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I. INTRODUCTION
increasing degree of uncertainty firms face. To account for this uncertainty, scholars
developed the real options approach to better deal with the stochastic nature of future
monetary flows. During the past two decades, an important number of studies have
appeared that not only enhanced the standard real options approach but provided empirical
applications as well. However, these studies are mostly based on the assumption of either
not take into account the strategic implications of many investment projects.
industry, recent work on strategic investments merged the standard real options approach
with the analytical and mathematical tools of game theory. During the past few years,
several studies have emerged that utilize this “real options game theoretic” approach. Most
Nevertheless, the reality of the business environment seems to demand more general
models, which account for the asymmetry that exists amongst firms and that stems from
several sources, like different access to technology, differing organizational and learning
capabilities, and disparate regulatory frameworks. A few studies have appeared in the
financial economics literature in order to better deal with the asymmetric nature of firms
1
(e.g. Pawlina and Kort, 2006). Additionally, another element of today’s business
oligopolistic setting may have different access to information about several important
variables, such as project costs, or potential revenue flows. Again, only a few studies have
emerged that deal with strategic projects under imperfect information (e. g. Thijssen et al,
2003).
The purpose of this study is to develop a general model that takes into account,
within a strategic real options framework, both the asymmetric nature of firms and the
study will provide theoretical extensions that are applicable to specific kinds of strategic
investment projects.
The rest of this introductory chapter is organized as follows. In the next section, an
introduction to the research problem will be delineated. In this part, the main ingredients
and sources for the proposed study will be outlined. The third section will present the
significance and limitations of the proposed study. Finally, the introductory chapter will
evolve into the main set of research questions and their extensions.
The most utilized tool in investment projects analysis is the DCF (discounted cash
economics literature that this technique tends to be insufficient, since it provides essentially
static results (i.e. it does not account for dynamics of any sort). Today’s business
environment is full with sources for uncertainty. Uncertainty may stem from demand,
2
technology (which may result in cost uncertainty), product market, or even systematic risk
The real options methodology was developed in order to account for the perceived
flaws in DCF valuation. Financial options deal with volatility in financial markets, and in a
similar manner, real options treat uncertainty on real investment projects. The literature
dedicated to studies that utilize the real options approach has multiplied in the past two
decades. Several fields of study have used this technique to improve both the understanding
of real investment projects and their valuation as well. Table 1 shows some examples of
is that holding a real investment project under uncertain prospects is formally similar to
holding a financial call option. It involves the right, but not the obligation, to spend
resources at some future time in order to obtain an asset whose value is stochastic. Thus,
the use of real options accounts for the flexibility that firms confer to managers to
undertake an investment at a present or future time; it involves the options to wait for the
investment, to abandon the project later on, or to disinvest from it at a later date.
The analysis of investment projects must also account for another form of option: a
growth option. This growth option involves the opportunity that is created, by completing a
certain investment project, to undertake further related growth projects at future dates. For
example, buying land may give a firm or individual the right to build a new estate
development at a future date. But furthermore, it may be the case that, by having
undertaken the investment, it may have also acquired the opportunity to buy more adjacent
3
Table 1: Real Option Topics and Areas of Aplication
4
potential for further investing in related projects constitutes a growth option. Nevertheless,
this simple analysis does not take into consideration the possibility of rivals entering the
There are several kinds of investment projects that may require an analysis based on
potential reaction by competitors to this event. Most studies that are based on real options
methodologies fail to recognize this fact, and are based on either monopolistic or perfectly
reactions into account since there is none under a monopoly assumption, and in the second
case, any reaction taken by rivals does not affect the industry since under perfect
competition the number of firms is so large that no single firm’s actions affects an industry.
However, most investment projects actually occur within the confines of imperfectly
projects must be seen as strategic. They affect the competitive environment and may be
affected by it. Due to their magnitude or their nature, rival firms are affected by particular
investment decisions. In turn, these events may induce specific reactions by these rival
firms that have to be accounted for in order to better assess the whole valuation process.
These investments result in the possibility of firms gaining a strategic advantage over its
rivals.
The talk of strategic value emerges from the imperfect nature of oligopolistic
The preferred tool appearing in the literature with regards to strategic analysis is game
theory. In order to account for the perceived gap in the finance and economics literature
5
with regards to the analysis and valuation of strategic investment projects, the uncertainty
analysis tools provided by the real options approach have been combined with the
analytical tools for strategic considerations that game theory contains. This merging of
analytical approaches has produced several important studies with regards to investment
What follows briefly outlines the importance and limitations of these studies. To
facilitate the exposition, the studies have been clustered according to similarities and/or
extensions.
Kulatilaka and Perotti (1998) introduced the term “strategic growth options”. They
refer to this term as an investment that results in the acquisition of a “capability” that allows
a firm to take better advantage of future growth opportunities and that helps it gain a
strategic advantage. Compared to standard real options analysis, strategic growth options
are allowed to affect both prices and market structure, since they take into account rivals’
reactions to strategic investment projects. This particular study deals with an investment in
technology that may confer a firm a cost advantage versus its rivals under future demand
uncertainty.
In addition to the study by Kulatilaka and Perotti (1998), several studies have
appeared in the literature extending the use of real options under strategic considerations
and the notion of strategic growth options. Kulatilaka and Perotti (1999), Weeds (2002),
Grenadier (2002), Lambrecht and Perraudin (2003), Pawlina and Kort (2006), Huisman et
al (2001), Bouis et al (2006), Imai and Watanabe (2005) are some examples of studies that
6
have integrated real options and strategic analysis to account for the different twists in
strategic investments. All of these studies are based on one key assumption: firm symmetry.
However, it is very rare to oversee processes where competing firms are actually identical.
potential sources of asymmetry, we can cite the following: cost asymmetry, revenue
conditions. In other words, firms may have similar cost structures buy may react differently
asymmetry may occur because firms may have differing access to economic or financial
information crucial for specific investment projects. Only until very recently have a few
studies appeared in the strategic real options literature that deal with investment projects
Pawlina and Kort (2006) extend the strategic growth options literature and develop
a theoretical model, based on the investment models proposed by Dixit and Pyndick (1994),
in order to incorporate investment cost asymmetry. In this study, cost asymmetry is treated
as an exogenous process in which firms enter the market with cost asymmetry stemming
study is the intent to produce a more general framework for strategic real options
7
contributions. By incorporating ex-ante asymmetry between firms, the case of firms gaining
step further by accounting for asymmetry in both investment costs and revenue flows.
A key assumption that is present in the above mentioned studies is that of complete
information. According to Lambrecht and Perraudin (2003), this approach has two
limitations. First, the assumption of complete information may very well be unrealistic,
since beliefs about competitors’ behavior often prove to be wrong. Second, if information is
complete and an optimal cooperative equilibrium may be achieved, why is it that it very
study is more focused on the welfare effects of information imperfection. Smit et al. (2004)
contest game. They recognize the fact that imperfect information and information
asymmetry play a key role in the valuation process in acquisitions. Nevertheless, the
Efforts have been recently put in to try to develop a more general framework that
encompasses the different studies that have appeared in the financial economics literature. Comentario [U2]: It is not clear
what you want to say in this
sentence and paragraph. I believe
On one hand, there are studies that try to deal with the asymmetric nature of firms by this is where you interject what
the gap is in this area. Rethink this
paragraph.
extending the strategic options models to account for asymmetry. On the other hand, a few
framework. However, to our knowledge, no model has been developed in order to deal with
both of these elements. This is precisely the main driver for this study. The importance of it
8
resides in the acknowledgement of both asymmetry and imperfect information as two key
Different kinds of strategic investment projects have unique features that confer a
special character because of their relative importance to their field. In fact, the real options
the business environment. Table 1 shows some of the research areas where this approach
Mergers and acquisitions (M&A) can be seen as an interesting case. In the last few
years, and among other causes, due to economic liberalization and global openness, the
business world has seen an increasing wave of mergers and acquisitions (The Economist,
industries. Among them, the financial services industry, the cement industry, and the
However, studies have demonstrated that between 55 and 75% of mergers and
acquisitions actually destroy at least some part of shareholder value (Paulter, 2002). Thus,
there is a need to better understand this phenomenon using different perspectives. From the
financial economics point of view, there is a need for better valuation processes that take
into account both the uncertain nature of future flows, as well as the strategic
recently tried to undertake this task. Smith and Triantis (1995) conceptually developed the
idea of M&A’s as a set of corporate options. However, this work does not take strategy into
9
consideration. Smit (2002) refines the concept of strategic growth options developed by
Kulatilaka and Perotti (1998) in order to account for industry reaction in an acquisition
into new and related markets. Thus, it helps to conceptually explain why firms may be
willing to “overpay” for acquisitions as a strategic tool to gain footholds into new and
to these types of events in order to gain a better understanding of their dynamics. Smit et al.
(2004) treat acquisitions as bidding games under uncertainty and they take into account the
strategic nature of bidding games. Under their assumptions, the bidders behave as identical
perfect way. Therefore, there is a need to study the M&A process using a more general
framework, one that takes into account the asymmetry present in firms’ true nature, the
rivals to a merger or acquisition, and the uncertain nature of today’s business environment.
investment decisions as real options. It is often beyond the resources of a single firm to
purchase the right to expand in all potential market opportunities. Joint ventures are
investments that provide firms with the opportunity to expand in favorable environments,
10
but avoid at least partially the losses from downside risk (Kogut, 1988). Under the real
options setting, firms may engage in a joint venture, where the potential exists in the future
for either of the participating firms to acquire or divest from the other’s stake according to
Kogut (1991) derived a model that is concerned with the timing of exercise of the
acquisition options that develop with joint ventures. With this model, they provide
empirical support to the treatment of joint ventures as real options. This study recognizes
that the most common option in a joint venture is the option to acquire the partner’s stake.
Chi (2000) developed a theoretical model for international joint ventures under a
real options perspective where each partner treats the venture’s valuation as a stochastic
variable. This model extends the previous work by taking asymmetry between the partner
firms into account. An application of this model may be made to the case of joint research
and development, where there may exist asymmetry in the value of results to the partner
firms. In this sense, one firm may find the results from the investments more valuable than
the other due to differentiated capabilities, scope economies, or learning processes. Folta
and Miller (2002) study equity partnership in the context of partner buyouts under
competitive assumptions. Under the empirical framework developed in this study, strategic
considerations exist. Partner buyouts may be exercised as a tool to preempt rivals from
entering into an industry by completing the acquisition or a partner firm. This empirical
work is mainly based on the strategic growth options concept of Kulatilaka and Perotti
(1998). Tong et al (2005) also provide empirical support to the existence of real options
features in joint ventures. However, they limit this support to specific types of joint
ventures, such as minority and diversifying ventures. Nevertheless, none of these studies
11
provides a suitable theoretical model for international joint ventures on neither asymmetric
Gilroy and Lukas (2005) develop a suitable theoretical model for strategic alliances
and international joint ventures. In this study, an optimal threshold where firms decide
whether to conclude their partner’s buyout or to divest from the venture is found. The
results are based on the standard assumptions of perpetual options, and more importantly
with regards to this particular work, they are based on the assumptions of perfect
information flows.
between partner firms. These asymmetries may stem from the degree of partnership
between the firms in a venture, or may emerge from asymmetric managerial behavior. This
study intends to provide a more general model that may further advance the real options
approach in joint ventures setting by incorporating imperfect information into its modeling.
e. Summary
account of the changing conditions present in today’s business environments. These studies
should also incorporate the strategic considerations stemming from imperfectly competitive
industries. Firms’ actions affect not only their own future flows but also rivals’ behavior.
Finally, information flows are often not perfect. Some firms participating in investment
projects may have better information than others with regards to future revenue flows, and
12
The purpose of this study is to extend the work done in analyzing investment
projects as strategic real options and thus to provide a more general model that takes the
above factors into consideration. This more general model will then be extended to the
cases of acquisitions and international joint ventures, where the concerns described in the
above paragraphs, have actually been raised in the financial economics literature. Comentario [U3]: What about
applying it to the issue of joint
ventures?
The study of investment projects as strategic real options is a relatively recent event
in the financial economics literature. However, there is a need to further deepen this
analysis stemming from the imperfections that exist in the competitive environment. Some
of these imperfections have been studied in the strategic real options context. Among them,
we can cite the work by Pawlina and Kort (2006) on strategic real options under cost
asymmetry by firms, and Smit et al (2004) who have modeled acquisitions as an options
This study contributes to the generalization of the strategic growth options model
by combining both the asymmetric nature of firms and the imperfect information
environment in which investment projects occur. Evidence has been found about the merits
itself fails to explain the intricacies of strategic behavior under an oligopolistic setting with
imperfect but realistic conditions, such as asymmetric firms and imperfect information.
Only by developing new models, such as the one proposed in this study, will we be able to
better understand the underlying processes that may result in better valuation for strategic
projects.
13
Moreover, the growth in importance of specific kinds of strategic investment
projects merits the existence of suitable models to analyze them. Mergers and acquisitions
have overseen an important increase in their occurrence in the past few years. As stated
before, the majority of M&A’s actually result in financial failure. Therefore, the need for
the theoretical model developed in this study is to analyze the acquisition process from the
strategic real options approach. In this case, the contribution is to extend the general model
to provide a specific and suitable model for imperfect information to the case of
This is another area of important growth in the business world. Although in nature, there
are similarities with acquisitions as investment projects, there are also important
undertakes an investment and therefore a “call” option for future growth, international joint
ventures offer a “two-sided” option. Under these assumptions, a firm purchases two
options, an acquisition “call” option to buy its partner’s shares at a future date, or a
divestment “put” option where it can abandon the project by selling its own stake to its
partner. Thus, with the elements provided by this study, a suitable model that takes into
and theoretical models developed in this work, empirical support must follow. Furthermore,
the need appears to develop models that are appropriate for other strategic projects, such as
14
In these strategic investment projects, the main characteristics of the competitive
As stated before, the analysis and valuation of strategic investment projects needs
further refinement. The intent of this study is to answer to the following question: Can a
more general and comprehensive model for valuing strategic investment projects be
developed such that it considers the following factors: uncertain revenue flows, strategic
behavior by other participants in an industry, the asymmetric nature of rival firms, and
It is evident that not all investment projects may be treated under the above assumptions.
Nevertheless, it appears that several types of investment projects actually fall into this
category. What kind of applications can be derived from such a general model? In
particular, may a suitable model be developed in order to obtain better valuation processes
for strategic acquisitions? May the same be replicated for the case of international joint
ventures? The model developed in this study and its extensions to acquisitions and Comentario [U4]: This is the first
time you mention “international
joint ventures.” If the focus is on
international joint ventures will help to clarify these questions and suggest new and related international joint ventures then
you need to go back to the section
on joint ventures and talk about
avenues of research. them as well.
Even though the goal of this study is to advance the strategic real options literature
towards more general modeling, it must be acknowledged that not all investment projects
15
lend themselves to be analyzed by this model. Plenty of investment projects affect the
actions and flows of the investing firm and are not affected and do not affect their
exploration. Other projects are present in unique competitive environments, such as the
case of investment by monopolistic or state controlled firms. On the other hand, the case of
industries where a very large number of small firms participate, approximate the perfectly
applications such as the ones discussed above seem to have the characteristics alluded to in
The rest of this study is organized as follows. Chapter 2 will provide an overview of
the current state of the literature on strategic options. This literature review will provide
both the path that strategic options studies have taken to date, as well as the main sources
behind this study’s development. Chapter 3 will portray a proposed general model that may
help to deal with the issues of imperfect information and the asymmetric nature of firms for
strategic growth options. Two applications are proposed for this model. Chapter 4 will
provide a suitable theoretical model for the case of strategic acquisitions under both cost
asymmetry and imperfect information. Chapter 5 will extend the model to the case of
international joint ventures. Finally, some concluding comments, as well as suggestions for
16
CHAPTER 2
LITERATURE REVIEW
I. INTRODUCTION
sections are contained in this chapter. The first section consists of an overview of the real
options approach after its introduction in the financial economics literature two decades
ago. This overview will center in the main models that have been developed within the
strategic options context. This overview will trace the evolution of strategic real options in
order to provide support for the development of the more general model proposed in this
study. As stated before, this model incorporates both asymmetry amongst firms, as well as
Section 2 of this chapter consists of a review of the studies that have related the real
options approach to the case of acquisitions. Smith and Triantis (1995) were the first to
suggest that strategic acquisitions in the context of uncertainty must have clear real options
features. Several studies have emerged since then that have tried to operationalize this
notion. This second section will lead to the extension of the proposed model under a
Finally, section 3 of this chapter provides the necessary background to extend the
general model to the case of international joint ventures. Particularly, this section deals with
ventures that provide the option to the involved parties to acquire or divest their venture in
the future. Although few studies have actually dealt in a specific manner with this
At the heart of standard real options reasoning there are two concepts that this
methodology incorporates. The first concept is uncertainty. Uncertainty may stem from
several sources. Among these sources, we may cite demand uncertainty, technological
uncertainty by itself does not justify the use of real options. The second and more important
concept that the real options approach is able to deal with is managerial flexibility.
Managerial flexibility provides firms with “options” to invest and act. It is important to
note that traditional DCF analysis is not able to incorporate the “flexibility” that managers
have to operate. Trigeorgis (1995) enumerates several types of options that managerial
flexibility confers firms with. Table 2 is based on this work. Comentario [U5]: See comment in
Chapter I. The table goes on the
next page once it is mentioned on
It is beyond the scope of this study to incorporate the reasoning behind all different the text.
types of options. Among the different types of options that firms possess as part of their
investment schedule, this study is primarily concerned with growth options. Any
investment that is undertaken in order to provide future growth opportunities for firms may
be thought of as a growth option. Under real options reasoning, an early investment may be
equivalent to purchasing the right (but not the obligation) to make further investment at a
later date. Examples of growth options may be R&D investment, strategic acquisitions,
strategic alliances or international joint ventures, technology adoption, etc. Several studies
have been developed to cope with each issue using the real options approach. Table 3 Comentario [U6]: See comment
above.
provides some examples of growth options examined using the real options approach.
18
Table 2: Real options categories
Category Description
Option to defer Management holds a lease on resources. It
can wait some time until demand signals
justify new construction.
Staged investment Undertaking stage investments creates the
option to abandon without incurring all
the costs. Each stage may be viewed as an
option.
Option to alter operation scale If market conditions are favorable, the
firm can expand. If conditions are
negative, it can reduce its scale of
operations.
Option to abandon If market conditions decline severely,
management can abandon operations
permanently and realize the salvage value.
Option to switch Either product flexibility (management
can change the output mix of the facility),
or process flexibility (same outputs using
different types of inputs).
Growth options An early investment is prerequisite for the
opening up of future growth opportunities.
Among these, we can cite strategic
acquisition, R&D, lease on undeveloped
land.
Multiple interacting options Real-life projects often involve both
upward-potential and downward
protection options, where their combined
value differs from the sum of separate
options (when they interact).
Source: Trigeorgis (1995)
19
The actual marketplace is characterized by change and uncertainty, and these factors
are captured by the above studies. However, a third element that is inherent to today’s
business environment is strategic interaction (Trigeorgis, 1995). The studies that are
presented in Table 3 fail to capture this important issue. Indeed, they are either based on the
perfectly competitive industries. In either case, the actions of a firm are not affected by its
rivals’ reactions.
20
However, these assumptions are strong and inappropriate in the majority of
industries. Most industries have several participants that often behave in response to rivals’
actions. Under a strategic investment context, decisions are often affected by the perceived
response of rivals, or are aimed at affecting them. Therefore, the need arises to deal with
particularly, modern industrial organization studies, provide plenty of cases that utilize
game theory to undertake strategic analysis. The purpose of this sub-section is to provide a
brief overview of the main studies that have been used to consider the strategic behavior of
firms involved in oligopolistic competition with regards to the kind of investment projects
that have been discussed above. Reviewing the IO literature on strategic behavior is beyond
rivals into an industry. Dixit (1980) analyzes the role of investment in entry deterrence. In Comentario [U7]: Poor sentence.
please redo.
stay in the marketplace and thus to prevent entry by rivals. A key element in this analysis is
the fact that investments are irreversible and thus act as sunk costs. The irreversibility of
investments is a key element in the growth options reasoning as well, since if it were not
21
the case, any number of firms would be willing to participate on any given investment
project.
Dixit’s model was extended by several studies in order to deal with uncertainty.
Among them, Maskin (1986) found that under the assumptions of quantity or capacity
competition, the incumbent firm chooses a higher capacity to deter entry than it would
under a deterministic setting. In turn, this makes entry deterrence less likely by increasing
its cost. Another interesting extension that is also related to this work may be seen in
Rasmussen (1987). This study holds that under the assumptions of perfect information, zero
always have the incentive to merge and thus form a monopoly, since they can always do at
least as well as the aggregate profits of the firms under duopolistic competition. Finally,
Fudenberg and Tirole (1985) use a spatial model to formalize the equilibrium strategies in
potential entrant. Either sequential entry or preemption are the outcomes of this preemption
game. These studies have provided the necessary support to incorporate the strategic
(uncertainty) but it involves a strategic game against both nature and competition. Whereas
22
a simplification of standard real options modeling is an extended net present valuation
consisting of the sum of the traditional DCF method plus the managerial flexibility value
(real option), it now must incorporate as another element the strategic value stemming from
Smit and Ankum (1993) developed a theoretical model to account for the difference
in economic rents under different competitive assumptions. In order to analyze the case of
oligopolistic competition, they utilized game theoretic tools, and came up with several
interesting propositions, depending on the importance of project values and the intensity of
competitive rivalry: when there is low project value it may be attractive for both firms to
defer investment; however, as soon as one of the firms invest, the other will follow suit. If
competitive rivalry is intense, both firms will invest immediately, which may be
suboptimal. When there is asymmetric market power among firms, investment may result
in a credible threat of complete preemption. Even though this study proposes a conceptual
model to better deal with strategic investments and deals with the very general idea of
economic rents, it has helped to set the foundations of strategic options thinking.
Kulatilaka and Perotti (1998) derive a model for a specific investment project. In
this study, a firm may decide to undertake a project (potentially some kind of technology
adoption) that confers the firm with a strategic cost advantage versus its competitors. In
tune with Dixit (1980) and his view of irreversible investments as a strategic threat to
commitment to a more aggressive future strategy. The acquisition of this strategic cost
advantage endogenously leads to the capture of a greater market share, either by dissuading
entry or by inducing competitors to take an accommodating stance and make room for the
stronger competitor. An important result emerging from this study is that the effect of
23
uncertainty on the relative value of the strategic growth options is ambiguous under
imperfect competition. This stems from the fact that in an oligopoly, profits are convex in
demand, since oligopolistic firms respond to better demand signals by increasing output
and prices, and thus expected cash flows increase with volatility. The main factor affecting
the valuation of such an investment is whether or not the project possesses a strong
preemptive effect. This result is different from the standard real options model, which
predicts an unambiguous correlation between the project (and the option) value and the
degree of uncertainty. Main and important assumptions that are present in this model are
those of linear demand and symmetric Cournot competition, as well as a discrete time
framework. In this context, and under the assumptions of sequential entry, the strategic
investment confers the competitor a higher entry threshold, which if high enough, may
In a follow-up study, Kulatilaka and Perotti (1999) analyze the impact of another
investment project: the decision to invest in distribution capabilities that allow the firm to
deliver a product faster than competitors under Cournot competition. The most intriguing
result is that greater uncertainty unambiguously favors the early commitment to invest. The
standard real options literature concludes that in a context of perfect competition the value
of the option to wait increases with uncertainty. When strategic considerations are taken
into account, the value of this time-to-market option always increases more than the value
of not investing. This stems again from the fact that profits are convex in demand due to the
oligopolistic market structure. The assumptions are the same than in the previous study;
however, there is an important difference. This particular framework allows only for a
situation when the time-to-market option may only be acquired today and thus there is no
option to wait. These two studies provide ample support to the fact that early investment
24
has a different market impact in an imperfectly competitive environment. However, they
are suitable models for specific investment situations and are based on fairly strong
assumptions and developed under the less general ideas of discrete time.
strategies in a continuous-time Cournot framework. The main “tool” that appears in this
One of the key assumptions that appear in this study is that related to the existence
of any number of symmetrical firms, and that the cost of increasing output is linear. While
other studies assume specific stochastic processes and demand functions, this study
provides a general result for different functions. As the main result of this study, the author
is able to explain why empirical results that provide evidence of firms behaving in a way
closer to the standard NPV rule than to standard real options predictions actually do so.
exercise their options sooner, as the fear of preemption diminishes the value of their options
to wait. Thus, the option premium that emerged from the real options literature is in effect a
function of the intensity of competition and the number of participants. This is a result that
differs from the predictions of Kulatilaka and Perotti (1998) which attribute this
relationship to the degree of the strategic advantage that may be captured with an
investment and not to the amount of participants. Again, it must be reiterated that a key
two respects: it introduces both uncertainty about future profits as well as technological
25
uncertainty over the success of R&D investments. Fudenberg and Tirole (1985) developed
the theoretical background to analyze games of entry and exit in a deterministic framework.
This extension also incorporates the insights developed in previous studies (such as Dixit,
1988) about technological uncertainty with deterministic returns, and combines both
branches with the real options treatment of uncertainty to extend both branches of the IO
literature to a stochastic environment. Once again, the setting is a duopoly and the
considers the benchmark case of two firms planning their investments cooperatively. It is
important since it may be similar to the case of a strategic alliance or a joint venture. The
main result that is evident from this study is that, contrary to Grenadier (2002), competition
between a small number of firms does not necessarily undermine the option to delay. In this
particular R&D setting, the fear of creating a patent race may further raise the value of
delay and increase the time before any investment takes place. In the case of two symmetric
firms, the identities of the leader and the follower in R&D are indefinite, while an extension
Huisman and Kort (1999) also extend the model developed by Fudenberg and Tirole
(FT) by incorporating the treatment of profit uncertainty. The framework is a duopoly with
identical firms. Three scenarios are identified. In the first one, which holds when first
mover advantages are large, a preemption equilibrium occurs where the moments of
investment of both firms are dispersed. In the second one, there is simultaneous investment
when demand is relatively large, and the result is similar to collusion. Finally, in the third
while the simultaneous investment occurs with large uncertainty at the moment of a high
level of demand.
26
Huisman et al (2001) base their methodology on the above mentioned work by
Fudenberg and Tirole (1985). Based on the assumption of duopolistic competition with Comentario [U8]:
identical firms, they develop a continuous time model for investment timing under
uncertainty when firms may gain an advantage by being a leader. Under this scenario,
previous studies have ruled out the existence of a simultaneous equilibrium since this result
is suboptimal for both firms (low payoffs). However, if both firms want to be the first to
invest and thus become a leader, each firm will want to preempt the other from investing
first and a coordination problem arises. This problem is solved with the use of the mixed
strategy approach appearing on Fudenberg and Tirole’s work. The main result is that under
this scenario, the simultaneous outcome exists with positive probability, which may help to
Pawlina and Kort (2002) study another specific investment decision in the face of
uncertainty and strategic interactions: the decision to replace a production facility. This
model is again based on the assumption of duopolistic competition with identical firms
under linear demand, and is in fact another extension of Fudenberg and Tirole’s with the
use of mixed strategies. The results are different than in Huisman and Kort (1999). In this
case, the type of equilibrium (preemptive or simultaneous) depends on the sunk investment
costs. If the investment cost is high enough a simultaneous equilibrium will occur, whereas
if this cost is low enough, a preemptive equilibrium is the dominant outcome. The intuition
is the following: if the advantage of being the leader and investing first is large enough (low
cost), firms have an incentive to make the early investment; if this advantage is small (cost
is high), firms will make the replacement simultaneously. The optimal threshold for
replacing the facility has two major components in this model, the waiting effect, which is
27
analogous to the option to defer the investment, and the strategic effect, which incorporates
Kort et al (2005) study the effect of uncertainty on the choice between different
degrees of flexibility in proceeding with investment. In this scenario, a firm may be able to
choose between two alternative strategies: investing in one lump or investing in small
increments gradually over time. While intuition may suggest that increased uncertainty
unambiguously favors sequential investment, the authors find that under strategic
considerations growth being uncertain actually favors the scale economies provided by a
single large investment. Some applications that are suggested by this study are related to
technology or to leapfrog to a more expensive next generation one; or the takeover decision
of firms that have to decide whether to acquire blocks of shares of the entire target
under uncertainty. This kind of models may be found in Dixit and Pyndick (1994).
Bouis et all (2006) extend the basic strategic option model, which is set under the
context, the results are quite different than those for the 2 firm case. Whereas the two firm
case results on a preemption equilibrium as its only solution, the three firm setting allows
for two types of equilibria. In the first one, all firms invest sequentially and in the second
one, the first two firms invest simultaneously while the third one invests at a later moment.
They also found the “accordion effect”, which is the term that they used to describe that
exogenous demand shocks affect the timing of entry of the odd numbered investors in the
same qualitative way, while the entry time of the even-numbered firms is affected in
28
exactly the opposite qualitative way. If a delay is observed for the “odd” firms, then the
The purpose of this brief overview has been to put in perspective the current state of
the art in the strategic options literature. A key factor that is present in all of these studies is
the fact that two strong assumptions are made: the existence of symmetric firms in
competition, and perfect information flows. As it was stated before, competition often
exists between firms with different size, different learning capabilities, or different access
to technology, and thus to recreate this realistic environment, a few studies have been made
in order to deal with the asymmetric nature of firms in the context of strategic investments
under uncertainty.
It has been stated before that the analysis of strategic options needs further
refinement, by taking into account the asymmetric nature of firms participating in the
marketplace. Few studies have extended the main models to incorporate this factor. The
race game in which a firm has an advantage in developing a particular technology. In the
context of this study, the advantageous firm has limited resources. There are two games to
the “powerful” firm chooses its R&D strategy before the other firm. The equilibrium
outcomes are radically different. Whereas the dominant strategy for the “P” firm is a low
effort strategy for the simultaneous investment case, its dominant strategy is a high effort
29
one for the sequential investment scenario, since by doing so, the firm signals a credible
commitment to gain a strategic advantage, and therefore the “weak” firm’s dominant
strategy is a low effort one. There are two elements in the valuation of this kind of strategic
option, a flexibility value and a strategic commitment effect. The signs for these two effects
are opposite and its relative valuation affects the strategic behavior of firms.
Organization deterministic models to better account for uncertainty. They utilize a mixed
strategies solution to what they call “the existing market model” developed by Smets
(1991). In the new market model that appears in Dixit and Pyndick (1994), two firms battle
to enter a new market, while in this study’s model, two existing firms have the opportunity
advantage. Under this model, depending on where the optimal joint investment curve lies,
either a preemption equilibrium exists or a tacit collusion one, in which all firms refrain to
invest until they get a strong enough signal from the market. This model is extended to
allow for asymmetric firms. In this extension, there is investment cost asymmetry among
firms. Contrary to the previous predictions, there exist now three types of equilibria. A
preemption equilibrium occurs when both firms have an incentive to become the leader
(when the cost advantage is relatively small). The result is that the strong firm invests at the
weak firm’s investment threshold. A sequential equilibrium occurs when the weak firm has
no incentive to become the leader and thus the strong firm simply maximizes its own
process as if it had a monopoly on the investment opportunity, although with its payoffs
positive probability. A crucial contribution that this study provides is that the factors
affecting the actual outcome are two key elements: the relative first mover advantage and
30
the degree of investment cost uncertainty. When the investment cost asymmetry is
relatively small, and with no significant first-mover advantage, the firms invest jointly.
When first-mover advantage is significant, the strong firm prefers to become the leader, and
thus the preemption equilibrium occurs. Finally, if the asymmetry among firms is large
Pawlina and Kort (2006) provide the most thorough study to date on the impact of
asymmetry on strategic real options. Its main conclusions are indicated in the above study,
which in part emerges from Pawlina and Kort. However, this study fully characterizes the
different equilibria and the conditions under which each occur. This characterization is
achieved by use of Monte Carlo simulation. Furthermore, this study analyzes the
implications of the results for economic policy and welfare. An interesting result for
asymmetry is more socially desirable that the same results for symmetric firms.
Finally, Kong and Kwok (2006) extend the study by Pawlina and Kort to
incorporate two kinds of asymmetry: investment cost asymmetry and revenue flows
asymmetry. Their results contradict the results of both Huisman et al (2003) as well as
Pawlina and Kort (2006). In this study, the simultaneous equilibrium can never occur under
cost asymmetry alone, and in their context, it can only occur under both cost and revenue
flows asymmetry. The authors utilize the same “existing market model” than both of the
All of the above studies provide significant contributions towards generating a more
general model that may help to gain better understanding of the strategic options processes.
However, a tacit assumption that all of these studies employ is that of perfect information.
31
A more realistic environment usually deals with imperfect or asymmetric information
flows.
develops a model in which private information is conveyed through the revealed exercise
strategies of market participants. A suitable scenario for this model is oil exploration. In
this case, it is frequent to find two or more firms leasing adjacent tracts of land for oil
exploration. A firm may take advantage of being the first to drill or wait until its rival has
done so and thus conveys the information about the success of the drilling, in which case
there may be a follower advantage. In equilibrium, as the potential benefits from option
exercise become greater, firms will trade off the benefits of early exercise with the benefits
of waiting for information to break through the actions of others. Equilibrium strategies in
this context are sequential, with the least informed firms free-riding on the information
conveyed by the most informed agents. In this setting, agents may find their own private
information overwhelmed by the others’ signals and simply jump on the bandwagon. This
may help to explain the occurrence of “overinvestment” in some industries. However, the
A significant event for many firms is that their conjectures about competitors’
behavior often prove to be incorrect. Lambrecht and Perraudin (2003) introduce a model in
which firms take into account for their strategic investment decision their rivals’ trigger
threshold. However, this trigger point is unknown to a firm’s rival, and their beliefs are
constantly updated by the realization of the stochastic variable. Thus, the optimal
32
investment strategy for each firm depends on the level of the implied fear of preemption
and on the distribution of competitors’ costs from which a firm updates its beliefs. This
optimal strategy may lie anywhere between the zero net present value trigger and the
optimal strategy for a monopolist. Limit cases exist for a large number of firms (perfectly
competitive scenario) and for the case of perfect information, whose results are well known
Martzoukos and Zacharias (2001) develop a model to analyze option games with
incomplete information and spillovers. Under their proposed setting, learning may be
Spillovers are also allowed resulting in a scenario where firms may decide to free ride on
their rivals’ investments. There are two decisions for the firms to make: the optimal level of
coordination in a joint investment context, and the optimal effort for a given level of
spillover effects. Nevertheless, in order to generate a more tractable analysis, the study is
based on the strong assumption that firms do not affect each other in the marketplace (they
either have a monopoly over the investment decision or prices are determined
exogenously). As it has been well commented, these are strong and often unreal
assumptions.
investment. Whereas Lambrecht and Perraudin (2003) study the effect of imperfect
information over their rivals’ actions, this study is concerned with imperfect information
over the success of the investment project. In this framework, signals arrive over time that
can either mean a low revenue or a high revenue project. As it is often the case in strategic
real options modeling, two opposite effects arise in this context. A first mover advantage
these effects: a preemption equilibrium for the case of a more valuable Stackelberg
advantage, or a “war of attrition” case where no firm is willing to invest first since
information spillovers will provide an advantage for the rival firm. It is important to
distinguish between uncertainty and imperfect information in this setting. The main
difference stems from the fact that signals do not guarantee a successful outcome for the
project under the imperfect information scenario, and the relative number of positive
signals is compared to the existence of a symmetric prior belief on the investment trigger
threshold.
The above models provide some discussion on strategic real options models under
imperfect information. However, all of them are based on the assumptions of symmetric
firms. This study intends to provide a more general model that accounts for both
asymmetry and incomplete information. This study intends to build on the conceptual work
of Smit and Trigeorgis (2003), by using a similar approach to Pawlina and Kort (2006) who
in turn built on an existing market model, and combining it with the insights provided by
basic signaling games present in the informational game theory literature (e.g. Fudenberg
and Tirole, 1991). Figure 1 provides an approximation to the path that strategic option
studies have followed, as well a graphic indication of this study’s general goals. A more
extended discussion and development of these models will appear in the next chapter.
Another aim of this study is to provide applications for the proposed general model.
Particularly, two applications are proposed, one related with the issue of strategic
acquisitions and the other to international joint ventures. A brief overview of the work that
has been done with regards to strategic real options in both contexts (acquisitions and
Smith and Triantis (1995) were the first to observe that acquisitions as an economic
phenomenon possess a lot of the features present on the real options reasoning. They
offered a rationale for a treatment of strategic acquisitions in a real options setting since
DCF Analysis
(Deterministic)
Strategic options
Symmetry
Perfect information
Asymmetric strategic
options
Strategic options
Imperfect information
Proposed general 35
model
methodological perspective: They are undertaken under uncertainty and therefore, in a
strictly economic sense, a strategic acquisition should be viewed as the purchase of a right
later date. Even though this study has been very useful in arousing the interest on real
options and acquisitions, it fails to capture the importance of strategic considerations under
Several empirical studies have been a part of the M&A literature that have given
support to the notion of the real options approach to valuing M&A’s (e.g. Pereira and
Rocha Armada, 2002, Dapena and Fidalgo, 2003). However, these studies fail to address
acquisitions context. It is evident that most acquisitions are undertaken as future growth
opportunities, in order for firms to gain a strategic advantage over its rivals via economies
preempt potential rivals. As such, the author suggests that the interaction between the real
options methodology and the game theoretical tools is the proper way to analyze strategic
acquisitions. Several questions arise in this study: How valuable are the growth
opportunities created by an acquisition? How is the industry likely to respond and how will
this response affect in turn the acquisition value? Thus, it sets the tone to provide
explanation for the pro-cyclicality of merger waves. Particularly, the study concentrates on
mergers that are motivated by economies of scale. Empirical evidence has shown that
merger waves tend to increase with economic expansion while they are slowed during
36
recessions. The model is based on the assumption of merging firms behaving as price takers
and under complete information markets. Under these assumptions, the author finds
theoretical support for the timing of mergers being pro-cyclical. By relaxing the assumption
of perfect competition, and assuming a different motive for the merger (that duopolistic
firms merge to become a monopoly), the study also shows that mergers that are motivated
by an increase in market power are also pro-cyclical. Finally, this work analyzes the case
for hostile takeovers and argues that while mergers are efficient, takeovers take place
Betton and Moran (2004) model the negotiation process between target and bidding
firms as a Stackelberg game with complete information. In the first stage the target defines
its reservation premium, and in the second stage, the bidder decides the optimal acquisition
time. The model predicts a positive relation between target growth and volatility, as well as
a positive relation between the premium and the expected wealth creation. It must be noted
that this model fails to consider potential competition for the target in the acquisition
process, and therefore, it does not fully capture the strategic implications of this
phenomenon.
Carow et al (2004) acknowledge the fact that despite the relatively wide acceptance
of first mover advantages, few empirical studies examine whether being an early mover
affects performance. They develop an empirical model that gives support to the hypothesis
that first-mover advantages are significant in industry acquisition waves. Acquiring a first-
mover advantage or dissuading entry are key elements of strategic behavior by firms and
managers, and are a key element in the strategic acquisition process. The study finds that
strategic “pioneers”, those acting in manners consistent with having superior information,
37
capture significant advantages. This superior information may be due to experience or
learning capabilities.
Finally, Smit et al (2004) develop a model that helps to treat acquisition as real
options bidding games. This model deals with strategic interactions and another key
element in the strategic acquisition process: imperfect information. The main contribution
of this study lies in the fact that this study shows the influence of asymmetric and imperfect
bidder may decide to make a preemptive or accommodating bid at the first stage.
Depending on the type of the bid and the similarity of the bidders (approximated by their
correlation), the second player decides to undertake a due diligence (if the initial bid is
accommodating) or abstain from it. When the second player abstains, the initial bidder
completes the acquisition at the preemptive bid. A double effect emerges from this setting.
When firms are similar, the opening bid signals high target value for the rival, and thus
induces it to undertake the due diligence. On the other hand, acquisition prices will be high,
inducing the second player to be less inclined for the investment. Another interesting result
is that value appropriation (for the winning bid) increases with uncertainty and thus the
likeliness of a bidding contest. Finally, value appropriation of the first bidder increases with
As it can be inferred from the above paragraphs, there have been limited studies on
economic phenomenon possess the necessary ingredients for a deeper understanding under
component that arises from industry wide and rivals’ reactions, the asymmetric nature of
participating (acquiring) bidders due to size and technological differences, and finally,
38
imperfect information flows that arise in a global context due to regulatory differences,
agency problems or other sources. In this context, the purpose of this study is to extend the
proposed general model in order to produce a suitable theoretical proposal that helps to
OPTIONS
Quite often, the task of building a market position and/or entering new markets
requires resources that are beyond a single firm’s capabilities. Thus, a strategic partner may
be sought in order to share the costs of obtaining the necessary capabilities to achieve the
proposed goals, and to share the inherent risk that comes along with investment in risky
projects. Thus, joint ventures serve as an attractive way to invest in future growth
opportunities. Furthermore, joint ventures often result in contracts that give the firms an
opportunity to complete the acquisition if the market conditions turn favorable or to divest
from it if conditions are deemed negative. In fact, Chen (2005) finds empirical support to
the notion that acquisition joint ventures are better analyzed under real options
find that joint ventures confer partner firms valuable growth options, but limited by certain
conditions. Specifically, they find that minority and diversifying IJV’s contribute to growth
Kogut (1991) explores this issue and assigns real options features to it. The main
concern in this study is related to the timing of the exercise of acquisitions under a joint
venture context. Under its empirical modeling, the author finds support to the notion that
39
acquisitions are completed when market signals regarding demand are favorable, and that
no divestment is undertaken as long as the signals are not that negative. The study finds
support to the main hypothesis that ventures will be acquired when their valuation exceeds
Chi (2000) develops a theoretical model in order to discuss the nature of the
acquisition decision by partners in an international joint venture. Under this model, each
partner’s valuation of the venture assets evolves stochastically over time. The assessments
of the two parties have some kind of correlation index, and the level of uncertainty falls
over time due to the learning that occurs about the venture’s outcome. An important
assumption throughout this study is that bargaining power is equal among the partner firms.
The results indicate that the option to acquire (divest) is more valuable to the two partners
when their valuations are less correlated, when there is any divergence between partners’
Folta and Miller (2002) examine the issue of buyouts and equity purchases of
partner firms subsequent to initial minority equity stakes. In an analogous way to Kogut
the first stage buyout results in the purchase of the right to exercise a second stage growth
option, which in turn involves future investments. This study takes strategic considerations
into account by acknowledging that early exercise decisions may be warranted in order to
preempt rivals or gain a learning advantage. The main results state that increased partner
valuation and less uncertainty make partner buyouts more likely and that when buyout
options are more proprietary (fewer partners associated with the target firm), partner buyout
is more likely. Maybe more important with regards to this study, when there are fewer
Thus, international joint ventures may be seen as investments that may have an intrinsic
negative value but that carry a high option value due to possible subsequent investment
opportunities. Gilroy and Lukas (2005) develop a two phase market entry model in order to
incorporate this reasoning behind FDI. The first phase serves as a platform and is in fact a
close collaboration project with a partner. The second phase is essentially divided in two
options: to acquire the remaining equity and transform the alliance into a merger or to
divest the venture by selling out to the partner. The authors utilize a simulation process and
find that the choice of investing in the first stage is not only driven by the growth option,
but also driven by the degree of flexibility to abandon the venture. It must be noted that this
study is based on the assumptions of a monopoly over the investment opportunities, and as
Juan et al (2007) focus their research in international joint ventures on the treatment
They develop a suitable model to deal with this “atypical” real options based on two case
studies and provide support to the notion of the compensation clauses as the purchase of
Finally, Savva and Scholtes (2006) depart from the mainstream literature on
strategic real options and merge cooperative game theory with the real options
methodology in order to incorporate the real options approach into the analysis of
partnerships, such as IJV’s. They introduce the idea of a cooperative option under a
complete markets assumption, which includes the assumption of perfect information and
perfectly tradable assets. The authors provide comparative results between cooperative and
41
non cooperative game theoretical analysis. The results provide some interesting managerial
insights. Partners with divergent risk attitudes gain more synergies with highly uncertain
environments; non cooperative options in this context must be carefully analyzed, since
there are two opposite effect to account for: on one hand, they are valuable for individual
partners since they cut off lower utility “edges”, but they can result in “empty” ventures
when partners are too greedy in their non cooperative clauses. This study provides an
interesting framework to analyze strategic alliances and joint ventures, but is still limited in
The purpose of this study is to extend the proposed model to include international
joint ventures where there is an embedded acquisition option for the partners. By utilizing
the proposed general model, and building on the existing work of strategic joint ventures,
particularly on the work by Girloy and Lukas (2005), this study intends to make further
V. SUMMARY
During the introductory chapters, this study has tried to introduce the research
understanding and valuation of strategic investment projects is in its early stages. The
models that have been developed to date utilizing the tools provided by both a real options
approach and game theoretical tools has helped to shed light on the intrinsic valuation of
strategic projects under uncertainty. Both theoretical and empirical models have provided
support to the existence of strategic options embedded in the context of certain kinds of
investment projects. However, in order to deal with important features present in real world
42
scenarios, there is a need to produce more sophisticated theoretical and empirical models.
This study intends to provide a more general framework to analyze strategic investment
projects and their valuation, by incorporating two elements that are present in today’s
to note that asymmetry may have several sources and information imperfections may be
studied in different ways. This study intends to concentrate in investment cost asymmetry
as the main source for studying asymmetry and in informative signals as a way to
approximate imperfect information. The next chapter will provide the necessary steps to
Some investment projects clearly present the features that this study intends to
portray. Strategic acquisition projects and international joint ventures are surrounded by
both uncertainty and strategic considerations related to rivals’ reactions to them. They
occur in a world with firms operating under asymmetric costs potentially due to the
changing environment of technology and the learning processed that accompany it. Both
strategic acquisitions and IJV’s, as strategic investments, are surrounded by imperfect and
This study intends to extend the proposed general framework in order to find suitable
applications in these phenomena. Chapters 4 and 5 develop these models to the case of
43
CHAPTER 3
I. INTRODUCTION
The previous chapters have provided the reasoning behind the need to develop a
more complete model in order to gain a better understanding of the strategic investment
phenomenon under uncertainty and with the presence of two important features: asymmetry
among firms and imperfect information. In particular, chapter I helped in the presentation
of the general research problem and the research questions underlying this study, while
chapter II aided in providing a more thorough description of the path that studies in this
area have followed, as well as showing the specific “gaps” that this work intends to cover.
Finally, the previous paragraphs have outlined the key studies in which this study is based.
The purpose of this chapter is to provide a more general theoretical model that is
helpful to analyze strategic investment projects under uncertainty. This model is mainly
based on two branches of the economics literature. The first one is the strategic options
treatment combining the standard real options methodology that deals with investment
under uncertainty and the game theoretical tools provided by the literature. The second
branch is related to imperfect information and how the Industrial Organization literature
deals with it. As stated before, this model follows closely in the work of Pawlina and Kort
(2006), who have in turn extended the strategic growth options modeling by Kulatilaka and
Perotti (1998), Grenadier (2000), and Huisman and Kort (2001) among others, in order to
incorporate the asymmetric nature of firms to strategic investment analysis. From the
imperfect information perspective, Thijssen et al (2003) study the role that information
44
plays on strategic investments and welfare. However, the strategic interaction in their work
is between two symmetric firms which can randomly become the leader or the follower in a
Stackelberg game.
The extension that this study proposes is rooted on basic signaling games of
imperfect information. The basis for this extension appears in standard game theory
textbooks such as Fudenberg and Tirole (1991). These basic concepts are added to a
dealing of asymmetry similar to the one proposed by Pawlina and Kort (2006).
The first section of this chapter provides the basic setting for the model as well as
the main assumptions underlying it. It also sets up the main equations that are to be solved
and discussed. The second section shows the different solutions that this model provides
and the conditions for the existence of each one. In particular, two kinds of equilibrium are
According to its “informational” content, two scenarios appear for each kind of
equilibrium: a separating equilibrium, in which a firm reveals its true type according to its
actions, and a pooling equilibrium, in which a firm acts in a certain manner notwithstanding
its true type. Conditions for each type and subtype of equilibrium are obtained and
discussed in this section. In the third section, the optimal investment thresholds for each
occurrence are obtained and compared, as well as the corresponding firm or project values.
From the standpoint of strategy, two kinds of equilibria are analyzed. For certain parameter
values a preemption equilibrium may be the solution to the maximization problems that
firms face, while for other values a sequential investment equilibrium is the optimal
maximize its value, the importance of firms’ and/or projects’ valuation is emphasized.
45
Finally, a fourth section appears in order to provide concluding comments as well as to
This section is concerned with developing a general model for the treatment for
strategic investment projects occurring under asymmetry and imperfect information. The
As stated in the above paragraphs, this study intends to provide a model that is able
asymmetry, in a similar manner to Pawlina and Kort (2006). The authors consider that
investment cost asymmetry may arise from several different sources. This asymmetry stems
from different access to capital or debt markets (different cost of capital), different learning
capabilities, different regulatory environment (which may be particularly true for the case
of international investment projects, when some firms may obtain special privileges from
government intervention), and different value of embedded options. This last possibility is
particularly interesting, since the economic cost of investment may be different amongst
firms due to the future growth opportunities that they may face.
Thus, firm 1’s investment cost is I, whereas firm 2’s investment cost is I. Pawlina
and Kort developed their model under the assumption of perfect information, and the role
of low cost firm was “assigned” to firm 1. In order to incorporate imperfect information at a
later stage, a change is introduced. In this case, (0, infinity), since this will allow to
46
extend the model for the imperfect information case. When takes a value starting from 0,
there is no previous knowledge of which firm is in fact the low cost one.
Three scenarios arise with regards to the investment timing. In the first scenario,
firm 1 becomes the leader and it invests first; in the second scenario, firm 1 becomes the
investment is the third scenario. A key finding in Pawlina and Kort is that introducing
asymmetry uniquely determines the firms’ roles (leader or follower). The low cost firm
always takes the role of the leader unless there is a simultaneous investment scenario.
When introducing imperfect information, this may not always be the case. Under the first
two scenarios, it is important to note that since the leader has already invested, the problem
the follower faces is basically a single-firm investment problem whose results are well
expressed as:
where DNiNj stands for the deterministic part of the profit function, and where the
47
d(t) = (t)dt + (t)dz, (2)
where and are constants corresponding to the instantaneous drift and to the
random increment, which follows a Wiener process (normally distributed with mean zero
and variance dt). Thus, and may be interpreted as an industry’s growth rate and
assumption present in the literature (e.g. Dixit and Pyndick, 1994) is that must be less
The first assumption ensures that the investment is profitable as compared with the
non investment alternative. The second assumption ensures that the decision to invest by
the follower reduces the first mover advantage. The third one makes sure that the follower’s
investment enhances its profit, while the fourth one ensures that the investment leads to a
deterioration of the profit of the firm that did not undertake the project. These general
This section incorporates the insights of a simple signaling game into the reasoning
behind growth options under asymmetry developed by Pawlina and Kort (2006). As stated
before, firms are aware of their own investment costs but are unaware of its rival’s. This is
analogous to having the parameter ranging from 0 to infinity instead of the interval
According to Pawlina and Kort, three types of equilibrium emerge under the
asymmetry scenario: A preemption equilibrium in which a firm is able to preempt its rivals’
48
entry, a sequential investment scenario in which the “leader” always invests first with a
which both firms decide to invest at once. The simultaneous investment scenario is ruled
out of this discussion since this study is concerned with the imperfect information
conditions and consequences, and simultaneity makes the informational content trivial.
In order to simplify the analysis and be able to incorporate a basic signaling game,
this study assumes that may take either a value of H or L. The first case corresponds to
a firm with larger than 1 (high costs), while the second case corresponds to a firm with
less than 1 (low costs). Two types of equilibrium are studied from the standpoint of the
strategy: preemption and sequential investment. It has been stated before that the
investment decisions. Since the simultaneous outcome does not depend on imperfect
information, this type of equilibrium is not analyzed. On the other hand, two types of
equilibrium emerge from the perspective of the credibility of the investment signal: a
the investment opportunity reveals its true type by its first period action, while in the
pooling equilibrium, the investment decision will be the same no matter what its true type
(high or low cost) is. Four different scenarios are therefore analyzed.
Separating equilibrium
As stated before, the key assumption under a separating equilibrium scenario is that
a player’s type is revealed by its action on the first period, with this action becoming a
credible commitment or confirmation of future actions. In this particular case, a firm has to
49
decide whether or not to undertake an investment based on the knowledge of its own costs
In this duopoly case, let’s arbitrarily assume that firm 1 has the opportunity to
undertake the investment first. Upon the realization of , it decides whether or not to invest.
As stated before, it knows its own investment costs but ignores its rival’s. Thus, the firm
does not know whether its investment costs are HI or LI.
On the other hand, firm 2 knows its own costs I, but reacts to firm 1’s actions in
period 1. First, we’ll analyze the problem that firm 2 faces. For that purpose, the
assumption is that firm 1 has already decided to make the investment. There must exist a
certain threshold H for which firm 2 decides to be the follower and also make an
investment. Under the imperfect information case, firm 2 bases its decision on the beliefs it
For values of situated above the threshold H, firm 2 decides to be the follower
and invest at period 2 since it is profitable for both firms to participate in the investment.
On the other hand, for levels of situated below a threshold L, and without taking into
account strategic considerations, no firm would invest since it would not be profitable to do
so. The more interesting interval is for values of located between both thresholds L and
H. For this interval, firm 2’s decision depends on its beliefs about firm 1’s type.
Under the separating equilibrium scenario, it is important to note that firm 2 has
complete information in the second period, since the actions undertaken by firm 1 on the
first period will reveal its true type (H or L). Firm 1 decides whether or not to make the
50
investment based on the realization of and on strategic considerations with respect to firm
2’s reaction.
Since the true type of the investing firm is revealed based on its actions in period 1,
then “true” and perfect information is passed through to the follower. Thus, a separating
equilibrium results in the case of strategic options under asymmetry with perfect
information. As stated by Pawlina and Kort (2006), a preemptive equilibrium occurs when
both firms have the incentive to become the leader in the investment. This event takes place
when the perceived cost difference is small; that is, when is close to 1. In any case, in
general, any firm prefers to convey the information that its investment cost is low and thus
On the other hand, a sequential equilibrium occurs when firm 2 (the high cost firm)
has no incentive to become the leader. In this case, firm 1 acts as if it had the monopoly
over the investment opportunity, although its payoff will be affected by firm 2’s latter
investment. Following Pawlina and Kort, under the sequential equilibrium scenario it may
be concluded that firm 2 is never better off by becoming the leader compared to being the
follower.
Pooling equilibrium
From the informational perspective, the more appealing scenario arises for the
pooling equilibrium situation. In this case, firm 1’s actions are the same no matter what its
true type is. Thus, firm 2’s decision will depend upon the probability it places on firm 1’s
true cost type. Again, if the realization of is below a certain threshold, then it makes no
sense for either firm to invest and there would be no strategic considerations in light of the
51
fact that both firms will be better off by not making the investment. On the other hand, if
is larger than H, both firms will have an incentive to invest and the result would be a
If firm 1 makes the investment, firm 2 will not know firm 1’s true cost type, and
therefore firm 2’s decision will depend upon the probability it assigns to firm 1 being either
the low or the high cost type, as well as the values of and , which correspond to the
More precisely, is the probability that firm 2 assigns to firm 1 being the high cost
type (and itself being the cost leader). An investment threshold * is found under which
Thus, the investment decision for firm 2 depends on two factors besides the
realization of the stochastic variable : the value of , which reflects the relative cost
difference between firms and the value of , which may be thought of as a degree of “self-
esteem” or the strength on the belief that a firm may be the cost leader. If is close to 1,
there will be a relatively small investment cost difference between firms. On the other hand,
a value of close to 1 represents a strong belief of a firm in its own cost leadership,
On the other hand, firm 1 possesses its own beliefs about firm 2. However, in a
pooling equilibrium, firm 1 acts as the low cost firm no matter what its true conditions are.
In other words, as long as the realization of is larger than the minimum threshold L, firm
1 always invests since it expects to send the signal that it is the cost leader. If the signal is
credible enough for firm 2 (low values of 2 or low degree of “self-esteem”), then firm 1
52
may be able to preempt the investment by firm 2 and become the investment leader even if
< 1 (firm 2 being the cost leader). This result is different than the one found by Pawlina
and Kort (2006) for the analysis under asymmetry and perfect information, in which the
Under the pooling equilibrium assumptions, firm 1 always invests at its initial
opportunity as long as the realization of lies above the minimum threshold L. Thus, firm
2’s actions remain to be analyzed. Particularly, firm 2’s investment threshold and its
corresponding project value must be found. This is the purpose of the next subsection.
maximization problem faced by firm 2. It has been stated above that since the separating
equilibrium reveals the true type of firm 1, then it reduces to the case and results found by
Pawlina and Kort (2006), and which is equivalent to the full information scenario. On the
other hand, under the pooling equilibrium assumptions, firm 1 will have invested first and
thus, firm 2 faces a single firm maximization problem that may be solved by standard real
and Pyndick for a single firm’s investment opportunity, it follows that the optimal
investment threshold for firm 2, trying to maximize its value is similar to the result found in
53
= ½ - /2 + (3A)
In turn, the corresponding value for the investment project for firm 2 is expressed
Appendix 1 shows the way this threshold and the corresponding project (firm) value
Once the project value for firm 2 has been calculated, it is straightforward to
This expression is similar to the one found in Pawlina and Kort’s study. In this case,
it is important to note that while V1 is always larger than V2 in the aforementioned study, it
may be the case, due to information imperfection and to the signaling game, that V2 V1,
if 1.
It is quite interesting to analyze the above expressions for some limiting values. For
instance, it is important to verify the reaction of firm 2 when its “self-esteem” value (2) is
very low, that is, when it is close to zero. For this particular case, firm 2 believes with
almost complete certainty that it’s the high cost firm. Thus, firm 2 will always act as the
On the other hand, if 2 is close to 1, firm 2 will believe with almost complete
certainty that it is the cost leader, and under the above mentioned assumptions, will always
54
invest immediately after firm 1’s investment, since it is always optimal to do so,
For intermediate values of 2, several scenarios arise, depending on the specific
values and also on the particular type of “strategic equilibrium”. These equilibria are the
investment equilibrium, and a simultaneous investment one. As it has been stated above,
the simultaneous investment scenario has no informational content (since there are no
signals involved in it) and therefore will not be studied under the model proposed in this
investment cost asymmetry and perfect information yields a single investment leader (the
low cost firm), this is not the case once imperfect information is introduced. Specifically,
the pooling equilibrium scenario may result in the high cost firm being the investment
leader, as long as it possesses a high enough degree of “self-esteem” (2). Thus, the
Proposition 1: There is an interval for the realization of , for which the high cost
firm becomes the investment leader. Appendix 2 shows the proof for this proposition.
It is time to turn this study’s attention to the necessary conditions for the existence
For any scenario, if the realization of falls below the L threshold, no firm will
invest since it would be better off waiting for at least another period. On the other hand, if
55
the lies above the H threshold, any firm would want to invest whether it is the low or the
high cost type, since it would be profitable to do so. The interesting interval is for values of
For a separating equilibrium to exist, it must be the case that firm 1 (which has the
opportunity to invest first) will be better off by accommodating firm 2 in the second period
than incurring in an unprofitable investment on period 1 and thus obtaining the higher
realization D10 in the second period. In other words, and for simplification purposes, the
This may be the case for sufficiently large values of . In other words, if the cost
asymmetry is large enough, it may be the case that firm 1 may be better off by not investing
at all, and letting firm 2 undertake the investment at the next period.
As stated before, the “threat” of firm 1 actually being the cost leader must be a
credible one in order for firm 1’s signal to be meaningful. Hence, a range of ’s must exist
such that firm 2 perceives that it is not profitable to make the investment at the second
stage; that is, its perceived value must be lower when making the investment that when
refraining from doing so. From previous statements, this range will depend on the
probabilities firm 2 places on firm 1 actually being the cost leader (1-2).
In order for firm 1’s signal to be credible, firm 2 must have “cold feet” about
making the investment in period 2 and may perceive that it may be better off by not making
56
the investment at all. If the same “self-esteem” parameter for firm 2 is extended for this
For values of that lie above firm 2’s investment threshold *, from expression (4)
V2 = Dij/(r-) – I2 (8)
And thus, after some algebraic manipulations, it yields that the range of for a
value that firm 2 assigns to 2, the realization of and the relative values of D11 and D01.
It is important to note that a certain range of ’s may exist for which both a
separating and a pooling equilibrium may exist. For that range, a hybrid equilibrium (that
is, a randomization of both the separating and the pooling equilibrium) may actually exist.
However, since the purpose of this study is to provide tractable propositions and to show
that the results obtained by previous studied may vary when imperfect information is
Depending on the strategic position of firms, the realization values for , the relative
cost advantage (disadvantage) and the “self-esteem” parameter , two types of
equilibrium may be obtained under the imperfect information and investment cost
57
preemption setting, both firms would be better off being the investment leaders and thus
preempting their rivals from investing first. As it is mentioned by Pawlina and Kort (2006),
this scenario arises when the cost asymmetry is relatively small. Under the perfect
difference is relatively large and under realizations of above a certain threshold, the high
cost firm will always be better off when becoming the follower. Although similar,
important differences arise under the imperfect information settings when a signaling game
a. Preemption equilibrium
As it has been stated above, a separating equilibrium basically yields the same
results as in the perfect information case, since the true type of the firm that is allowed the
opportunity to invest first is revealed after its actions in the first period. Thus, it follows
that if an arbitrary firm 1 is the low cost type, and the realization of exceeds a certain
minimum threshold L, it will always invest first; whereas in the opposite case it will not
invest and firm 2 will. Therefore, the thresholds and project values under a separating
equilibrium are the same than the ones found in Pawlina and Kort (2006).
into “monopolistic” conditions with regards to industry structure, it will always invest once
the realization of reaches an optimal point. When there is competition involved, the
situation changes under the preemption scenario. When the cost difference is small, both
firms may be interested in undertaking the first period investment. Therefore, under a
58
perfect information scenario, it may be the case that for the high cost firm, it will be
optimal to invest at a level of that is below the cost leader’s optimal investment threshold.
In turn, the low cost firm will preempt the high cost firm and invest first. This occurs until a
certain level P is reached, which is the level of for which the high cost firm is
indifferent between making the first period investment and becoming the follower for the
next period.
The single firm threshold for an investment project is the following, which is a
standard result from real options theory (e.g. Dixit and Pyndick, 1994):
M = (/-1)I(r-)/(D10-D00) (10)
and the conditions previously described, the investment threshold for firm 1 under the
preemption scenario is the minimum between firm 1’s own investment threshold appearing
in expression (5) and 2P. Formally, 2P is the level of which results in the project value
being the same whether firm 2 is the investment leader or the follower.
yields the expected result of earlier investment by the cost leader. As it has been stated in
previous paragraphs, these results hold when imperfect information is introduced under a
Under either the perfect information scenario or the separating equilibrium setting, the
signal sent by the investing firm does always reveal its true type. However, under a pooling
equilibrium scenario, this may not always be the case. Thus, the case may arise where a
59
high cost firm 2 actually preempts the low cost one from investing first, as long as it
Let’s suppose that firm 2 now has the opportunity to invest first. Then, expression
Again, there exists a certain threshold P for which a firm is indifferent between
becoming the leader or the follower for the investment opportunity. For the separating
equilibrium case, the roles are exactly the same as in the perfect information scenario, and
thus firm 1 (the cost leader) will always know its true position and will choose the
minimum of 1M or 1P as its investment threshold. However, under pooling equilibrium
assumptions, as long as the high cost firm possesses a high enough “self-esteem”, it may
actually preempt the low cost firm from the initial investment. This may occur for values of
close enough to 1 (small cost advantage or disadvantage) and high values for 2 (high
self-esteem). Formally, there is an interval for the investment thresholds for which
expression (11) may actually result in lower values than 1M or 1P. Evidently, this is not
the case for either the perfect information or the separating equilibrium scenarios.
Therefore:
Proposition 2: Under a pooling equilibrium scenario, there exists an interval for the
realization of , under which the high cost firm preempts the investment by the low cost
one. Again, appendix 3 provides the necessary proof. This result is somewhat analogous to
the one found by Boyer et al (2001) in which under preemption equilibrium conditions and
a capacity investment game, the small firm actually preempts the large one to the initial
investment.
60
The above proposition is quite surprising in the sense that imperfect information
may help to produce unexpected results. However, this may help to explain why sometimes
smaller (and usually higher cost) firms quite often “beat” the larger firms to strategic
investments. It is time to turn the attention towards the sequential investment case.
As stated before, a preemption equilibrium occurs when the cost difference is small
between rival firms. On the other hand, sequential investment settings are based on the
existence of a large enough cost difference; that is, a parameter which differs greatly
enough from 1. This fact will yield results that differ from those found for the preemption
equilibrium scenario.
assumptions results in the acting firm revealing its true type, and thus, this scenario is
similar to the perfect information settings analyzed by Pawlina and Kort (2006). Under a
separating equilibrium, the high cost firm (firm 2 for simplicity) will never have the
incentive to become the leader and will always act as the follower. In turn, firm 1 will
always act as a monopolist and invests at its single firm investment threshold. This
This scenario is quite revealing. When the perceived cost difference is large enough,
a duopolistic competition may be reduced to a monopolist’s analysis and the leading firm’s
actions actually reflect those of a monopolist of the investment opportunity. This conduct
61
When pooling equilibrium conditions are imposed on the sequential investment set
up, the results resemble those of the separating equilibrium. A large enough cost difference
results in a non credible threat of preemption by the high cost firm. When the high cost firm
possesses a high “self-esteem” (large value for 2), and it possesses the initial opportunity
over the investment project, it may want to send the signal that it is the low cost firm and
invest first. However, the low cost firm, knowing its own costs, will always intend to
preempt the high cost firm, since the investment threat by the high cost firm will not be
credible. In turn, under these circumstances, the high cost firm will always be better off by
behaving as the follower and investing in the second period, as long as the realization of
is large enough.
separating equilibrium, reduces to the case of perfect information. Thus, with a large
enough cost difference ( sufficiently different from 1), the cost leader always becomes the
investment leader, and the high cost firm will always invest later. These findings are similar
to those found in Pawlina and Kort’s study. From the above perspective, the following
proposition is obtained:
difference between rivals, the results are analogous to the perfect information settings, with
the low cost firm becoming the leader and the high cost one becoming the follower for
This proposition confirms the idea that when the perceived cost difference is large
enough, any signal by the high cost firm that it is the low cost one will not be credible.
Thus, the results under imperfect information reflect those under a perfect information
62
scenario. Hence, the role that information plays when a large cost difference is common
knowledge is negligible.
IV. CONCLUSIONS
study of strategic options under uncertainty and asymmetric conditions. The role that
information plays in the context of strategic projects appears to be quite important. Pawlina
and Kort (2006) found that under perfect information and asymmetric investment costs, the
cost leading firm unambiguously assumes the role of the investment leader. These authors
study equilibrium conditions when firms face either preemption or sequential investment
simultaneous investment results in a trivial result since information does not have any
This study introduces a basic signaling game where a firm signals that it is either a
low cost or a high cost firm. By introducing signals and beliefs instead of perfect
information, it follows that for investment projects with asymmetry in investment costs and
uncertain conditions, the use of the strategic growth options reasoning results in different
and more ambiguous outcomes than the ones found in Pawlina and Kort. Of particular
interest is the fact that under pooling equilibrium assumptions, the investment leader does
This has important repercussions for a real business context. This may help to
explain why sometimes investment projects such as acquisitions, patent acquisitions, R&D,
or international joint ventures are not always undertaken by the larger firms (firms with
supposedly smaller investment costs). It is important to add that this study’s findings may
63
be extended to other areas that involve a strategic options reasoning. Among these areas,
strategic bargaining, patent races, M&A’s, international joint ventures, may be thought of
as phenomena that can be studied under the framework developed in this study.
It must also be acknowledged that the general theoretical model utilized in this
chapter is based on a very simple signaling game with important restrictions. More complex
and complete theoretical models may be necessary in order to develop more general models
that account for imperfect information in the context of more general environments.
Furthermore, empirical studies must be undertaken in order to test the predictive power and
significance of this kind of modeling. All of these limitations are suggested as future areas
of research.
A very interesting and evident extension for this model is the study of strategic
acquisitions under investment cost asymmetry and imperfect information. This is a very
plausible scenario under contemporary business environments. The next chapter will
64
CHAPTER 4
I. INTRODUCTION
environments. Under these conditions, traditional DCF (discounted cash flows) valuation
developed the idea that acquisitions may be viewed as strategic investment projects under
uncertainty and studied under a real options approach. The standard real options approach
deals with uncertainty prevailing in contemporary business contexts. However, this concept
oligopolistic industries.
The combination of the analytical tools present in game theory along with the
insights provided by a real options approach provide a more complete set of tools to
analyze phenomena such as acquisitions. Smit (2001) argues that the combination of game
theory and real options should yield valuation results that better reflect today’s competitive
and uncertain environments. However, this conceptual study fails to capture the role that
information plays in the acquisition processes. Morellec and Zhdanov (2003) analyze
competition but this study is focused on the abnormal returns obtained in a bidding contest
by both bidders and targets. Smit et al (2004) study acquisitions as bidding contests under
65
imperfect information. Nevertheless, these studies do not intend to analyze the phenomenon
It seems plausible to think of acquisitions as strategic projects that occur under the
between potential acquirers may stem from different sources: imperfect regulatory
the other hand, imperfect information may stem from the availability (or lack thereof) of
data, unreliable information, etc. With this in mind, it does also seem plausible to think
about beliefs by firms with regards to the other’s investment or acquisition costs.
A large percentage of acquisitions are actually perceived as failures, and fail to add
value to all stakeholders (Louri et al, 2001). Thus, there is an apparent need to better
between standard valuation techniques and the financial results provided by acquisitions. At
least some of these flaws may be attributed to informational anomalies under environments
with less than perfect information, to prevailing uncertainty or volatility, and to the
asymmetric nature of competing firms. This chapter intends to provide some insights into
A general model has been developed on the previous chapter trying to analyze the
behavior of competitive firms trying to undertake general investment projects. This general
model will be extended in the following sections in order to serve as an application for the
study of acquisitions.
66
II. ACQUISITIONS AS STRATEGIC GROWTH OPTIONS UNDER
MODEL
Chapter III showed the construction of a general model for the treatment of general
characteristics with regards to the general model. In the general investment model, several
kinds of equilibrium may occur. Pawlina and Kort (2006) report three different kinds of
finally, a simultaneous equilibrium. Under a different setting, Boyer et al (2001) report two
which firms tacitly agree to either postpone investment until a better realization of the
potential rents.
However, the nature of acquisitions as investment projects limits the scope for the
fact, there is only one target and room for only a single firm making a “winner take all”
for analysis.
If there were always perfect information involved in acquisition processes, the low
cost or large firm would always complete its acquisition, since valuation would be the
result of perfect data and available for all suitors. Since asymmetry would then stem from
investment costs, the firm with lower investment costs would always be the one to
complete the acquisition, just as the theoretical results shown for perfect information in
67
previous studies. Nevertheless, business contexts often result in the smaller or more nimble
firms actually preempting the larger corporations to acquisitions. This is the role that
As discussed above, for a preemption equilibrium to exist, it must be the case that
the cost difference must be small. If it were large, then there would be no incentive for
the high cost firm to become the leader in the investment, or in this case, to even consider
the option to acquire the potential target. If the is large enough, and under duopolistic
competition, the large firm would always act as if it were the only firm with the investment
opportunity and it would only have to solve a single firm’s standard investment problem.
On the other hand, for small cost differences and perfect information, the low cost
firm would complete the acquisition at its rival’s threshold of indifference (2P). This
threshold has been defined as the realization of the stochastic variable for which the high
cost firm is indifferent between being the leader and becoming the leader for general
opportunity to become a follower, and thus, the indifference threshold becomes the high
cost firm’s own single firm investment threshold. Since by assumption, the investment
threshold for the high cost firm is always higher than for the low cost one, the problem is
uncertainty over the actual role of firms with regards to their investment costs situation.
The argument that will be formally presented in the next section is that the high cost firm
may then be able to complete the acquisition (and therefore preempt the low cost firm to the
investment) by sending a credible signal about itself being the cost leader. In order for this
68
to happen, must be small enough and the degree of “self-esteem” 2 must be large
enough.
Once some of the important characteristics of the acquisitions model with relation to
the general model developed in the past chapter have been discussed, it is time to turn the
attention to the assumptions these features involve. The next subsection will formally
Main assumptions
When developing the general model, the deterministic part of instantaneous profits
was defined as Dij, where the suffix ij determined the participation or not of firms in an
investment project. In particular, D11 indicated the instantaneous profits of firms when both
projects, it is clear that this term will be eliminated in the following discussion, since there
is no possibility for two rival firms to complete the acquisition of a target in a single
acquisition context.
The next assumption stems from the initial assumptions present in the previous
This is not dissimilar to studies such as Kulatilaka and Perotti (1998), where
investing in technology results in gaining a strategic advantage versus a rival firm. In this
69
strategic advantage versus the competition and this is reflected in the relative values of D10,
according to:
where and are constants corresponding to the instantaneous drift and to the
random increment, which follows a Wiener process (normally distributed with mean zero
and variance dt). Thus, and may be interpreted as an industry’s growth rate and
assumption present in the literature (e.g. Dixit and Pyndick, 1994) is that must be less
two cost elements. The first one is related to the target value. In this case, a key assumption
is that the target valuation is common knowledge, and can be approximated by its book or
market value, which is assumed to be known to both firms. The second element of
acquisition costs is related to investment costs. These costs include learning costs,
transactions costs, and the use of any particular resources that firms must employ in order
to incorporate the target firm. These investment costs are assumed to be asymmetric and
When there is a large cost difference, it has been stated that the low cost firm will
always complete the acquisition, as long as it is profitable; that is, as long as the realization
70
of lies beyond the single firm investment threshold L, and thus it is not interesting to
study this case. On the other hand, is has also been stated that under informational
scenario. Therefore, the pooling equilibrium scenario for small cost differences is studied
is close to 1,
These are the conditions developed in the previous chapter for the existence of a
pooling equilibrium under general investment conditions. However, since D11 does not
Once the assumptions have been expressed, then it is time to turn the attention to
model
Under the proposed model developed by Pawlina and Kort (2006) and under the
preemption scenario, a firm that acts on a duopolistic context must consider both its own
monopoly investment threshold and what the authors describe as a preemption threshold P
(the level of for which the high cost firm is indifferent between being the leader or the
71
follower on the investment). Once these two levels are defined, the low cost firm invests at
When imperfect information is introduced to the model, the results under the
preemption equilibrium scenario are more ambiguous since there exists an interval for the
stochastic variable for which the high cost firm actually preempts the low cost one. This
depends on the value of both the cost difference , as well as the degree of the high cost
introduced to the model. As before, the basic problem is to find the optimal timing of an
irreversible investment I, given that the value of the acquisition project follows a geometric
Brownian motion. This threshold value maximizes the firm’s value. For a perfect
information scenario, the results are analogous to a single firm investment problem, since
the low cost firm will always invest first and complete the acquisition, and thus:
This expression holds true for all values of that are larger than the minimum
monopolistic firm investment threshold. This expression is also analogous to expression (5)
without taking into account the profits lost to the rival firm’s later investment since in this
Once imperfect information is introduced, this reasoning follows: both firms know
that if the other completes the acquisition, it will earn profits D01, if neither firm completes
the acquisition, then both will get D00, while the one completing the acquisition will get
72
D10 – Ii, where i ={1,2}. As before, it is assumed that there is asymmetry in investment
When only one firm is involved in the acquisition under the conditions of
uncertainty described by the above assumptions, it will complete the acquisition at its
single firm optimal investment threshold. Thus, the investment threshold would be at the
point where the firm’s value with the completed acquisition exceeds the value of the firm
Once two firms are involved, each would like to invest at the point where the firm’s
value with the acquisition exceeds that of the firm’s value with its rival having acquired the
target. If firms were symmetric, then once the realization of reaches a certain level, each
would complete the acquisition with probability ½. However, once asymmetry and
imperfect information, the results may vary due to the stated asymmetry in investment costs
and to beliefs by firms with regards to their rivals’ costs. When a rival firm completes the
acquisition, a firm is left with the low value profits D01 and thus it may have the incentive
to preempt its rival and have an “earlier” investment which results in a lower value for the
investment threshold.
In any case, the Bellman equation for the continuation region (when no investment
has taken place yet) is the same as for the general investment case. Thus, the expression for
Expanding this expression with the help of Ito’s lemma, the expression results in the
73
These are standard results from the real options literature, and can be found in
several studies and texts (e.g. Dixit and Pyndick, 1994). In fact, these are the single firm
results found in the literature. However, the initial conditions change from both the single
firm and the general duopoly investment model. Any firm participating in the above
mentioned set-up under a preemption scenario must take into account that by allowing its
rival to undertake the investment its own profits will result in a lower value. On the other
hand, the acquisition context differs from the general investment one in that a “follower”
investment is not allowed due to the particular nature of acquisitions as strategic projects.
investment threshold than it would under monopolistic conditions. The next proposition
is completed at a lower threshold level than it would under single firm investment
conditions.
Proof: Under uncertainty and perfect information, the single firm investment
M = (/-1)I(r-)/(D10-D00) (10)
undertaking the investment and simply not making it. On the other hand, out of fear of
getting the lower profit level D01 and get preempted by the high cost firm, the low cost
D = (/-1)I(r-)/(D10-D01) (17)
74
This expression results from the same construction as before. However, it utilizes
the lower D01. Since D01 is lower than D00, the threshold D results in a lower value than
M. This expression essentially is the equation for which the low cost firm is indifferent
between completing the acquisition or letting the high cost firm complete it. However,
since the investment cost I is lower for the low cost firm, the threshold will always be lower
for the low cost firm under the perfect information scenario.
Once imperfect information is introduced, it may be the case that the high cost firm
possesses a high degree of “self-esteem” and thus complete the acquisition before the low
cost firm. In order for this to happen, two things must be present in the acquisition context:
a low degree of investment cost difference, and a high degree of “self-esteem” by the ex-
post high cost firm. From this reasoning, the following proposition is presented:
Under duopolistic competition for a single acquisition, both firms face the same 3
basic scenarios:
1) No firm completes the acquisition and each is left with instantaneous profits
investment threshold.
2) The low cost firm completes the acquisition and the high cost one is left with a
3) The high cost firm completes the acquisition and the low cost one is left itself
The first scenario occurs when the realization of is low enough so that the value of
completing the acquisition is negative and it is better for both firms to stay out of the
investment. Under values of that lie above this threshold, one of the firms will always
75
acquire the target firm. Under perfect information, or with values of and 2 that are
respectively far enough from 1 (high cost difference) and/or low enough (low “self-
esteem”), the low cost firm will always be the one completing the acquisition in this single
investment context.
On the other hand, in order to find the appropriate investment thresholds, we define
2 as:
V01 = Value of the firm that does not complete the acquisition
When 2=0, the firm is indifferent between completing the acquisition and
accommodating its rival’s investment. For scenario 1 to occur it must be the case that 2 is
lower than zero, and for either scenario 2 or 3, the perceived (ex-ante) value of 2 must be
larger than zero for the acquiring firm. The next step is to find the investment threshold for
the acquisition to be completed by the low cost firm under assumptions of perfect
information.
In a perfect information context, an expression for V10 and V01 for both firms will
be built. For values of that are less than the investment threshold A, no firm will invest
and both will earn profits corresponding to D00. First, an expression for the acquisition
76
Under perfect information, it can be assumed that I2 = I, where is by assumption
larger than 1; that is, firm 2 is the high cost firm. From the expression (18) it can be
observed that the threshold is always less for the low cost firm, and thus, it will always
complete the acquisition before the high cost firm. In turn, and as expected, competition
leads to early investment by the low cost firm as compared to the single firm investment
opportunity.
A key assumption underlying the development of this model is the fact that firm’s
valuation is exogenous to the model and common knowledge (public and perfect
information), and the asymmetry stems from investment cost difference. This case results in
early investment by the low cost firm as a result of competition. However, it can be related
to a case of private valuation by firms resulting in the low cost firm overpaying for its
By the procedure leading to the calculation of the investment threshold A, the
acquiring firm (low cost one) gets the following value for its acquisition. For simplicity, it
When the investment is not yet completed, the first row of the above expression
applies. It is a modified net present value formula where the first term is the traditional net
present value and the second one is the option that firm 1 possesses to acquire the target.
Under perfect information, firm 2 does never have an opportunity to complete the
77
V2 = D01/(r – ) for larger values of . (20)
Thus, although the threat of preemption by the high cost firm is credible and forces
the low cost firm to an early investment, this threat is never fulfilled and firm 1 will always
be the one completing the acquisition in this single acquisition context. Once imperfect
information is introduced, the results may vary as can be seen in the following subsection.
investment threshold for the low cost firm, and therefore, it is always able to complete the
acquisition before its rival. Once imperfect information is introduced, the results are more
ambiguous and the high cost firm may be able to complete the acquisition and preempt its
and imperfect information, there is an interval for the realization of , under which the high
cost firm completes the acquisition before the low cost firm.
For this to happen, it must be the case that the perceived ex-ante investment costs
for the high cost firm must be lower than the actual costs for the other firm. The other
ingredient that must be present in order for this to happen is a relatively low degree of cost
asymmetry. If the value of were large enough, then the threat posed by the high cost firm
would never be credible and thus, the results would be equivalent to the perfect information
scenario.
As before, both firms face an acquisition opportunity where the target’s valuation is
78
asymmetric investment costs that are not known to the rival firms. For simplicity, it will be
assumed that firm 1 is the ex-post low cost firm but no firm knows this for sure ex-ante.
Both firms are willing to invest once the realization of is large enough according to 2 ≥
0.
stated by expression (18). The firm with the lower investment threshold will preempt its
rival to the acquisition. From this expression, it can be concluded that the difference among
I is the investment cost for firm 1 and I2 is the investment cost for firm 2. However,
I2 is, under the imperfect information scenario, equivalent to the following from the
perspective of firm 2:
This value must be lower than I for the high cost firm to preempt its rival and
With simple algebraic manipulations, it results that values of 2, L and H exist for
which this expression is true. The only consideration is that 2 and L must be rather large
(close to 1) while H must be rather small (again, close to 1). This implies a large degree of
“self-esteem” for the high cost firm and a low degree of cost difference among firms.
When 2 = 0, the scenario turns into a perfect information set-up where firm 2 is the
high cost firm. On the other hand, when 2 = 1, the context will be one where firm 2 is the
low cost firm. On either case, these are the scenarios with asymmetry among firms and
79
perfect information described in the previous subsection. Under either extreme, the low cost
Finally, high values of H will result in the inequality in expression (22) not
complied with, and therefore, under this context, the high cost firm would never be able to
preempt the low cost one. These results are analogous to the ones under perfect
information. Even though the assumptions appearing in this chapter are somewhat
restrictive, some important conclusions and considerations may be drawn from it. The
concluding subsection will provide these as well as some suggestions for future research.
III. CONCLUSIONS
approach was developed in this chapter. This model incorporates the real options
applies the recent advances combining standard real options reasoning with the analytical
tools provided by game theory. In particular, the purpose of this chapter is to study the
information is present.
From the development of the strategic options model for acquisitions, some
important conclusions may be drawn. Although the assumptions that prevail in this study
make the model quite restrictive, it may help to explain why several events occur in the
introduced to a model that includes asymmetry in investment costs, the high cost firm may
complete an acquisition before its low cost rival. This finding may be helpful in explaining
80
why sometimes the “small fish in the pond” preempts the larger ones to acquiring other
firms. In other words, imperfect information may be part of the reason behind some
acquisitions being completed by smaller and arguably higher cost ones that compete with
This study also provides support to the idea that competition leads to early
investment by firms in the context of acquisitions. A suitable model may also be found that
helps to explain why firms overvalue its targets when faced with competition for
acquisitions, and why these acquisitions are sometimes made by the higher cost firm.
restrictive. Particularly, assuming that firms’ valuation of their targets is exogenous to the
tractability and as a means to provide a general idea beneath the acquisition phenomenon, it
is valid. Data such as market or book value may be used for this approximation. Thus, the
general conclusions that appear in this chapter may serve as a basis for future research with
order to better deal with information complexities. This study introduces a basic signaling
model where only two values for investment costs are allowed. It is evident that models that
allow for more general informational contents should be developed. Another issue that
must be examined within the acquisitions and strategic options framework is related to the
welfare implications of the model. Pawlina and Kort (2006) analyzed the welfare
implications of cost asymmetry and they concluded that a significant asymmetry may be
81
socially desirable under perfect information. It remains to be studied whether this result is
support for the theoretical findings present in this work. Also, as stated before, some other
applications of the general model developed in the previous chapter are in the general
bargaining area, patent races, etc. The next chapter will provide another extension for this
general model. The particular case of international joint ventures will be analyzed and a
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CHAPTER 5
I. INTRODUCTION
The task of building market positions and competitive capabilities into new markets
or new lines of business requires significant investments. As a result, it is often in the best
interest of firms to share the implied risk of the investments. A partner may be sought in
order to share the “risky” costs and also in order to decrease the total investment. In this
However, in order to exercise the decision to expand, the parties face a difficult
decision that usually requires further capital commitment and thus, a renegotiation among
partners. In this sense, the timing when it is desirable to exercise the option to expand is
entry tool. As stated before, by engaging in IJV’s rather than acquisitions, firms can spread
risk over multiple capital providers. Also, multinational corporations (MNC’s) can take
advantage of local partners’ knowledge of domestic market conditions, legal and regulatory
uncertainty, and thus the need to utilize the valuation tools exemplified by the real options
reasoning. This reasoning provides the answers to key features such as uncertain demand
parameters, and the fact that MNC’s acquire the right, but not the obligation, to expand
83
after making a limited investment and thus exploit rather than avoid, the sources of
uncertainty.
the contracting parties to buy the equity of the partner who decides to withdraw. However,
this must not be viewed as the real options. IJV’s are real options in terms of the economic
opportunities to expand and grow in the future. Indeed, joint ventures may be viewed as
investments that provide firms with the opportunity to expand in favorable environments
while avoiding some of the losses from downside risk (Kogut, 1991). A key distinction
between general joint ventures and IJV’s is that the MNC is foreigner to a new market
under an IJV context, while this is not necessarily the case for general joint ventures
As is the case for most strategic investment projects, firms face several sources of
uncertainty. Among them, we can cite demand, cost, regulatory, or technology uncertainty.
In an international context, these sources are likely to be magnified since partners are
brought together along with different cultural backgrounds and with different social and
regulatory frameworks (Tong et al, 2006). The general model provided in chapter III
utilizes a general stochastic variable which can stem from any of the above sources.
The first study linking joint ventures with real options was done by Kogut (1991). A
key element in this study is the interpretation of a joint venture as an opportunity to acquire
or divest. A firm makes an initial investment in an IJV and then watches over the behavior
of a stochastic project value. When this value gets to a certain growth threshold, the MNC
may decide to complete the acquisition by purchasing the remaining equity from its partner.
On the other hand, the partners possess the option to terminate the venture and the MNC
84
may divest from it by selling its own equity. Therefore, the MNC possesses a percentage s
of the joint venture, while its partner owns the remaining part 1 –s.
After this study, several empirical studies provided support to the notion that IJV
investment captures the value of growth options into them. Among them, we can cite Chi
(2000), Kumar (2005), Tong and Reuer (2005). Folta and Miller (2002). All of these
studies deal with the IJV under a real options and game theoretic approach; and they all
assume that a non-cooperative strategic process underlies the IJV process. On the other
hand, Savva and Scholes (2006) combine the idea of strategic partnership with cooperative
game theory in order to develop a suitable model to treat strategic alliances and compare
All studies cited above utilize assumptions based on perfect information scenarios.
Information may result imperfect to parties involved in a joint venture out of several
The purpose of this chapter is to extend the general model presented in chapter III to
the particular features and assumptions necessary to deal with IJV’s, ventures in which
generally speaking, a MNC jointly invests with a domestic firm in order to purchase an
option to expand into a new market, new products, new technology, etc. The setting is
similar to the one in chapter IV in the sense that by engaging in a joint investment, a firm
possesses an option to acquire the partner firm (their equity share) once a certain threshold
is reached among conditions of uncertainty. This acquisition does also imply additional
investment costs due to learning, cultural integration, and regulatory obstacles among other
sources. However, in the context of an IJV, both partner firms acquire this option and
is precisely the purpose of this study. The next sections will develop a suitable model for
international joint ventures treated under a real options approach and under conditions of
asymmetry among firms and imperfect information surrounding the venture investment.
IJV’s as strategic growth options under asymmetry and imperfect information: The model
In order to construct the model, building blocks will be presented in the next
subsections. First, some peculiar features of IJV’s will be shown along with some key
assumptions needed to characterize the model. A basic model will be built considering a
perfect information scenario, and finally imperfect information will be included in order to
often foreseen as an unavoidable conclusion to the venture (Kogut, 1991). The timing and
identity of the acquisition are the critical values to be found in this context. Thus, the
acquisition is justified only when the perceived value to the buyer is greater than the
In this expression, s stands for the share of the venture owned by firm I (and
obviously 1 –s stands for the partner’s share), while P is the price of the investment for
acquiring the complete venture. Finally, C stands for the value of the call option that the
Where S is the value of stock of the joint venture and Ii stands for the required
investment costs. From expression (22), it results that the acquisition will only be
A key distinction between the acquisition scenario and the IJV context is that the
MNC possesses indeed two options: the option to complete the acquisition of the joint
venture and the option to divest from its investment and sell its share of the venture to its
partner. The first option is analogous to a financial call option while the second one is
similar to a financial put option. The results for financial options are readily found in the
intriguing, this study will continue under the premises of non-cooperative game theory in
which each firm tries to maximize its value and thus adopt its strategy (acquire or divest).
In the context of an IJV, asymmetry appears naturally. It may be assumed that the required
investment costs required for the MNC to complete the acquisition of a joint venture are
different than those of its partner when it acquires the joint investment. The main
contribution of this study to the IJV literature will be to outline the role that information
plays for the exercise of either the call option (acquisition) or the put option (divestment).
economic context in which the IJV takes place. This particular model assumes a single IJV,
and thus does not consider the more complicated compound option that develops when the
intention of the investment is to set a foothold to gain access into new markets and thus to
acquire a compound growth option. Under a compound option environment, the MNC may
decide to keep a “losing” venture, as long as it assures itself of the opportunity to grow into
87
adjacent markets. Although this is an appealing issue, this study is designed to be an
exploratory one into the role that information plays in an IJV context. The treatment of
compound options is evidently more complex and is left as an interesting topic for further
research.
As before, the joint venture provides instant profit flows according to:
= DJV (25)
Where DJV stands for the deterministic part of the joint venture profits and
expression (3):
where and are constants corresponding to the instantaneous drift and to the
random increment, which follows a Wiener process (normally distributed with mean zero
and variance dt). Thus, and may be interpreted as an industry’s growth rate and
assumption present in the literature (e.g. Dixit and Pyndick, 1994) is that must be less
costs under the IJV framework. Whereas in the competition for an acquisition, it may be
thought that the larger firm possesses lower investment costs, the case for an IJV is quite
different. Under an IJV, due to knowledge of local culture, regulatory environments, and
market specific conditions, the domestic firm may in fact possess a lower degree of
88
investment costs. Thus, the signals the domestic firm may send towards a completion of its
own venture acquisition are even more credible than the under the acquisition scenario.
The next step in building the suitable model for IJV’s under uncertainty and
subsection will do so by being based on previous work, particularly, the work by Gilroy
The original equity stake the MNC has invested is s. There is a time interval for
which the partners become acquainted with each other and at the end of that time span (T),
the MNC has to decide whether to continue with the venture by converting the IJV into a
cross-border merger (acquiring the remaining shares 1 –s) or divest the option and sell its
Thus, there are two triggers that result in different actions: Once reaches a certain
level U, the investment will be seen as an attractive one, and the merger will be completed
with the acquisition of the 1 –s stake owned by the domestic firm. On the other hand, if
reaches a level below L, the put option is exercised and the divestment will be completed
For the call option (acquisition) to be undertaken at time T, it must be the case that
the value of the call option exceeds the partner’s share value plus investment costs. On the
other hand, the MNC also holds the option to abandon the project and divest by selling it to
89
its domestic partner for an abandonment value B that might have been previously agreed
upon.
The results for the call option are standard results for a single firm investment
option and are present in the literature. Following Dixit and Pyndick, the following
expression follows:
The first line of the expression stands for a modified NPV rule, where the second
term reflects the option to wait for the acquisition investment. The second line represents a
The second option that a MNC possesses under the above assumptions is the option
to abandon the investment and sell its stake to the local partner. Upon this exercise, the
MNC forsakes the existing project with value sV and attains its abandonment value B. This
is analogous to a standard put option, whose results may also be found in the literature.
Thus, from the MNC standpoint, the strategic flexibility value from the divestment option
results in:
In this expression, TJV represents the value of the divestment option for the MNC in
the joint venture context. This result comes from the application of standard results for a
90
financial put option. B is the abandonment value or the previously agreed upon divestment
payment the MNC gets from its partner, s is the MNC’s original share of the investment, L
stands for the divestment investment threshold, and finally, 2 is the result for the following
expression:
L = 2B/s(2 – 1) (30)
The complete value of the flexibility that the MNC owns under an IJV agreement is
the result for the compound option consisting on considering all the alternatives together.
The mathematical complexity of these expressions is beyond the purposes of this study and
is left as a suggestion for future research. The aim of this work is to provide insights into
the role that informational imperfection plays in strategic investments such as the one
exemplified by international joint ventures. The next subsection will show precisely how
the thresholds may be modified once imperfect information is introduced to the model.
information.
result of the difficulty to calculate the learning costs implicit into a new culture adoption,
the costs associated with different legal and regulatory environments, and the development
91
of the necessary organizational capabilities needed to pursue an acquisition project in this
framework. These costs are relevant and must be considered when calculating the total cost
of an acquisition investment. On the other hand, if the divestment value is agreed upon in
the joint venture agreement, there should be no source for imperfect information with
As was the case in the previous chapters, a firm, in this case the MNC, does not
have enough information about its own investment costs. The MNC may perfectly know
the market valuation for the venture, but does not have enough information about its
learning costs in particular once an acquisition may be completed. Following the basic
ideas developed in chapter III, the MNC knows its investment costs are either high or low,
Thus, from its own standpoint, the necessary cost that result in order to pursue the
acquisition are:
In this expression, s is the share of the joint venture owned by the MNC, S is the
total stock valuation of the venture, i is the parameter that results in either a low or a high
valuation for the investment costs, and is the “self-esteem” parameter introduced in
When this new expression for P is substituted into the upper threshold obtained in
expression (27), the calculation for this threshold is modified. If there is a high degree of
investment costs may be lower than those for the perfect information scenario. Evidently,
92
the acquisition threshold results in a lower value and therefore, it would evolve into an
When the opposite is true; that is, a low “self-esteem” value and/or a relatively large
value of H/L (much larger than 1), a late investment scenario develops in which the
investment threshold raises to a level above the perfect information level U and where the
The effect that imperfect information has on the divestment option is quite different.
An important assumption made in this study is that the abandonment value B has been
agreed upon in the joint venture contract, and therefore there is always a perfect
information scenario when calculating the value of the put option. Evidently, this fact is
present in expressions (28) and (30) for the put option valuation and the divestment
threshold, where all parameters are known ex-ante except the stochastic variable .
However, in order to calculate the complete chooser option, which is a compound option
that integrates all the possible outcomes, information plays a role that is proportional to the
role it plays in the calculation of the acquisition threshold and the corresponding project
valuation. The next section provides concluding comments with regards to international
joint ventures from the perspective of strategic growth options as well as some suggestions
V. CONCLUSIONS
The study of international joint ventures from the perspective of the real options
methodology is relatively recent and although there are several empirical studies that
provide support to the notion that IJV’s possess a lot of features present in real options,
93
there are relatively few studies that have tried to develop a suitable model for this
phenomenon under a real options approach. Furthermore, the role that information plays in
By extending the model developed by Gilroy and Lukas (2006), this study intends
to provide insights into the importance that imperfect information has for the calculation of
for IJV’s. The main finding appearing in this study is that imperfect information in joint
ventures may result in either early or late investment, and therefore, it may occur at a less
than optimal timing, which may result in a loss of efficiency and deadweight losses.
It must be acknowledged that some important restrictions have been placed on the
development of this model. It should be noted that, similar to the acquisitions phenomenon
investigated in chapter IV, the framework in which this model is built, is one of a single
investment and thus, the potential of more complex options in which a firm is willing to
incur losses in exchange of later growth options, must be analyzed in future studies. It has
also been acknowledged that the complete option calculation requires a more advance
mathematical treatment which is beyond this study’s scope. However, the effect that
imperfect information has on the more complex option is always in the same direction than
abandonment or divestment value that is known to both parties (the MNC and the domestic
partner) and that is previously agreed upon in the joint venture contract. This assumption
results in a perfect information scenario for the divestment option calculation and thus there
94
Empirical studies may be developed in order to provide support to the conceptual
and theoretical findings present in this chapter. It is particularly interesting to find out
whether high or low signals for the investment costs result in the corresponding early or
late acquisitions of joint ventures by MNC’s. Finally, another appealing area for future
research is to utilize the ideas behind cooperative game theory in order to analyze
partnerships such as IJV’s from that perspective. Following on the work by Savaa and
Scholes (2007), the results obtained from a real options game theoretic approach must be
compared to those obtained under the cooperative results in order to better understand the
joint venture phenomenon, which by its own nature, may lend itself to a different approach
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CHAPTER 6
environments are more complex and uncertain than ever before. The globalization process
has brought along a rapid pace of change, and thus new challenges for both academics and
practitioners. This fact has had several consequences from the strategic and management
standpoints. Among these consequences, we can cite the rapid consolidation inside
industries, with corresponding merger waves, the need for the internationalization of
businesses and therefore an increasing pace of international joint ventures, and the
This complex environment brings along the need for a better grasp of phenomena
such as the ones outlined above. With relation to this study, three key elements stand out as
necessary ingredients towards a more sophisticated and complete approach to the study and
practice of contemporary strategic investments. The first one is the prevailing uncertainty.
The new growth opportunities for industries are often evident in markets located in more
unstable environments such as the ones present in emerging economies and markets.
Secondly, asymmetry among firms is present in the development of new markets and
technologies. Firms possess different cost structures, differentiated learning capabilities and
quite frequently, they operate under different legal and regulatory environments. Finally,
imperfect information, stemming from several sources such as agency problems, access (or
timing, and demand conditions, all of which are subject to modeling exercises.
The real options approach has been developed in order to better deal with
Game theory provides the necessary tools to deal with the imperfect competition that most
of the time presents itself at the industry level, and the developments in informational game
strategic framework.
Plenty of work has been done in trying to better understand strategic projects under
uncertainty. Game theoretic tools have been added to the real options methodology in order
more complete framework. Although most of these studies are based in the assumption of
duopolistic competition among symmetric firms, a few have also considered the
asymmetric nature of competing firms. On the other hand, a few studies have taken into
account imperfect information and added it to its work, although these studies have also
The purpose of this study is to add the three key elements described above and
provide the basis for more complete models that may be helpful in order to study the
strategic investment phenomenon. By extending the models provided by Pawlina and Kort
(2006) and Gilroy and Lukas (2005) among others, this study incorporates the ideas of a
basic signaling game into models that deal with strategic investment with uncertainty and
asymmetry such as the ones cited above. By doing so, this study gives rise to equilibria that
of a general model for strategic growth options under asymmetry and imperfect
information. Under the assumptions of a rather basic game, the key contribution of this
chapter is that while under a perfect information scenario with asymmetric firms
(investment costs asymmetry), the role of the leader is always pre-assigned to the low cost
firm, this may not be the case for the imperfect information context. Two kinds of
whose results are always the same than under a perfect information scenario, since any
signal by firms always reveals its true type; and a pooling equilibrium which results in the
more ambiguous results previously stated. From a strategic point of view, also two types of
equilibrium appear, a preemption scenario and a sequential investment. When the relative
cost advantage is low, the preemption scenario is the one to consider while if this advantage
is high, a sequential investment where imperfect information plays no role is the relevant
one. For all cases, the corresponding investment thresholds are obtained.
The key parameter that this study introduces is a “self-esteem” parameter which
represents the probability that a firm places on itself being the cost leader. In order for these
results to appear, it must be the case that the high cost firm possesses a relatively high
degree of this “self-esteem” along with a relatively low value of cost disadvantage. This
kind of results may help to explain why sometimes smaller firms with arguably higher costs
Based on the framework provided by the general model, chapters IV and V extend
this work in order to develop suitable models for specific applications. Chapter IV is
concerned with the acquisitions phenomenon while chapter V deals with international joint
ventures.
98
It is important to acknowledge that some restrictive assumptions are placed on both
chapters. In particular, the possibility for compound growth options is not analyzed.
Compound growth options result when a firm considers an investment as a source for
potential further investments, and thus may be willing to forego profit flows in order to
“purchase” the option for further acquisitions or IJV’s. This kind of investment is often
found in the strategic planning of firms. For instance, when a firm decides to gain a
foothold in a new geographic market that in turn has adjacent and potentially more
attractive markets, it may be willing to suffer losses in its first investment, as long as it has
the potential for future access and success in those markets. However, the mathematical
complexity of dealing with compound options makes the task rather difficult and provides
an avenue for future research. This study is developed under the assumption of single
investment projects and in the context of exercising and valuing a single growth option.
information. This work is developed under the assumptions of a simple signaling game
where a firm can either be a low cost or a high cost firm. The purpose of this study is to
shed light on the role that information plays in the context of strategic investments and thus
this basic model achieves its goal. However, in order to continue with this research line,
more sophisticated and general models should appear that deal with informational
anomalies stemming from probability distributions and where more sophisticated signaling
asymmetric (in investment costs) firms compete for the opportunity to complete an
acquisition project. When perfect information is assumed, the low cost firm is always the
one completing the project. However, it sometimes happens that smaller firms preempt
99
larger ones to acquisitions. In this chapter, it is suggested that imperfect information may be
In this case, when a small degree of investment cost disparity (disadvantage) exists
and a firm possesses a high “self-esteem” parameter, it may be the case that the high cost
firm invests “early” and preempts the low cost firm to the acquisition. The conditions under
which this may happen are discussed and analyzed. When a large degree of cost disparity
exists or the high cost firm has a low enough “self-esteem”, the conditions revert to the
perfect information scenario when the low cost firm is always the one that completes the
project. Investment thresholds related to the realization of the stochastic variable are
Finally, chapter V describes the international joint venture scenario. Fewer studies
are found in the literature with regards to IJV’s as real options. The main rationale behind
this model is based on the conceptual ideas of Kogut (1991). Under his study, the situation
that is depicted is one where a foreign multinational corporation agrees to a joint venture
with a domestic partner. Once a certain time frame is achieved, the evolution of the venture
arrives to a state such that the MNC either acquires the share owned by its partner or
By building on the model proposed by Gilroy and Lukas (2005), this study
stochastic variable arrives to a certain upper threshold, the acquisition will be completed.
On the contrary, if it arrives to a specific lower threshold, the MNC sells its share to the
domestic partner. These thresholds are obtained for the case of perfect information.
is discussed. Under the assumptions of this chapter, imperfect information and the degrees
100
of the “self-esteem” and asymmetry parameters may result in either early or late exercise of
the call (acquisition) or put (divestment) options. In the two applications spelled out in this
dissertation, the proposed theoretical framework can be clearly applied, for which this is a
There are other extensions that remain to be studied. This model could be applied to
the understanding of bargaining processes, patent races, and R&D as strategic investments.
All of these events often evolve in the context of uncertainty, asymmetry among rivals, and
imperfect information scenarios. Furthermore, they have strong strategic consequences for
firms and industries, and thus, appear to be suitable extensions of the general model
business environments, and may be helpful in explaining some of the anomalies present in
the literature.
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Appendix 1: Threshold for the investment model under asymmetry and imperfect
information
In this appendix, the threshold for the investment of firm 2 under a pooling
equilibrium scenario is calculated once firm has invested in the first period. As it was
previously stated, the project value follows a geometric Brownian motion, since it is based
on a linear relationship with the stochastic variable , and thus, it behaves itself as a
geometric Brownian motion. The threshold value * maximizes the project (firm) value.
techniques to solve for firm 2’s maximization problem. Thus, for firm 2, the Bellman
equation in the continuation region (when the investment is not yet made) is the following:
This expression states that the sum of the expected capital gain and the payout from
the firm over the infinitesimal interval dt equals the riskless rate of return r. Applying Ito’s
lemma to the right hand side, and dividing both sides by dt (tending to zero) results in the
The general solution for this differential equation follows the general form:
106
1 = ½ - /2 + [(/2 – ½)2 + 2r/2]1/2 (A5)
order to find the values for the constants A1 and A2, boundary conditions must be observed.
This condition states that the project (firm) value is zero at =0. This condition
arises from the fact that if the value V goes to 0, it will stay at zero as an implication of the
stochastic process (Dixit and Pyndick, 1994). In turn, this condition implies that the
Respectively, these are the value-matching and the smooth-pasting conditions, and
they ensure continuity and differentiability of the value function at the investment
threshold. By substituting the general form (A3) into (A8) and (A9), both the optimal
2*=[/(-1)]I2(r-)/(D11-D01) (A10)
and
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However, from the perspective of firm 2, I2 depends on both the value of , as well
as the values esteemed for 2. Thus, the complete expressions for the optimal investment
threshold as well as its corresponding project value are shown in equations 3 and 4.
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Appendix 2: Proof of Proposition 2
Under a preemption scenario, let’s assume that firm 1 is the low cost firm and that it
has the opportunity to invest first. Under preemption assumptions, the cost advantage
(disadvantage) is small, and both firms have the incentive to become leaders in the
Under perfect information, the low cost firm invests at the minimum of its own
monopoly investment threshold (as if there were no other rival firm for the investment) or
the high cost firm’s indifference threshold (when the high cost firm is indifferent between
V2L() is the value of the firm (project) when firm 2 is the investment leader while
V2F() is the firm’s value when it becomes the follower. The solution to this expression is
the threshold 2P, and the cost leader invests at the minimum of this threshold and
expression (10).
combination of a small cost difference (value of close to 1) along with a high level of
“self-esteem” (2 close to 1) results in the possibility of the high cost firm preempting the
investment by the low cost firm. For this to happen, it must be the case that the high cost
(9) (that is, as long as a pooling equilibrium exists), an interval for exists such that the
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high cost firm (firm 2 for the aforementioned expression) actually preempts the low cost
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BIOGRAPHICAL SKETCH
bachelor’s degree in Electrical Engineering in 1984 and his MBA in 1997. From 1985 until
now he has been employed in Comercial Encanto as the Chief Operations Officer. He has
also taught Mathematics courses at Preparatoria Eugenio Garza Sada. In 1999, Eduardo
began his studies leading to the Ph. D. candidacy at EGADE-Monterrey. These studies
included taking courses at Tufts University, London School of Economics, and Rice
CV in Monterrey, Mexico.
Permanent Address: Antillas 427, Col. Vista Hermosa, Monterrey, Nuevo León 64620,
Mexico.
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