the construction process. This is expected to reduce the risk of delays in construction and increase price slightly with no expected change to the risk of not being accepted.

The fifth phase of the project is construction. Management has the option of delaying construction in order to further analyze the situation. Mr. Vanegor feels confident in the decision to globalize and sees no reason to delay construction. Hence, there are no real options in this phase to consider.

The sixth phase of the project is the acquisition of factory equipment. Management has the option of acquiring equipment from local equipment manufacturers. This is likely to result in a lower cost, but Mr. Vanegor is concerned that regional equipment manufacturers may not be able to supply equipment of the desired quality. Management has the option of buying local equipment but it is decided that the risk of production problems outweighs the cost savings.

The seventh phase of the project is the formation of a distribution channel in the region. Normally sales teams that report directly to the SG Corporation would be used. However, local sales agents trained and hired by SG may have a difficult time gaining acceptance by local companies. Management has the option of using a regional wholesaler instead of the usual sales teams. This is expected to decrease the risk of not being accepted by local companies. However, Mr. Vanegor is concerned that the use of a wholesaler may increase the risk of delays in the collection of revenues. Management decides to forego the option of using a regional wholesaler.

The eighth phase of the project is the organization of marketing activities in the region. The decision of management, in the previous phase, to use local sales teams influences the decision to be made in this phase. Normally, the sales force would market directly to construction companies. An American-type sales team is expected to have some risk of fitting in with Middle Eastern construction companies. Management has the option of marketing instead to local retailers. The idea here is that the members of the sales force will build stronger relationships with fewer customers than would be the case if the sales force focused on direct marketing to the construction companies.

The ninth phase of the project is the consideration of quality control issues. The SG Corporation has a successful quality control program in its US facilities, but it is not ISO 9000 certified. Management knows that ISO certification is considered to be more important internationally than it is in the US. Management has the option of implementing ISO certification. It is not expected that ISO 9000 certification will have any impact on product quality, but it may reduce the risk of not being accepted by local companies that are familiar with ISO certification.

The tenth and final phase of the project is launch. Mr. Vanegor is happy with the decision making process to this point and is convinced that globalization is necessary. Management has no real options. Figure 5 lists the expected probabilities of the above-identified risks for two cities in two Middle Eastern countries.

The fifth step of Cave and Minty's method is the calculation of the project's NPV. Figure 6 summarizes the cash inflows and outflows expected to be associated with this project. Based on the data from Figure 6, the NPV for the Cairo facility is approximately $125,830,565 and the NPV for the Kuwait City facility is approximately $116,193,546. Both of the projects have positive NPVs, but since they are mutually exclusive, NPV analysis suggests that the facility be placed in Cairo.

The sixth step in the real options pricing methodology of Cave and Minty (2004) is the identification of real options. Differences in the value of the real options associated with the two facility locations may change the relative desirability of the two locations. Figure 7 summarizes the real options identified by Mr. Vanegor and his team concerning a facility in Cairo. Similarly, Figure 8 summarizes the real options that have been identified concerning a facility in Kuwait City.

Figures 7 and 8 include the critical decisions and risks that management has some control over. Figure 7 is associated with Cairo. Figure 8 is associated with Kuwait City. By exercising the appropriate options, management can reduce the risk of negative outcomes. For example, using selective bidding in Kuwait City will reduce the probability risk of delay by 15%.

The seventh step of the option pricing methodology is obtaining additional data if necessary. Mr. Vanegor is happy with the decision making process so far. He feels that no additional data is necessary.

The eighth step in the real options pricing methodology of Cave and Minty (2004) is the calculation of the project's strategic NPV. Figures 9 and 10 summarize the cash inflows and outflows expected for the project for Cairo and Kuwait City if all appropriate options are exercised.

Based on the data from Figure 9 and Figure 10, the strategic NPV for the Cairo facility is approximately $150,095,347 and the NPV for the Kuwait City facility is approximately $160,917,435. Once again the two projects are mutually exclusive. The Cave and Minty (2004) method suggests that the facility be placed in Kuwait City. Note that this is a reversal of the decision arrived at by NPV. This is because the options associated with a Kuwait City facility make it more desirable. When real options are ignored, NPV analysis underestimates the value of both projects. The consideration of real options increases the value of both projects. The decision for the location of the facility is reversed once real options are considered. Management expects that there is greater flexibility associated with the Kuwait City location, thus making it more appealing than a Cairo location.

The ninth and final step of Cave and Minty's method is to perform a sensitivity analysis. The purpose of the sensitivity analysis is to assess the sensitivity of the model to changes in the various inputs. In the case of the SG Corporation, these inputs are the risk probabilities from Figures 7 and 8. Ross, Westerfield and Jaffe (2008) identify sensitivity analysis as what-if analysis. The decision maker could ask "What if the probabilities were ..." an infinite number of sets of values. Here two what-if scenarios are explored.

In the first scenario, management is pessimistic in its ability to respond to uncertainty so the value of all options are reduced by 10%. This is shown in Figure 11.

In the second scenario management is optimistic in its ability to respond to uncertainty so the value of all options are increased by 50%. This is shown in Figure 12.

The Kuwait City project is more sensitive to changes in the option values than the Cairo project. This is what leads to the reversal of decisions from the fifth to the eighth step of the methodology. When all option values are set equal to zero, Cairo is more valuable. As the options are introduced, both NPVs increase. Because the Kuwait City project is more sensitive, its value increases faster and surpasses the value of the Cairo project.

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R. Samuel Sale

Assistant Professor

Department of Management and Marketing

Lamar University

rssale@hotmail.com

Guclu Atinc

Doctoral student

Louisiana Tech University

Figure 1: Nine activities adapted from Cave and Minty (2004)

Activity Objectives

 Assess general external environment Identify
 the feasibility of the opportunity Identify
 broad opportunities and threats Develop the
Think Strategically foundation for decisions

 Identify risks that could impact the
 opportunity Quantify risks (magnitude and
 probability) Indicate entrepreneur's risk
Value Risk Exposure

 Identify milestones within which key
Identify major decisions must be made Segregate project
milestones into phases for focused analysis

Identify decisions Develop decision and event tree paths for
events and each phase Highlight key uncertainties and
uncertainties in each possible options Incorporate volatility
phase estimates into decision trees

Calculate passive Identify and quantify investments and
NPV revenues

 Determine the flexibility at each decision
 node Modify the passive event trees to
Identify available real highlight these flexibilities Determine the
options relationships between options

 Determine the alternations required to the
Obtain additional data event trees Incorporate and quantify issues
for real options if identified in strategic thinking into NPV
necessary calculations

Determine the Calculate the strategic NPV Determine real
strategic NPV options'

Perform sensitivity Identify key factors values
Analysis

Figure 2: Proactive management of options adapted from Leslie and
Michaels (1997)

Desired Outcomes Suggested Actions

 Maintain entry barriers
 Signal ability to exercise
Increased option duration Innovate to hold technology lead

 Extent opportunity to related
 markets

Increased uncertainty of Encourage complementary products
expected cash flows Bundle products

 Develop marketing strategies
Increased present value of Develop alliances with low-cost
expected cashed flows suppliers

Increased risk-free interest Monitor the risk-free interest rate
rate
 Leverage economies of scale
 Leverage economies of scope
Reduced present value of fixed Leverage economies of learning
costs
 Create implementation hurdles for
Reduced value lost by waiting competitors
to exercise Lock up key resources

Figure 3: Excerpt from Feasibility Study

Place of the
New Factory Cairo Kuwait City

Initial
Investment ($) 15,000,000.00 16,500,000.00

Time to
Complete (Years) 3.00 2.00

Annual Construction
Costs until completion ($) 2,500,000.00 3,000,000.00

Average
Labor Cost ($/h) 4.00 5.00

Annual Required Labor (Total 3,000,000.00 3,000,000.00
Hours)

Annual Required Raw Material ($) 25,000,000.00 22,500,000.00

Annual Other Costs ($) 2,500,000.00 3,500,000.00

Yearly Production
Capacity ($) 40,000,000.00 40,000,000.00

Market Demand
in Middle East ($) 1,000,000,000.00 1,000,000,000.00

Current Local Supply ($) 750,000,000.00 750,000,000.00

Estimated Yearly Sales
in Middle East ($) 50,000,000.00 50,000,000.00

Tax Rate 0.08 0.06

Annual Estimated Net Income ($) 9,660,000.00 8,460,000.00

Figure 4: Potential risks associated with Globalization Project

Risk of delays in collection of revenues Risk construction delays

Risk of not being accepted by local
companies Risk of terrorist attacks

Risk of import-export problems Risk of war in the region

Risk of currency fluctuations

Figure 5: Expected probabilities associated with risks

 Kuwait
 Cairo City

P(Risk of delays in collection of revenues) 0.05 0.001
P(Risk of not being accepted by local 0.10 0.05
companies)
P(Risk of import-export problems) 0.05 0.01
P(Risk of currency fluctuations) 0.10 0.05
P(Risk of delays in construction) 0.10 0.15
P(Risk of terrorist attacks) 0.05 0.01
P(Risk of war in the region) 0.01 0.01

Figure 6: Expected cash flows for NPV

 Cairo
 Year 0 Year 1 Year 2 Year 3
Capital -- -- --
Spending $15,000,000 $2,500,000 $2,500,000 $2,500,000

Operating Cash
Flows *

 Kuwait City
 Year 0 Year 1 Year 2 Year 3
Capital -- --
Spending -$16,500,000 $3,000,000 $3,000,000

Operating Cash
Flows * $8,460,000

 Cairo
 Year 4
Capital
Spending

Operating Cash
Flows * $9,660,000

Capital
Spending

Operating Cash
Flows *

Required Rate of Return = 7%

Annual Growth Rate in Sales = 2%

* For practical purposes the Net Income after the launch is
considered a growing perpetuity

Figure 7: Options associated with a Cairo facility

 Critical Associated Associated Risk
 Decision Option Risk Elimination

Construction Construction Selective Risk of
bids company Bidding delay 10%

 Marketing Risk of
Marketing through not being
activities Market method retailers accepted 5%

 ISO Risk of
Quality Control certifi- not being
control method cation accepted 5%

Figure 8: Options associated with a Kuwait City facility

 Critical Associated Associated Risk
 Decision Option Risk Elimination

Construction Construction Selective Risk of
bids company Bidding delay 15%

 Marketing Risk of
Marketing Market through not being
activities method retailers accepted 10%

 Risk of
Quality Control ISO not being
control method certification accepted 10%

Figure 9: Expected cash flows for strategic NPV--Cairo

 Cairo (Figures based on the probabilities)
 Year 0 Year 1 Year 2 Year 3

Capital ($13,500,00 ($2,250,00
Spending 0) 0) ($2,250,000) ($2,250,000)

Operating
Cash
Flows *

Strategic $150,095,34
NPV 7

 Cairo (Figures
 based on the
 probabilities)
 Year 4

Capital
Spending

Operating
Cash
Flows * $11,109,000

Strategic
NPV

* Year 0 = -15,000,000 + (15,000,000 x 0.10) = -$13,500,000
* Year 1 = -2,500,000 + (2,500,000 x 0.10) = -$2,250,000
* Year 2 = -2,500,000 + (2,500,000 x 0.10) = -$2,250,000
* Year 3 = -2,500,000 + (2,500,000 x 0.10) = -$2,250,000
* Year 4 = +9,660,000 + (9,660,000 x 0.05) + (9,660,000 x 0.05) +
(9,660,000 x 0.05) = +$11,109,000
Based on these new outcomes, the new NPV for Cairo project is
Cairo Project Strategic NPV = (-13,500,000) + (-2,250,000/1.07) +
(-2,250,000/[1.07.sup.2])
+
(-2,250,000/[1.07.sup.3]) + ((11,109,000/(7%-2%))/[1.07.sup.4]) =
$150,095,347

Figure 10: Expected cash flows for strategic NPV--Kuwait

 Kuwait City (Figures based on the probabilities)
 Year 0 Year 1 Year 2 Year 3
Capital
Spending ($14,025,000) ($2,550,000) ($2,550,000)

Operating
Cash
Flows * $10,998,000

Strategic
NPV $160,917,435

* Year 0 = -16,500,000 + (16,500,000 x 0.15) = -$14,025,000
* Year 1 = -3,000,000 + (3,000,000 x 0.15) = -$2,550,000
* Year 2 = -3,000,000 + (3,000,000 x 0.15) = -$2,550,000
* Year 3 = +8,460,000 + (8,460,000 x 0.10) + (8,460,000 x 0.10) +
(8,460,000 x 0.10) = +$160,917,435
Based on these new outcomes, the new NPV for Kuwait project is:
Kuwait City Project Strategic NPV = (-14,025,000) + (-2,550,000/1.07)
+ (-2,550,000/[1.07.sup.2]) + ((10,998,400/(7%-2%))/[1.07.sup.3]) =
$160,917,435

Figure 11: All option values reduced by 10%

 Sensitivity Analysis

 Percentage Change Percentage Change
Change in Probability of Cairo NPV of Kuwait City NPV

P(collection of revenues) -0.4910% -0.8583%
P(acceptance) -0.9820% -1.7166%
P(import-export problems) 0.0000% 0.0000%
P(currency fluctuations) 0.0000% 0.0000%
P(delays in construction) -0.1436% -0.2044%
P(terror) 0.0000% 0.0000%
P(war) 0.0000% 0.0000%

Figure 12: All option values increased by 50%

 Sensitivity Analysis

 Percentage Change Percentage Change
Change in Probability of Cairo NPV of Kuwait City NPV

P(acceptance) 4.9099% 8.5831%
P(terror) 0.0000% 0.0000%
P(collection of revenues) 2.4550% 4.2916%
P(war) 0.0000% 0.0000%
P(currency fluctuations) 0.0000% 0.0000%
P(import-export problems) 0.0000% 0.0000%
P(delays in construction) 0.7182% 1.0218%