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Article

Real options for optimal investment strategies

Finance

How can companies optimize their long-term investment decisions? To answer this question, Bertrand Quélin and Charlotte Krychowski have studied the use of real options. Drawing on the case of a cell phone provider, have shown that by making experimentation possible, this method often proves more effective than future cash flow analysis.

investment

Corporate finance professionals have wondered how to optimize investment strategies for a long time, and the increasingly uncertain economic environment has made this issue even more critical. The combination of monetary crises, rapid technological change, and difficulties in anticipating demand has created an economic context where companies often have to invest a great deal to seize new opportunities. However, they are not always able to determine the conditions required to achieve ROI. 

Real options and future cash flow

In corporate finance, ROI is predominately anticipated through analysis of future cash flow. “This is a solid approach,” says Quélin, “but it is not always reliable, because it is based on the principle of definitive, non-modifiable investment decisions.” To deal with this problem, researchers have drawn on finance theory and adapted the principle of real options to apply it to material investments. Quélin explains, “As with financial options, taking out a real option on a new activity consists of making a test investment to find out whether it is worth investing further.” Keeping track of the initial consequences of an operation should reveal whether it would be wise to continue. The method involves separating investments into two parts: an observation phase and a phase during which an option is either exercised (investment continued) or not (investments stopped). 

Application of the theory

To validate this approach, the researchers examined the case of Mobitel, a cell phone provider (see “Methodology”) hesitating to invest in 3G technology. The technology seemed promising, but it would be a risky investment choice because of high uncertainty in the following three areas.

• Potential success of the technology: This question is related to the presence of another technology, EDGE, which, while less powerful, might win over consumers.

• Investment timing: Should investments be made all at once or should they be segmented and spread out over a period of time?

• The competition: What are competitors planning to do? How risky would it be for Mobitel to postpone this investment for a year? Mobitel decided to delay total investments, while nonetheless developing 3G technology in key cities to assess demand. A year later, the investment had proven profitable, so Mobitel extended the network throughout the country. If this had not been the case, Mobitel would have instead invested in EDGE technology, which is less powerful than 3G but also significantly less costly to deploy.

Advantages of real options

Studying the Mobitel strategy in the light of the theory of real options enabled Krychowski and Quélin to identify three major advantages of this approach. 1) Remove a degree of investment uncertainty, especially in the case of oligopolistic competition, where other players’ strategies can be modeled. 2) Improve information sharing among decision makers. When it comes to future cash flow analysis, few people are involved. “A project team generally presents an investment proposal to a finance director, who in turn presents it to the executive committee,” explains Quélin. As a result, financial input carries the most weight in the decision-making process. In contrast, experimentation via the real options approach stimulates information sharing between sales, marketing, R&D, and finance teams, etc. For example, the cell phone provider had to find out whether or not consumers would really adopt 3G technology to determine investment strategy. 3) Finally, trial investments make it possible to revise hypotheses as a project unfolds and thus improve investment monitoring. In sum, this iterative approach leads to better decision-making.

An infrequently used tool

Despite these significant benefits of the real options method, Quélin and Krychowski have found it to be little-used. “75-85%of companies base investment decisions on net present value; just 27% of companies use real options analysis.” This reluctance to use the latter is related to the technical nature of the tool and its analytical format. It calls for a level of formalization which often puts managers off (i.e., Monte Carlo method, Black-Scholes model, etc.). Furthermore, while the method is promising in industries that can spread out investments over time (i.e., mining, oil exploration, pharmaceuticals, etc.), it is not as well-suited to companies in sectors where this is not as easy to do.

 

Based on an interview with Bertrand Quélin and the article “Real Options and Strategic Investment Decisions: Can They Be Of Use To Scholars?” (Academy of Management  Perspectives , May 2010, pp. 65-78) co-authored with Charlotte Krychowski.

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