Strategic NPV: Real Options and Strategic Games under Different Information Structures

• Author: Lenos Trigeorgis,Han T. J. Smit
• Published date: 01 December 2017
• Date: 01 December 2017
• DOI: http://doi.org/10.1002/smj.2665

Strategic Management Journal

Strat. Mgmt. J.,38: 2555–2578 (2017)

Published online EarlyView 13 June 2017 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2665

Received 10 November 2015;Final revisionreceived 25 February 2017

Strategic NPV: Real Options and Strategic Games

under Different Information Structures

HanT.J.Smit

1and Lenos Trigeorgis2,3,4*

1Erasmus School of Economics and Erasmus Institute of Management (ERIM),

Erasmus University Rotterdam, Rotterdam, The Netherlands

2University of Cyprus, Nicosia, Cyprus

3King’s College London, London, UK

4MIT Sloan School of Management, Cambridge, Massachusetts

Research summary: Among the most difcult rm strategicchoices is the trade-off between making

a long-term commitment or holding off on investment in the face of uncertainty. To operational-

ize strategic management theory under demand, technological and competitive uncertainty, we

develop a StrategicNet Present Value (NPV) framework that integrates real options and game the-

ory to quantify value components and interactions at the interface between NPV, real options, and

strategic games. Our approachresults in new propositions clarifying the way learning-experience

conditions, technological uncertainty, and proprietary information interact to tilt the balance in

the interplay between wait-and-see exibility and strategic commitment. As such, Strategic NPV

adds to our understanding of the conditions where NPV, real options, or strategic thinking are

more rel evan t.

Managerial summary: This study develops and elucidates implementation of a new valuation con-

struct, “Strategic Net PresentValue (NPV),” that integrates real options and game theory to more

accurately portray strategic decisions underlying management theory. Among the most difcult

rm strategic choices in capital intensive industries, such as energy, mining, chip manufactur-

ing, and infrastructure development, is the trade-off between making a long-term commitment or

holding off on investment in the face of demand, technological,and competitive uncertainties. The

study provides new insights on the way various conditions, such as learning-experience effects,

technological uncertainty,and proprietary information, interact to tilt the balance in the interplay

between commitment and wait-and-see exibility. As such,Strategic NPV adds to our understand-

ing of when NPV, real options, or strategic thinking matter more critically for decision making.

Copyright © 2017 John Wiley & Sons, Ltd.

Strategy is concerned with value creation and

value capture in imperfect markets (e.g., Chatain

& Zemsky, 2011). Managers in organizations make

decisions under conditions of market uncertainty,

competitive rivalry, and incomplete information.

Value and valuation of a rm or project-level

Keywords: strategic decisions; real options; game theory;

valuation; R&D; JEL: G31, L63, D81

*Correspondence to: Lenos Trigeorgis, MIT Sloan School of

Management, E62-688, 100 Main Street, Cambridge, MA 02142.

E-mail: lenos@mit.edu

Copyright © 2017 John Wiley & Sons, Ltd.

investment is important to the strategic manage-

ment eld as it involves a fundamental trade-off

and assessment of the costs and long-term benets

of a strategic initiative. Strategy decision making,

especially decisions concerning strategic invest-

ments, explicitly or implicitly involvesa cost versus

benet/value calculation under such conditions.

Management theories such as Transaction Cost

Economics (TCE) or agency theory pay attention to

cost (value capture, as well as value creation), while

Resource-based View (RBV) and related variants

like dynamic capabilities (Teece, Pisano, & Shuen,

2556 H. T. J. Smit and L. Trigeorgis

1997) and the knowledge-based view (Grant, 1996)

give most attention to value creation.1

Among the most difcult cost versus value

choices rm strategists must make under com-

petition and uncertainty conditions are those that

involve making a long-term commitment to a given

course of action or alternatively holding off or

staging such investments in the face of uncertainty,

as the market entry and global expansion of Zipcar

exemplies. Fail to make a commitment in an

industry with steep learning-curve or network

effects, and the rm might effectively be shut out.

Make a commitment too early, and the rm risks

missing the eventual market opportunity, techno-

logical standard, or materialization of demand. The

right balance between commitment and exibility

can prove critical to survival and success. Werner-

felt and Karnani (1987) identied a pressing, yet to

this date, unlled research gap: “Since strategy is

concerned with the future, the strategic context of a

rm is always uncertain …under uncertainty there

is a trade-off between focus [commitment] and

exibility …this analysis is further complicated

by the presence of competition …the literature

on strategic planning has avoided discussing the

trade-offs involved in confronting uncertainty.”

The strategic management literature has long

recognized the importance of the commitment

versus exibility trade-off, but it has provided little

guidance on how rms can actually quantify these

interactions under both uncertainty and rivalry.

Although extant management theories focus

on different sources of cost or value, they are

not explicit about what valuation framework they

(should) rely on. Traditional Net Present Value

(NPV) is disconnected from strategic analysis (e.g.,

it fails to view the unfolding of strategy in stages as

options or to properly account for competitive reac-

tions) and does not capture the inherent tug-of-war

between commitment and exibility. Real options

theory is superior in valuing the exibility or stag-

ing dimension under uncertainty,while game theory

alone is advantageous in accounting for industry

dynamics and competitive interactions under rather

predictable conditions. As in most real-life strategic

1The focus of the new institutional economics theories (including

the Williamsonian branch of TCE, property rights theory, and

agency theory) is on the efciencyin the organization of economic

activities under the supposition that suboptimal organizational

choices giverise to perverse incentives and result in the dissipation

of value to be created in economic activities. These theories are as

much concerned with value creation as with cost efciency.

decision contexts, both conditions of market uncer-

tainty and competitive rivalry are concurrently

present, a key question is: How can one meaning-

fully inform strategy decision making on the impor-

tant interactions between commitment and exibil-

ity. Specically, this article contributes to strategy

research by answering the question: How can the

combination of real options theory (that helps quan-

tify the benets of exibility) with a game-theoretic

approach (that allows analysis of commitment)

shed new insight on strategic management?

The article introduces the methodology of

“option games” to the strategy eld, presents the

basic structure of such a model, and illustrates

what insights might be gained from the application

of this integrative approach to the examination of

key strategy questions. The main contribution is

to use analytical models— combining real option

analysis and game theory— to examine the specic

conditions that affect different components of rm

value, which in turn affect the aggregate “Strate-

gic NPV,” and thus, may shape rms’ strategic

decisions to invest in innovation or R&D. Our

ndings shed new light on a number of trade-offs

between commitment and exibility in strategy

decision making that improve our understanding

of the conditions involving different information

structures when NPV, real options, or strategic

game-theoretic analysis are more relevant.

Given that value and valuationmatter critically to

strategy, we develop and elucidate implementation

of a new valuation construct, “Strategic NPV,”

to help build a stronger connection to the strategy

eld and more accurately portray strategic decisions

underlying alternative management theories. This

construct, besides accounting for traditional sources

of committed value captured in an NPV analysis,

also helps bring out the interplay among added

sources of value from making a strategic com-

mitment (based on game theory) as well as wait-

and-see exibility (highlighted by real options). By

properly integrating real options and game theory,

Strategic NPV provides the strategist a more

complete representation of the various value com-

ponents and trade-offs from competing courses of

action.2

2This is an extension of “Expanded NPV” developed by Trige-

orgis (1996) to capture exogenous (e.g., demand) uncertainty in

competitive markets. Direct NPV here refers to the value bene-

ts of direct investment, for example, the cost savings that may

result from a strategic R&D investmentin a superior technological

Copyright © 2017 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 2555–2578 (2017)

DOI: 10.1002/smj