Post on 03-Aug-2020
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
1
Welcome!
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
2
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
3
The question is not: “to risk or not to risk?” “The question is: where do you put your big bets? Coz if
you don‘t place a big bet, you are never going to achieve exceptional results. Where do you place your big bets and
bound your risks at the same time?”
Make the right bets!
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
4
Know WindowKnow-Window
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
5
https://coggle.it/diagram/WI39NGMMG6JeK03F
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
6
ROG on R&D Case
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
7
The (Simple) Option to Defer
• The most valuable for irreversible investments• Proprietary
• Extraction indust.• Farming etc.
• Shared (exogenous competition)• High-tech indust.
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
8
The (Simple) Option to DeferHold my hand valuation (License)
Net Present Value w ScenariosOption Valuation is risk-neutralCertainty equivalent
What is INVEST NOW vs WAIT-AND-SEE value?
What is really of interest in an uncertain world is not the value of investment per se, but rather the value of an opprotunity to invest
Actual Probability = 50%CoC = 20%Risk-Free Rate = 8%Investment Outlay 80 MIO
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
9
Sony & Phillips both consider developing CD technology:1. Sony goes alone2. Sony waits and shares the payoffs 50/50
Option value of the incumbent got eroded by exogenous competitive entry – Game Theoretic elementA firm anticipating competitive entry, tends to commit to excess capacity building to preempt the marketIn the absence of the exogenous competition, firm might choose to wait and enjoy the flexibility benefits
Shared option to deferExogenous competition
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
10
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
11
Compound Options
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
12
R&D Valuation
PV(t=0) of Inflows = 852 MIO USDPV(t=2) of Inflows = 1 127 MIO USDPV(t=0) of Outflows R&D = 63 MIO USDInvestment outlay (at t=2) = 1 200 MIO USDPV(t=0) of Investment outl. = 1 109 MIO USD
𝜎 = 0,41
u = e% = 𝟏,𝟓
d =1u = 𝟎, 𝟔𝟕
CoC= 15%RF Rate = 4%
3 steps to value a compounded option1. Construct an event tree of the underlying values2. Make decision based on conditional payoffs3. Calculate the PV of the conditional payoffs
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
13
Smit‘s regular wisdom slamFancy Haircut-Soren
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
14
Step 1. Event tree
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
15
Step 1. ExtendedDecisions we face:1. Should we undertake the R&D?2. Should we invest afterwards?
Flexibility element is absolutely crucial!Without it only a fool would undertake R&D ventures.
Notice the similarity with call option:Time to maturity: 2yr (European)Exercise price: 1 200 MIO USDVega(Volatility): captured by sigma 0,41
The optimal decision is determined at the end-node!
Remember, the worst possible outcome after the exploration can be 0!
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
16
Step 2. The Optimal Decision
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
17
Step 3. Calculate PV of the Payoffs
𝑝 =1 + 0,04 − 0,671,5 − 0,67 = 0,45
𝐶 = 𝑝 ∗ 𝑉: + 1 − 𝑝 ∗ 𝑉;
1 + 𝑟
𝐶 = 0,45 ∗ 717 + 0,55 ∗ 0
1,04 = 310
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
18
Winners Curse
If the average bid is accurate, than the highest bidder is the sucker!By definition, winners in auction are lead to overpay
The average bid is unimportantThe more uncertainty there is, the more likely the winner is to overpay
UTS licences – all overpaid!
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
19
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
20
Smit‘s regular Wisdom Slam
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
21
Zero-Sum games
Oskar Morgenstern John von Neumann
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
22
Concept of Strategic INTERdependenceZero-Sum Games – Strategic Decisions
“Making a killing” mindset vs. Co-Opetition mindsetWin-Win solution
Players | Actions | Timing | Payoffs
Game Theory
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
23
• Rationality • Players aim to maximize their profit• Players are perfect calculators
• Common knowledge• Each player knows the rules of the game• Each player knows that each player knows the rules • Each player knows that each player knows that each player knows that each
player knows that each player knows the rules
• “Thinking about thinking converges to an equilibrium”
Assumptions
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
24
1. Find Dominant strategies 2. Eliminate Dominated strategies 3. Find Nash equilibrium in pure strategies 4. Find Nash equilibrium in mixed strategies 5. Use backward induction to solve sequential games 6. Find a sub-game perfect equilibrium 7. Use real options or certainty-equivalent valuation in backward inductions
for sequential games under uncertainty
Solving the game
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
25
Innovation RaceFinding Dominant Strategy
Prisoner‘s dilemma1st mover advantage eroded the optional value
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
26
Simultaneous Innovation
„Grab the Dollar“Patent Races – Competitors make parallel investments
Usually only 1 standard sticks! (VCR, VHS, DVD)
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
27
Sequential InnovationBackward Induction
Burning the BridgesSignalling function of commitment (credibility!)
Intel preempted 80% of the microprocessor market
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
28
Simultaneous Innovationunder Incomplete Information
Firm does not know it‘s competitor‘s precise characteristics but estimates it correctlyNash-Bayesian Equilibrium
In NB eq. Players correctly anticipate the strategy for each type of the other player.
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
29
Most favored customer clause“All talk, no action” – raising venture capital
Incentive Alignment – comp scheme is a perfect GT example
Commitment
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
30
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
31
Outset:• The plant is currently idle
• Prospective buyer has interest in land (unlikely to pay very much)
• Mrs. Duncan (your CEO) asks you to prepare an assessment of the sale (get it done until next morning‘s planning meeting )
Case:
• United has 2 plants• 8 000 tons per year• 2 000 tons per year – currently idle (for sale)
• Associated Cement (our competitor) has only 1 site 20 000 tons per year.
• Currently the industry is in overcapacity both competitors operate on 50%
• Fixed costs negligible, Variable costs $2 MIO per 1000 ton
• Price $5 MIO per 1000 ton
United Cement CasePlant sale
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
32
Marketing Study findings:• Lowering the price to $ 4 MIO per 1000 tons while Associated do nothing
• 50 % of Associated‘s customers switch to us
• Both firms lowers the price• Each would maintain original share
You dig deeper:• United‘s B plant has not run for a few years
• Why? Few C level managers believed the demand might go up
• You ask previous CEO why he did not sell the plant and find a capacity issue
• Industry is in chronic overcapacity! • What will be the impact of lowering it? Can the sale of idle plant have an impact on industry‘s pricing?
United Cement Case
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
33
Plant Sale -> Capacity Decrease -> Pricing Dynamics -> ???Game Theory
Crack the case
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
34
1. The first step in GT analysis is to ASK PRECISE QUESTION:
“What is the correct pricing strategy for United with and without the sale of the plant and, given the answer to that question, at what price should the
plant be sold? “
Even with limited information and a number of simplifying assumptions, game theory can produce much strategic insight.
Crack the Case
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
35
2. Actions to consider• Pricing – How two companies set prices• Capacity – Sale of the idle plant
Crack the Case
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
36
Crack the Case
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
37
Should United sell & lower the price?
Crack the Case
1. Find Dominant strategy2. Eliminate Dominated strategies
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
38
What will Associated do?
Crack the Case
We calculate thair conditional profits and find out
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
39
UNITED is willing to PAY THE BUYER J to take the plant off its hands and disassemble it!
Case is Cracked!
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
40
Case Debriefing
Why the price decrease resulted only in $ 1 MIO increase in profit?• Marketing indicated that 50% of customers would leave Associated • Nevertheless 50% of 10 000 tons = 5 000• Since we sold the Plant B we have 8 000 tons capacity and had 5 000 tons
sales prior to selling Plant B• Hence, we accommodate only 3 000 tons from Associated
The sale of the idle plant is effectively a credible commitment by United not to steal too much demand if it has a lower price than Associated.
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
41
A one-shot game analysis of the pricing dynamics of the current situationbefore the sale of the plant suggests that United has a dominant strategyto lower its price. Associated anticipates this dominant strategy andchooses its best response to United’s lower price, which in this case is tolower price as well. Thus, the prediction of the one-shot game with theidle plant B is that both lower price. This is obviously not what we observein reality, where both companies maintain price. How did the managersachieve this outcome? One possibility is that the multiple rounds of playexplain the difference. United and Associated compete with each other weekafter week. This competitive situation is a good example of a repeated game. IfUnited decided to maintain price in the first round, with the crediblethreat to lower the price next round if Associated decided to lower itsprice, what would Associated’s best response be? If Associated believesthat United will maintain its price, it has an incentive not to lower. By usingthe threat of lowering, United can facilitate cooperation and gain $15million (every year) rather than the $10 million it would get in the one-shot game.
Additional Remarks
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
42
You know that management is conservative and know nothing about the game theory. How would you simplify your explanation?
2nd Approach
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
43
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
44
The Wason Card Problem
2 i e8
If the card has a vowel on one side, it must have an even number on the other!
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
45
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
46
Firms choose quantity to be produced, market demand determines the price (e.g. OPEC)“Clearing price” P – customers buy everything (QA + QB)
Cournot (Q)
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
47
Cournot (Q)
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
48
While choosing the quantity, firm might not now the quantity chosen by its competitor = prepare contingencies.Reaction curve – “the best response curve” shows the optimal quantity to be chosen based on the quantity manufactured by competitor
• For every output of one firm, assigns the profit maximizing output of another
Reaction Curves
Cournot-Nash
Equilibrium
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
49
Total outcome of 8 units is suboptimal!If the firms could cooperate they would both manufacture
(how much units?) yielding (how much profit?)
Under competitive threat, each firm has an incentive to increase its production!
Industry POV
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
50
Cournot (Q)
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
51
Isoprofit curves
Stackelberg‘s 1st mover advantageFirms choose their output sequentially!
Aggressive commitment pays off. Build overcapacity!
Second mover would drive down prices if he followed Cournot-Nash eq.1st mover should calculate with 2nd mover‘s qunatity prior to commiting.
(Prices will be affected!)
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
52
Instead of Q firms choose Price!In Bertrand‘s framework choosing a lower price bids down industry prices!
𝑸𝒊 𝑷𝒊,𝑷𝒋 = 𝜽 − 𝒃𝑷𝒊 + 𝒅𝑷𝒋The quantity sold by firm i is a negative function of its own price and
positive function of competitor‘s price.
Bertrand (P)
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
53
Competitive Reactions
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
54
Competitive StrategiesContrarian vs. Reciprocating Comp
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
55
With game theory a complex strategic problem can be reduced to an analytical structure with 5 dimensions:
Players | Actions | Timing | Payoff | Backward Induction
A general criticism is that by trying to rationalize known behavior in a stylized way, standard game theory models often fail to produce
testable predictions (the insights from the analysis can be self-evident in stable environments ).
Particularly relevant in oligopolistic markets e.g., Unilever and Procter and Gamble, Coca-Cola and Pepsi, or Boeing and Airbus.
When combined with real options theory novel insights can be gained for uncertain environments.
Dr.Max | RegioJet vs. LEOex. | SAZKA vs Fortuna
Summary
1FP580 Advanced Corporate Finance & Strategy
©Michal KaszasISTI Valuation & Strategy Specialist
56
OVERDELIVER.