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1FP580 Advanced Corporate Finance & Strategy

©Michal KaszasISTI Valuation & Strategy Specialist

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Welcome!



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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!



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Know WindowKnow-Window



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https://coggle.it/diagram/WI39NGMMG6JeK03F



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ROG on R&D Case



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The (Simple) Option to Defer

• The most valuable for irreversible investments• Proprietary

• Extraction indust.• Farming etc.

• Shared (exogenous competition)• High-tech indust.



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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



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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



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Compound Options



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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



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Smit‘s regular wisdom slamFancy Haircut-Soren



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Step 1. Event tree



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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!



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Step 2. The Optimal Decision



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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



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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!



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Smit‘s regular Wisdom Slam



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Zero-Sum games

Oskar Morgenstern John von Neumann



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Concept of Strategic INTERdependenceZero-Sum Games – Strategic Decisions

“Making a killing” mindset vs. Co-Opetition mindsetWin-Win solution

Players | Actions | Timing | Payoffs

Game Theory



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• 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



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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



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Innovation RaceFinding Dominant Strategy

Prisoner‘s dilemma1st mover advantage eroded the optional value



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Simultaneous Innovation

„Grab the Dollar“Patent Races – Competitors make parallel investments

Usually only 1 standard sticks! (VCR, VHS, DVD)



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Sequential InnovationBackward Induction

Burning the BridgesSignalling function of commitment (credibility!)

Intel preempted 80% of the microprocessor market



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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.



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Most favored customer clause“All talk, no action” – raising venture capital

Incentive Alignment – comp scheme is a perfect GT example

Commitment



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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



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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



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Plant Sale -> Capacity Decrease -> Pricing Dynamics -> ???Game Theory

Crack the case



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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



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2. Actions to consider• Pricing – How two companies set prices• Capacity – Sale of the idle plant

Crack the Case



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Crack the Case



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Should United sell & lower the price?

Crack the Case

1. Find Dominant strategy2. Eliminate Dominated strategies



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What will Associated do?

Crack the Case

We calculate thair conditional profits and find out



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UNITED is willing to PAY THE BUYER J to take the plant off its hands and disassemble it!

Case is Cracked!



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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.



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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



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You know that management is conservative and know nothing about the game theory. How would you simplify your explanation?

2nd Approach



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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!



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Firms choose quantity to be produced, market demand determines the price (e.g. OPEC)“Clearing price” P – customers buy everything (QA + QB)

Cournot (Q)



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Cournot (Q)



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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



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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



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Cournot (Q)



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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!)



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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)



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Competitive Reactions



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Competitive StrategiesContrarian vs. Reciprocating Comp



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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



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OVERDELIVER.

Welcome! [hardwoodcapital.eu]hardwoodcapital.eu/wp-content/uploads/2017/05/Game_Theory .pdf · Sony...

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