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Strategic Management/
Business Policy
Competitive Dynamics:Real Options
Power Point Set 9b
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Competitive Dynamics
Competitive dynamics:results from a series of competitiveactions and competitive responses among firms competingwithin a particular industry.
Mutual interdependence: results when companies recognize
that their strategies are not implemented in isolation from theircompetitors actions & responses.
E.g., Coke versus Pepsi
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CompetitiveDynamics
A first moveris a firm that takes an initial competitive
action.
Successful actions allow a firm to earn above-averageeconomic returns until other competitors are able to
respond effectively. In addition, first movers have theopportunity to gain customer loyalty.
For instance, Harley-Davidsonhas been able to maintain a
competitive lead in large motorcycles due to intense customerloyalty.
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Competitive Dynamics
A first moverfaces potentialdisadvantages:
High risk;
High development costs;
and
High demand uncertainty
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Competitive Dynamics
A second moveris a (second, third, fourth, etc.) firm
that responds to a first movers competitive action often
through imitation or a move designed to counter the
effects of the initial action.
BankOnewas a fast second mover in Internet banking.
New Balance is a successful second mover in the athletic
shoe industry.
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Competitive Dynamics
Second mover advantagesinclude:
Reduction in demand uncertainty;
Market research to improve satisfying customer needs;
Learn from the first movers successes and shortcomings;and
Gaining time for R&D to developa superior product.
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Scenario Analysis -The RelationshipBetween Finance & Strategy
Traditional Evaluation Of Financial ProjectsNet Present Value or Discounted Cash Flow Analysis
time
CF
+
-
Traditional Evaluation Of Financial
Projects
Net Present Value or Discounted CashFlow Analysis
time
CF
+
-
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3 Basic Factors Determine3 Basic Factors Determine
C/S Market ValueC/S Market Value
1) Amount of1) Amount of
2) Timing of2) Timing of
3) Risk of3) Risk of
Expected cash flows
Discounting Cash Flows
NPV =
CF1
1+r +
CF2
(1+r)2 +
CF3
+
CFt
+ +
Horizon
Valuet+1
NPV: Net Present Value
CFt: Cash Flow at time t
r : Discount ra te
Horizon Value: Value of
ongoing enterprise after time t
(1+r)3 (1+r)t (1+r)t+1
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Scenario Analysis -The RelationshipBetween Finance & Strategy
Differences Between Strategy and Finance:
Finance: Payoffs are determined exogenously or bychance
Strategy: Our actions affect the economic payoffs we arelikely to experience
Decision-Theoretic Vs. Game-Theoretic Analysis:
Games against Nature Vs. Games against otherpeople
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Irwin/McGraw-Hill
How To Handle Uncertainty
Sensitivity Analysis - Analysis of the effects
of changes in sales, costs, etc. on a project.
Scenario Analysis - Project analysis given a
particular combination of assumptions.
Simulation Analysis - Estimation of the
probabilities of different possible outcomes.
Break Even Analysis - Analysis of the level of
sales (or other variable) at which the
company breaks even.
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Trigeorgis (1997): Real Options
A theoretically-accurate NPV analysis should include realoptions values.
The asymmetry deriving from having the right but not theobligation to exercise an option is at the heart of the real
options value.
Managers making investments under uncertainty can createeconomic value by building in flexibility, because flexibility
has economic value.
Real Options: Managerial Flexibility andStrategy in Resource Allocation
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Real Options
Nucor Steel Mini-mill
Stand-alone investment:
NPV = -$50 million
Abandonment Option:High (Low sunk cost)
Growth Option: High(Follow-on investments)
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Commitment Versus Flexibility -The Value of Time
Cost to Build Plant = $1600
Cost of Capital = 10%
Price(t=1) = $100
Price(t=0) = $200
Price(t=1) = $300
.5
.5
Price = $100
Price = $300
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Commitment Versus Flexibility -The Value of Time
Time Expected CashFlow
(Traditional NPV)
Expected CashFlow
(Scenario 1)
Expected CashFlow
(Scenario 2)
0 $ (1,400) $ - $ -
1 $ 200 $ (1,300) $ (1,500)
2 $ 200 $ 300 $ 1003 $ 200 $ 300 $ 100
4 $ 200 $ 300 $ 100
5 $ 200 $ 300 $ 100
6 $ 200 $ 300 $ 100
7 $ 200 $ 300 $ 1008 $ 200 $ 300 $ 100
Infinity $ 200 $ 300 $ 100
NPV $ 600 $ 1,545 $ (455)
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Build now (classic NPV) versus value of
waiting
NPV calculation
($1400) in year 0
.5($300) + .5($100)= $200 for each yearafter
Value of $200perpetuity=$2000
Expected NPV($1400) +$2000=$600
Waiting Year 0 = $0 Scenario 1 (price = $300)
Yr. 1=($1300) Perpetuity of $300 NPV =$1545
Scenario 2 (price = $100) Yr. 1=($1500) Perpetuity of $100
NPV =($455) NPV of waiting:
.5($1545) + .5(0) = $773
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Value of waiting one period
Expected value of building the plant inperiod 0 = $600
If the firm waits a year, the uncertainty isresolved, and the firm will undertake theinvestment only if the price is $300
By waiting a year, the firms expected value
is (1545*0.5 + 0* 0.5) =$773, as opposedto $600
Value of the option = 773 600 = $173
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Competencies and Strategic Flexibility
Strategic flexibility is analogous to having options and
commitment is analogous to the exercise of an option.
The greater the uncertainty the firm faces, the more
valuable are its real options.
The resolution of uncertainty over time
is the catalyst which induces a manager
to make (sunk cost) commitments.
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Competencies and Strategic Flexibility
Note however, that if by waiting there is no decrease in the
level of uncertainty, then if the narrow NPV is positive, youshould go now.
We have so far ignored other players in the market. Thus,
we have been analyzing the problem as decision theoretic.However, we now are going to move on to considerations
where the timing of the investments also depends on how
other players will respond. Therefore, strategic management
must take into account both decision-theoreticproblems and game-theoretic problems (e.g., as
the number of potential competitors increases,
our incentives for acting now will typically increase).
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