In this chapter, we have discussed real option concepts and strategic action framework. The key points are the following:
- It is often difficult, if not impossible, to use the financial techniques including discounted cash flow, NPV, and economic value added to justify an investment in certain projects, “exploratory” or “experimenting” or learning projects in particular. The “Jin Beans Tonic Elixirs” case nicely illustrates this very point.
- Firms should keep options open under the conditions of uncertainty and irreversibility and develop a portfolio of investment opportunities. Firms can defer “commitment” under uncertainty and irreversibility. This way of thinking can make a big difference for firms’ strategy, including portfolio decisions, mergers and acquisition decisions, governance choice, technology adoption decisions, and so forth.
- To develop a portfolio of investment opportunities, firms need to keep monitoring risk, assessing market trends, and trying new things on a small basis of experimentation.
Investment decisions are never easy. Cash flows, whether they are positive or negative, are fraught with uncertainty. Selecting the appropriate discount rate is never easy, but it has a dramatic influence on the go/no-go decision. Technical analysis using discounted cash flow techniques does not alleviate the uncertainty and does not permit hunches and intuition. One student noted that his presentation in another class was marked down because he had a hunch that a company should invest in a project, even though the NPV analysis was unfavorable. After discussing the issue for a short time, I let him in on the great secret that was revealed to me by one of my mentors after I had spent days trying to justify a modest expenditure using return on investment calculations. He told me to tinker with the numbers until they fit the desired outcome. Investment in emerging technologies and a new product line rarely result in positive NPVs unless the data have been cooked. Real options when combined with the development of a product and project portfolio can bring truth, beauty, and enlightenment into the investment process.
Real options concepts can be applied in a variety of ways. Smaller organizations can focus on learning-about by investing in education, reading high-tech magazines and trade publications, attending trade shows, and attending research conferences. Larger organizations can use real options as the basis for learning-about as well as investing in basic research and using learning-by-doing strategies to develop prototypes. The important point is to keep ones options open and to develop a portfolio of investment opportunities. Important activities included in the development of the portfolio include monitoring risk and frequent monitoring and assessment of the product and project portfolio by a cross-functional team of key personnel who understand and are aligned with the business mission.