Strategic Audit Report

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Strategic Management Week 7 – Chapter 6

Flexibility & Real Options

The Strategic Management Process

Business Level Strategies

Options: 1. Cost leadership 2. Product differentiation

Both these require focus and commitment 3. Strategic flexibility

Maintaining multiple strategic options simultaneously—the opposite of focus and commitment

What Is Strategic Flexibility?

A firm has strategic flexibility when it can choose among several strategic options

Southwest Airlines’ acquisition of AirTran

• Route expansion

• Geographic expansion

Geico’s advertising

• Continue with the gecko

• “Tiki’s barbershop”?

• “Running of the bulldogs”?

Real Options and Real Assets

A real option exists when a firm has the ability, but not the obligation, to invest in real assets of some type. Real assets are tangible resources that can have an impact on a firm’s production, including land, buildings, etc.

Intel Capital

• Founded in 1991 as the venture capital arm of Intel • Goal: make small investments in promising (disruptive?)

technologies • $12.2 billion invested in 1,480 companies worldwide till date • 627 companies have either gone public or have been acquired

(mid-2017)

Table 6.1 Types of Flexibility with Examples

Type of Flexibility Example

The option to defer An oil company leases land for potential exploration instead of buying it.

The option to grow A firm builds a plant with the ability to add capacity at low cost.

The option to contract A firm hires contract and temporary employees instead of full-time employees.

The option to shut down and restart A firm outsources distribution to a firm that distributes the products of many firms instead of outsourcing distribution to a firm that distributes only its production.

The option to abandon A firm builds a manufacturing plant that employs only general-purpose machinery.

The option to expand A firm invests to create one product because that investment could lead to the development of other products in the future.

Competitive Advantage

If a strategic flexibility strategy meets the VRIO criteria… Is it Valuable? Is it Rare? Is it costly to Imitate? Is the firm Organized to exploit it?

…it may create competitive advantage.

Risk

A decision-making setting is said to be risky when:

• the outcome of that decision is not known with certainty,

• but the possible outcomes associated with that decision are known, and

• the probabilities associated with each outcome are known.

Example: Playing the slot machine at a casino

Incorporating Risk in Strategic Decision- Making

• The Capital Asset Pricing Model (CAPM) incorporates risk by using β(historical returns of a diversified portfolio of stocks)

• Present value analysis incorporates risk via the discount rate – Low discount rate = low risk – High discount rate = high risk

Uncertainty

A decision-making setting is said to be uncertain when:

• the outcome of that decision is not known with certainty,

• the possible outcomes associated with that decision are not known, and

• the probabilities associated with the outcomes are not known.

Example: Non-franchise Hollywood movies

Uncertainty and Present Value Analysis

Why does it not work? • Under conditions of uncertainty, cash flow projections are simply

unreliable • Under conditions of uncertainty, the riskiness of the cash flows

generated (the discount rate) cannot be reliably anticipated • The present value approach assumes that decisions about

strategies and their implementation are made all at once – In reality, strategic choices are often made over time, in a

staged manner

Table 6.3 Characterizing the Value of a Real Option Subjectively

Attribute of a Real Option Effect on Value of Real Option

Exercise price (X) The lower the exercise price, the greater is the value of a real option.

Cash flows generated (S) The higher the cash flows generated by exercising an option, the greater is the value of a real option.

Time to maturity (T) The longer the time to maturity, the greater is the value of a real option.

Risk-free interest rate (rf) The higher the risk-free interest rate, the greater is the value of a real option.

Uncertainty about future flows The greater the uncertainty about future cash flows, the greater is the value of a real option.

( )s2

Quantitatively Valuing Strategic Flexibility

1. Recognize real options 2. Describe a real option using financial option parameters 3. Establish a benchmark 4. Calculate option value metrics 5. Estimate the value of the option from a Black-Scholes option

pricing table 6. Compare full present value with the benchmark value

Figure 6.1 Categorizing Your Register of Opportunities

Source: R. G. McGrath and I. MacMillan, The Entrepreneurial Mindset. (Boston: Harvard Business School Press, 2000).

Table 6.7 Real Options under Technical and Market Uncertainty

Positioning options Technical uncertainty is high: Take multiple small positions in alternative technologies and wait until technological uncertainty resolves, then invest.

Scouting option Market uncertainty is high: Put several new offerings in consumer hands to gauge their reactions; once consumer preferences are clear, invest.

Stepping-stone options Technical uncertainty and market uncertainty are high: Avoid fixing on a particular design or set of features early; fail fast, fail cheap; learn fast, and try again.

Source: R. G. McGrath and I. MacMillan, The Entrepreneurial Mindset. (Boston: Harvard Business School Press, 2000).

Strategic Flexibility and Sustained Competitive Advantage

• Flexibility and real options related to – History – Path dependence (Chapter 3)

• Previous path determines future path • Costly to turn back from a fully invested path • Makes sense when real options facing a firm are path

dependent

Organizing to Implement Strategic Flexibility

• Vertical Integration reduces flexibility – Market exchanges and strategic alliances are better

• Organizational structure, management controls, and compensation practices need to be flexible

• Highly bureaucratic systems are inconsistent with flexibility

The Human Side of Flexibility

Company Layoffs

H-P 30,000

Cisco 14,000

Wal-Mart 17,500

Intel 12,000

• Employees treated as temporary or contract workers • Increases organizational flexibility but is not costless