CHAPTER 1

INTRODUCTION TO THE STUDY

I. INTRODUCTION

An important ingredient in today’s business environment is undoubtedly the ever

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

perfectly competitive environments or under monopolistic assumptions, and thus, they do

not take into account the strategic implications of many investment projects.

Most competitive settings in today’s business environment are imperfect. In order to

incorporate oligopolistic assumptions that integrate strategic behavior by participants in an

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

of this recent literature is based on the assumptions of duopolistic competition with

identical firms and perfect information flows.

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

environment is imperfect or asymmetric information. In this case, firms operating in an

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

informational imperfections that permeate a “real” business environment. Furthermore, this

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.

II. STATEMENT OF RESEARCH PROBLEM

The most utilized tool in investment projects analysis is the DCF (discounted cash

flows) valuation methodology. However, it is well documented in the finance and

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

such as risky political or macroeconomic environments.

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

different studies in different areas. Comentario [U1]: Once you cite a

Table, you need to place it on the
page that follows.
The origin of the real options approach can be traced to Myers (1977). The analogy

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

land to complete further investment projects. This

3
Table 1: Real Option Topics and Areas of Aplication

Topic or Area References

Natural resources Tourinho (1979), Brennan and Schwartz (1985ª,
1985b), Siegel, Smith and Paddock (1987), Paddock,
Siegel, and Smith (1988), Trigeorgis (1990),
Schwartz (1997, 1998), Smit (1997), Tufano (1998),
Cortazar, Schwartz and Casassus (2000), Moel and
Tufano (2000)
Competition and corporate strategies Bandwin (1982, 1989, 1991), Trigeorgis (1991,
1996), Kulatilaka and Perotti (1992), Smit and
Trigeorgis (1995), Grenadier and Weiss (1997),
Farzin, Huisman, and Kort (1998), Busby and Pitts
(1997), Economides (1999)
Manufacturing Kulatilaka (1984, 1988, 1993), Baldwin and Clark
(1994, 1996), He and Pindyck (1992), Kamrad and
Ernst (1995), Mauer and Ott (1995)
Housing and real estate Stulz and Johnson (1985), Titman (1985), Capozza
and Li (1994), Grenadier (1995, 1996), Childs,
Riddiough, and Triantis (1996), Sirmans (1997),
Downing and Wallace (2000)
International Baldwin (1987), Dixit (1989), Kogut and Kulatilaka
(1994), Bell (1995), Buckley and Tse (1996), Capel
(1997), Schich (1997), Buckley (1998)
R&D Morris, Teisberg, and Kolbe (1991), Newton and
Pearson (1994), Childs, Ott, and Triantis (1995),
Falulkner (1996), Ott and Thompson (1996), (Herath
and Parkm (1999), Carter & Edwards (2001), Perlitz,
Peske, and Schrank (2001)
Regulated firms and utilities Mason and Baldwin (1988), Teisberg (1990, 1993,
1994), Edleson and Reinhardt (1995)
M&A and corporate governance Hathaway (1990), Smith and Triantis (1994, 1995),
Hiraki (1995), Vila and Schary (1995), Ikenberry and
Vermaelen (1996),
Interest rates Ingersoll and Ross (1992), Ross (1995), Lee (1997)
Inventory Chung (1990), Stowe and Gehr (1991), Stowe and Su
(1997)
Labor force Kandel and Pearson (1995), Bloom (2000)
Venture capital Sahlman (1993), Willner (1995), Gompers (1995),
Zhang (1999)
Advertising Epstein, Mayor, Schonbucher, Whalley, and Wilmott
(1998)
Law Triantis and Triantis (1998)
Hysteresis effects and firm behavior Pindyck (1991), Dixit and Pindyck (1994)
Environmental compliance and conservation Purvis, Boggess, Moss, and Holt (1995), Wiebe,
Tegene, and Kuhn (1997)
Industrial organization Imai (2000), Huisman and Kort (2000)
Patents and innovation, high technology pricing Schwartz and Moon (2000), Kellogg and Charnes
(2000), Bloom and Van Reenen (2001), Boer (2000),
McGrath and MacMillan (2000)
Source: Lander and Pinches (1998)

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

land market for this case.

There are several kinds of investment projects that may require an analysis based on

strategic considerations. When firms undertake an investment, a key element is the

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

competitive environments. In the first case, it is not significant to take competitors’

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

competitive or oligopolistic settings (Smit, 2002). Under these circumstances, investment

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

competitive environments. The strategic value of investments is interpreted as the

acquisition of growth opportunities relative to competitors (Kulatilaka and Perotti, 1998).

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

projects under uncertainty and strategic considerations.

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.

a. Strategic Growth Options

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.

b. Strategic Growth Options under Asymmetric Conditions

Several sources of asymmetry arise in industries’ competitive environments. Among

potential sources of asymmetry, we can cite the following: cost asymmetry, revenue

asymmetry, and information asymmetry. Cost asymmetry may be obtained by way of

different scales, different technologies or simply different regulatory environment. Revenue

or demand asymmetry may be had by having different reaction capabilities to market

conditions. In other words, firms may have similar cost structures buy may react differently

to changing market conditions stemming from learning capabilities. Finally, informational

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

under competitive settings and some sort of asymmetry amongst firms.

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

from different access to capital markets, different degrees of organizational flexibility or

quite simply, as a consequence of different regulatory conditions. Another feature of this

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

a strategic advantage as a result of investments, is generalized. Kong and Kwok (2006) go a

step further by accounting for asymmetry in both investment costs and revenue flows.

Thus, they develop a richer set of strategic interactions.

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

seldom occurs? Thijssen et al (2003) investigate the role of information on strategic

investments imposing either a Stackelberg advantage or a follower advantage as potential

gains from a first-mover or an information spillover advantage, respectively. However, this

study is more focused on the welfare effects of information imperfection. Smit et al. (2004)

develop a model that treats acquisitions under asymmetrical information as a bidding

contest game. They recognize the fact that imperfect information and information

asymmetry play a key role in the valuation process in acquisitions. Nevertheless, the

departure point is that of two identical bidders.

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

studies have tried to incorporate imperfect or asymmetric information to a strategic options

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

issues that are present in today’s business environment.

c. Applications to Mergers and Acquisitions

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

methodology has been applied to a multiplicity of investment projects in different areas of

the business environment. Table 1 shows some of the research areas where this approach

has been undertaken.

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,

2006). There appears to be a growing appetite for consolidation in a large variety of

industries. Among them, the financial services industry, the cement industry, and the

pharmaceutical industry serve as examples of this M&A wave.

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

considerations embedded in an imperfect oligolopolistic environment. A few studies have

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

environment. In particular, it views acquisitions as the purchase of further growth options

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

potentially large markets.

Nevertheless, there is a need to develop a theoretical framework which is applicable

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

firms under imperfect information.

As stated before, it is a rare occurrence where firms participating in an imperfectly

competitive environment are actually symmetrical, and where information flows in a

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

imperfection embedded in potential targets’ information flows, the potential reaction by

rivals to a merger or acquisition, and the uncertain nature of today’s business environment.

d. Applications to International Joint Ventures

An analysis of international joint ventures provides interesting insights into

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

some contractual agreement.

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

conditions or in the context of imperfect information.

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.

As is the case for mergers and acquisitions, it is sensible to think of informational

imperfections. In a joint venture environment, there may be informational asymmetries

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

Investment projects need to be studied in a more comprehensive way to take better

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

therefore informational asymmetries occur.

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?

III. SIGNIFICANCE OF THE STUDY

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

game with asymmetric information.

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

of real options as a valuable tool in valuation processes. Nevertheless, this technique by

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

better models to study this phenomenon clearly appears. A straightforward application of

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

asymmetric firms competing for an acquisition project.

Another extension of the model is the application to international joint ventures.

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

differences. While acquisitions may be treated as “one-sided” options where a firm

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

consideration strategic behavior and asymmetry by participants will be developed.

It is important to acknowledge that in order to provide support for the conceptual

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

R&D investment, technology adoption, greenfield investment in international markets, etc.

14
In these strategic investment projects, the main characteristics of the competitive

environment proposed under the above assumptions, seem to exist.

IV. RESEARCH QUESTIONS

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

imperfect information flows?

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.

V. DELIMITATIONS AND LIMITATIONS OF THE STUDY

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

competitive environment. Such may be the case of estate development or energy

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

competitive scenario. Finally, a number of scenarios may be thought of where no

asymmetric information exists, such as perfect auction bidding. Nevertheless, several

applications such as the ones discussed above seem to have the characteristics alluded to in

this introductory chapter.

VI. ORGANIZATION OF THE DISSERTATION

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

future research, will be presented in the final part of this work.

16
 CHAPTER 2

LITERATURE REVIEW

I. INTRODUCTION

In this chapter, an overview of the relevant literature is presented. Three main

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

the notion of imperfect or asymmetric information flows.

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

strategic acquisition setting.

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

phenomenon, it must be acknowledged that international joint ventures have increasing

occurrence in today’s business world.

17
 II. THE REAL OPTIONS APPROACH

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, revenue flows uncertainty, and informational uncertainty. However,

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

assumptions of monopoly or founded on the idea of

perfectly competitive industries. In either case, the actions of a firm are not affected by its

rivals’ reactions.

Table 3: Growth options studies

Type Description Studies
Research and development An R&D investment may Weeds (2002)
entail a firm to a Schwartz (2003)
competitive advantage on
new product development
Strategic acquisition An acquisition may Smith and Triantis (1995)
provide access to new Smit (2002)
markets Smit et al (2004)
Joint ventures Equivalent to the purchase Kogut (1991)
of a right to complete Gilroy and Lukas (2005)
acquisitions at later dates
or to gain footholds in new
markets for later
investments
Technology adoption Investment in new Kulatilaka and Perotti
technologies may provide (1998)
strategic growth
opportunities by way of
first mover or cost
advantage
Land development Lease on new land may be Moel and Tufano (2003)
similar to acquisition of
rights for later growth
opportunities (real estate,
mining, natural resources)
Capacity building Capacity may signal a Kulatilaka and Perotti
commitment for future (1999)
aggressive strategy, and
viewed as an opportunity to
take advantage of future
positive demand

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

project valuation and analysis in a more comprehensive manner.

a. Strategic Behavior of Firms

In order to deal with imperfect competition, the economics literature, and

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

the scope of this work and thus this review is selective.

One of the main considerations present in “strategic behavior” in the industrial

organization context is related to the effects of entry or potential entry by

rivals into an industry. Dixit (1980) analyzes the role of investment in entry deterrence. In Comentario [U7]: Poor sentence.
please redo.

this study, investment in capacity is utilized by firms as a signal of their commitment to

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

transaction costs, and no legal impediments to mergers; in a duopolistic setting, firms

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

preemption games. In this deterministic setting, several equilibrium strategies may be

observed under different conditions in the preemption game by an incumbent and a

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

reasoning into the real options methodology.

b. Strategic Growth Options

Under oligopolistic competition, investment opportunities are exercised under the

acknowledgement of competitive reaction by rivals. In these conditions, a strategic

investment no longer represents an internal value optimization problem against nature

(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

competitive interactions (game theory) (Smit and Trigeorgis, 2003).

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

competitors, strategic investment under uncertain conditions can be viewed as a

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

result in preemption altogether.

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.

Grenadier (2002) presents a tractable approach to derive equilibrium investment

strategies in a continuous-time Cournot framework. The main “tool” that appears in this

study is that, by transforming the industry demand curve, it can approximate an

oligopolistic setting to an “artificial” perfectly competitive industry. In this manner the

author is able to provide closed form solutions in a continuous time model.

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.

Under this proposed scenario, increasing competition unambiguously leads firms to

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

ingredient for the transformed demand curve is that of symmetrical firms.

Weeds (2002) extends previous studies in the industrial organization literature in

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

assumption is that of symmetrical firms. An important feature of this study is that it

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

to asymmetry would provide a unique definition.

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

scenario the preemption equilibrium is appropriate to environments with low uncertainty,

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

explain the investment waves that exist in certain industries.

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

the value of being the leader in this setting.

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

the adoption of new technologies, whether to invest in an intermediate (and cheaper)

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

company. The model itself is a variation of prototype models of irreversible investment

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

assumption of duopolistic competition, to a three firm scenario. In this symmetrical 3 firm

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

“even” investors will invest sooner.

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.

c. Strategic Growth Options with Asymmetric Firms

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

following lines will provide a brief overview of these studies.

Smit and Trigeorgis (2003) develop a conceptual model to analyze an innovation

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

be studied: a simultaneous investment game and a sequential investment scenario, in which

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.

Huisman et al (2003) develop a model to extend the prevailing Industrial

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

to place a new investment (potentially R&D or technology adoption) to gain a strategic

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

affected by competition. Finally, a simultaneous investment equilibrium is achieved with

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

enough, the result is sequential investment.

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

welfare analysis is that it is possible that a preemptive or sequential equilibrium under

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

above studies while incorporating revenue flow (or profit) asymmetry.

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.

d. Strategic Options under Imperfect Information

The assumption of complete information is often unrealistic. Grenadier (1999)

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

model assumes the existence of n symmetric firms.

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

in the strategic options basic literature..

Martzoukos and Zacharias (2001) develop a model to analyze option games with

incomplete information and spillovers. Under their proposed setting, learning may be

achieved in a variety of ways: by acquiring information, exploration or marketing research.

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.

Thijssen et al (2003) study the effect of imperfect information on strategic

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

(Stackelberg) can be created, as well as a second mover (follower) advantage stemming

33
from information spillovers. Thus, two different situations arise from the relative weight of

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

IJV’s) will follow.

34
 III. ACQUISITIONS AS STRATEGIC GROWTH OPTIONS

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

they possess several characteristics that are inherent to this

Figure 1: Path for strategic option analysis

DCF Analysis
(Deterministic)

Real options Industrial Organization

(Uncertainty) Imperfect competition
Perfect competition 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

to enter new markets or to make further acquisitions in related markets or industries at a

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

the acquisitions umbrella.

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

the strategy issue that is adhered to this process.

Smit (2002) captures in a conceptual study the importance of strategic behavior in an

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

of scale, as footholds to new and potentially more profitable markets, or as a way to

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

theoretical models that operationalize the conceptual reasoning in this study.

Lambrecht (2004) utilizes a real options approach to provide a theoretical

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

inefficiently late, and thereby decrease total value.

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

information about firms’ resources on targets’ valuation. Under a two-player setting, a

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

higher information costs.

As it can be inferred from the above paragraphs, there have been limited studies on

acquisitions as strategic growth options. Nevertheless, it seems that acquisitions as an

economic phenomenon possess the necessary ingredients for a deeper understanding under

a strategic options framework: uncertainty in future cash flows, an important strategic

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

better understand the strategic acquisitions phenomenon.

IV. INTERNATIONAL JOINT VENTURES AS STRATEGIC GROWTH

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

considerations, as opposed to transaction costs analysis. Furthermore, Tong et al (2005)

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

value, but other types of IJV do not.

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

the base rate forecast underlying the valuation of the business.

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’

growth expectations, and when the volatility expectations diverge.

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

(1991), they characterize minority investments as two-stage compound options. Exercising

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

rivals in the marketplace, partner buyout is more likely.

40
 In general, real option theory suggests that foreign direct investment (FDI) is a

platform utilized by multinational enterprises (MNE’s) to carry further investments abroad.

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

such, it does not take into account strategic considerations.

Juan et al (2007) focus their research in international joint ventures on the treatment

of compensation options present in joint venture agreements as non-standard real options.

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

real options for future growth.

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

its development due to the strong assumptions of complete markets.

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

advances in the development of a suitable model for this phenomenon.

V. SUMMARY

During the introductory chapters, this study has tried to introduce the research

problem. The notion of strategic options as an analytical tool towards a better

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

business environment: asymmetry among firms and imperfect information. It is important

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

create this general framework.

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

sometimes asymmetric information. This may be due to regulation, agency problems, or

imperfectly informative signals about the feasibility or profitability of investment projects.

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

strategic acquisitions and international joint ventures, respectively.

43
 CHAPTER 3

STRATEGIC GROWTH OPTIONS UNDER ASYMMETRY AND IMPERFECT

INFORMATION: THE MODEL

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

generally obtained: a preemption equilibrium scenario and a sequential investment one.

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

solution. Since the purpose of a firm under an investment project perspective is to

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

suggest new avenues for future research.

II. MODEL AND ASSUMPTIONS

This section is concerned with developing a general model for the treatment for

strategic investment projects occurring under asymmetry and imperfect information. The

building blocks for this model appear in the next subsections.

a. Growth Options under Asymmetry

As stated in the above paragraphs, this study intends to provide a model that is able

to incorporate asymmetry in its analysis. Particularly, it is concerned with investment cost

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

follower while firm 2 undertakes the investment previously; finally, simultaneous

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

known in the standard (non strategic) real options theory.

Generally speaking, the instantaneous profit of firm i, where i  {1,2}, may be

expressed as:

NiNj() = DNiNj, (1)

where DNiNj stands for the deterministic part of the profit function, and where the

following are assumed:

D10 > D00,

D10 > D11,

D11 > D01, and

D00 > D01.

Nk = 0, if firm k has not invested, and Nk = 1 if firm k has invested.

 follows a geometric Brownian motion according to the following expression:

47
 d(t) = (t)dt + (t)dz, (2)

where  and  are constants corresponding to the instantaneous drift and to the

instantaneous standard deviation, dt is the infinitesimal time increment and dz is 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

volatility, respectively. The riskless rate will be denominated as r, and a necessary

assumption present in the literature (e.g. Dixit and Pyndick, 1994) is that  must be less

than r in order for finite solutions to exist.

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

assumptions allow the analysis from a Cournot or Stackelberg competition standpoint.

b. Growth options under asymmetry and imperfect information

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

(1,infinity) utilized by Pawlina and Kort.

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

sequential investment by the follower; and finally, a simultaneous investment scenario in

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

contribution of this study is in the addition of imperfect information as a factor affecting

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

separating equilibrium and a pooling equilibrium. In a separating equilibrium, the leader in

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

and on the realization of the stochastic variable . The realization of  is common

knowledge to all the firms participating in the investment opportunity.

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

possesses about firm 1’s cost type.

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

earn profits D in the next period.

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

simultaneous investment scenario.

Finally, if  is located between both thresholds, then the following arises:

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

constants in the geometric Brownian motion description

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

firm 2 is indifferent between making or not making the investment in period 2.

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,

whereas a value of  close to 0 shows a low degree of “self-esteem”.

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

cost leader always becomes the investment leader.

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.

c. Value functions and investment thresholds

In either form of equilibrium (pooling or separating), it is important to analyze the

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

options theory according to dynamic programming techniques.

Following a dynamic programming methodology, such as the one found in Dixit

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

Pawlina and Kort (2006), and thus:

2* = [/(-1)](r – )/D11 – D01[2L + (1-2)H]I (3)

Where  is defined as:

53
  = ½ - /2 + (3A)

In turn, the corresponding value for the investment project for firm 2 is expressed

by the following expression:

V2 = D01/(r – ) + [*(D10 – D01)/(r – ) – I](/*)for  ≤ *  

V2 = D11/(r – ) for larger values of .

Appendix 1 shows the way this threshold and the corresponding project (firm) value

have been calculated.

Once the project value for firm 2 has been calculated, it is straightforward to

calculate the corresponding value for firm 1.

V1 = D10/(r – ) - I - [*(D10 – D11)/(r – ) – I](/*)for  ≤ * 

V1 = D11/(r – ) for larger values of .

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

follower in an analogous manner to the results of Pawlina and Kort.

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,

considering that the realization of  is above the no investment threshold.

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

same mentioned in the strategic options literature: a preemption equilibrium, a sequential

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

work. In following subsections, the different kinds of equilibrium will be analyzed.

An important consideration is that while the strategic options model under

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

following proposition arises:

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

of either a separating or a pooling equilibrium.

d. Conditions for the existence of a separating equilibrium

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

 that lie between both thresholds.

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

following notation is utilized:

V1/D=D00 + E{V/D=D01} ≥ V1/D=D10 + E{V1/D=D11}-I, (6)

Where E stands for the expectation operator and  is a discount factor.

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.

e. Conditions for the existence of a pooling equilibrium

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

purpose, then the following expression may be applied:

2V2/D=D11 – I + (1-2)V2/D=D01 < 0 (7)

For values of  that lie above firm 2’s investment threshold *, from expression (4)

it may be said that

V2 = Dij/(r-) – I2 (8)

And thus, after some algebraic manipulations, it yields that the range of  for a

pooling equilibrium to exist results in:

 < 2(r-)I/[2D11 + (1-2)D01] (9)

In other words, the existence of a pooling equilibrium is mainly affected by the

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

introduced, that discussion will be left for later works.

III. TYPES OF STRATEGIC EQUILIBRIUM

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

asymmetry scenario. The first scenario to be studied is a preemption equilibrium. Under a

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

information assumptions, a sequential investment equilibrium arises when the cost

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

is involved, particularly under pooling equilibrium conditions. The next subsections

analyze the two different settings and their corresponding results.

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).

When a firm possesses a monopoly over an investment opportunity and is inserted

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)

On the other hand, once competition is introduced under a separating equilibrium

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.

Therefore, competition under conditions of uncertainty and information asymmetry

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

separating equilibrium scenario.

Alternatively, a pooling equilibrium yields different and more ambiguous results.

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

possesses a high “self-esteem” coefficient 2.

Let’s suppose that firm 2 now has the opportunity to invest first. Then, expression

(10) would be transformed by both and 2 as follows:

2M = [2L+ (1-2)H](/-1)I(r-)/(D10-D00) (11)

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.

b. Sequential investment equilibrium

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.

As in previous cases, a separating equilibrium under the imperfect information

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

threshold is obtained by expression (10).

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

reflects the myopic behavior found in studies such as Leahy (1993).

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.

In other words, the sequential investment scenario under either a pooling or a

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:

Proposition 3: When imperfect information is introduced with a large cost

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

either a separating or a pooling equilibrium.

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

Important distinctions are found when introducing imperfect information to the

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

conditions, or simultaneous investment conditions. With informational content,

simultaneous investment results in a trivial result since information does not have any

influence in the outcome.

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

not always have to be the cost leader.

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

concentrate on this particular phenomenon and its own specific characteristics.

64
 CHAPTER 4

AN APPLICATION OF STRATEGIC GROWTH OPTIONS UNDER ASYMMETRY

AND IMPERFECT INFORMATION: ACQUISITIONS

I. INTRODUCTION

Acquisitions are often analyzed and valued by practitioners under uncertain

environments. Under these conditions, traditional DCF (discounted cash flows) valuation

techniques may be flawed or quite simply, incomplete. Smith (1995) conceptually

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

fails to capture the idea of acquisitions under competitive environments, particularly,

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

takeover deals incorporating the concepts of imperfect information, learning and

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

imperfect information. They treat acquisitions as auctions by symmetric firms under

65
imperfect information. Nevertheless, these studies do not intend to analyze the phenomenon

from the asymmetry perspective.

It seems plausible to think of acquisitions as strategic projects that occur under the

assumptions of asymmetry in investment costs and imperfect information. Asymmetry

between potential acquirers may stem from different sources: imperfect regulatory

environments, different learning costs among organizations, different valuations, etc. On

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

understand the acquisition process. Particularly, there appears to be an important gap

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

the influence of these factors that affect the acquisition phenomenon.

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

ASYMMETRY AND IMPERFECT INFORMATION: BUILDING THE

MODEL

Chapter III showed the construction of a general model for the treatment of general

investment projects. Acquisitions as strategic investments possess some peculiar

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

“strategic” equilibrium: a preemption equilibrium, a sequential investment equilibrium, and

finally, a simultaneous equilibrium. Under a different setting, Boyer et al (2001) report two

different kinds of equilibrium: a preemption equilibrium, and a collusion equilibrium, in

which firms tacitly agree to either postpone investment until a better realization of the

stochastic variable is available, or undertake joint investment in order to maximize the

potential rents.

However, the nature of acquisitions as investment projects limits the scope for the

kinds of equilibrium to be studied. In the context of a single acquisition, there is no possible

collusion, no potential sequential investment and no chance for simultaneous investment. In

fact, there is only one target and room for only a single firm making a “winner take all”

acquisition investment. Thus, only a preemption equilibrium results a suitable possibility

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

information may play in the process.

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

investment opportunities. For the context of a single acquisition investment, there is no

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

trivial and reduces always to a single firm’s investment problem.

When imperfect information is introduced, then beliefs are introduced as well as

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

introduce these assumptions.

a. Acquisitions as strategic options under asymmetry and imperfect information:

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

of them participate in the investment. By the peculiar features of acquisitions as investment

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

chapter, and it concerns the ordering of instantaneous profits:

D10 D00 D01 (12)

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

study’s particular context, the purpose of completing an acquisition is precisely to obtain a

69
strategic advantage versus the competition and this is reflected in the relative values of D10,

D00 and D01.

Again, the instantaneous profit is defined as Dij, where  is a stochastic variable

possibly reflecting uncertainty in demand.  in turn follows a geometric Brownian motion

according to:

d(t) = (t)dt + (t)dz,

where  and  are constants corresponding to the instantaneous drift and to the

instantaneous standard deviation, dt is the infinitesimal time increment and dz is 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

volatility, respectively. The riskless rate will be denominated as r, and a necessary

assumption present in the literature (e.g. Dixit and Pyndick, 1994) is that  must be less

than r in order for finite solutions to exist.

Acquisitions as investment projects are composed, in the context, of this study, of

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

without perfect knowledge about them by the competing firms.

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

imperfection a separating equilibrium yields the same results as a perfect information

scenario. Therefore, the pooling equilibrium scenario for small cost differences is studied

along with its assumptions:

 is close to 1,

and there is an interval for , such that:

 < 2(r-)I/[2D11 + (1-2)D01] (9)

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

exist under an acquisition context, this expression reduces to:

 < 2(r-)I/(1-2)D01 (13)

Once the assumptions have been expressed, then it is time to turn the attention to

the development of a specific model to study the acquisitions phenomenon under

conditions of uncertainty, asymmetry among firms, and imperfect information.

b. Acquisitions as strategic options under asymmetry and imperfect information: The

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

the minimum of the two levels.

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

firm’s “self-esteem” 2.

Now the particular assumptions corresponding to the acquisitions context are

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:

V() = D10/(r-) – I (14)

This expression holds true for all values of  that are larger than the minimum

investment threshold M appearing in expression (10) and which corresponds to the

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

context there is no such later investment.

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

costs described by I2 = I, where  = (0, ∞).

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

under the no investment scenario.

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

each firm is as follows:

rVi()dt = D00dt + E[dVi()] (15)

Expanding this expression with the help of Ito’s lemma, the expression results in the

following differential equation:

rVi()= D00 + d/d Vi() + 1/222d2/d2Vi() (16)

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.

Therefore, under duopolistic competition an acquisition takes place at a lower

investment threshold than it would under monopolistic conditions. The next proposition

summarizes this particular feature:

Proposition 4: When firms are involved in duopolistic competition, the acquisition

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

threshold results in the following expression resulting from expression

M = (/-1)I(r-)/(D10-D00) (10)

This is essentially the realization of q at which a firm is indifferent between

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

firm will invest early at the following investment threshold:

D = (/-1)I(r-)/(D10-D01) (17)

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 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

D00. This corresponds to values of  that lie below a minimum value of

investment threshold.

2) The low cost firm completes the acquisition and the high cost one is left with a

value corresponding to the instantaneous profits D01.

3) The high cost firm completes the acquisition and the low cost one is left itself

with the lower value for instantaneous profits D01.

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:

2 = V10 – V01, where (17)

V10 = Value of the acquiring firm

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.

c. Acquisitions under 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

threshold for both firms under duopolistic competition is shown:

A = /( – 1)Ii(r – )/(D10 – D01) (18)

This expression is developed with standard options techniques and:

 = ½ - /2 + [(/2 – ½)2 + 2r/2]1/2

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 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

target as compared with the single firm (monopoly) investment opportunity.

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

is assumed that firm 1 is the low cost firm:

V1 = D00/(r – ) + [A(D10 – D00)/(r – ) – I](/A)for  less than A 

V1 = D10/(r – ) - I for larger values of .

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

acquisition and for the relevant range:

V2 = D00/(r – ) for  less than A

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 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.

d. Acquisitions under imperfect information

With perfect information, asymmetry among firms always results in a lower

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

rival to the investment.

Proposition 5: For acquisition projects under uncertainty, asymmetry among firms

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

common knowledge and there is an uncertain environment. Furthermore, there are

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.

The investment threshold by both firms participating in duopolistic competition is

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

investment thresholds simply emerges from the investment cost difference.

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:

I2 = 2LI + (1 – 2)HI (21)

This value must be lower than I for the high cost firm to preempt its rival and

complete the acquisition.

2LI + (1 – 2)HI – I (22)

It must be remembered that by assumption, both2 and L , while H

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

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perfect information described in the previous subsection. Under either extreme, the low cost

firm will always complete the acquisition before its competitor.

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

A suitable model to analyze the acquisition phenomenon from a real options

approach was developed in this chapter. This model incorporates the real options

methodology to the study of acquisition under uncertain environments. Furthermore, it

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

acquisitions phenomenon when asymmetry among firms is introduced and imperfect

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

acquisitions context. Particularly, it must be noted that when imperfect information is

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

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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

them in the acquisition opportunity.

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.

It must be acknowledged that the model developed in this chapter is somewhat

restrictive. Particularly, assuming that firms’ valuation of their targets is exogenous to the

model is a quite strong assumption. Nevertheless, for the purpose of mathematical

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

less restrictive assumptions.

More general models must be developed in order to provide an even better

understanding of acquisitions. More thorough and general models must be completed in

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

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socially desirable under perfect information. It remains to be studied whether this result is

robust once imperfect information is introduced.

From a different perspective, empirical studies should be made in order to provide

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

suitable model will be developed in chapter V.

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 CHAPTER 5

AN APPLICATION OF STRATEGIC GROWTH OPTIONS UNDER ASYMMETRY

AND IMPERFECT INFORMATION: INTERNATIONAL JOINT VENTURES

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

sense, joint ventures may be viewed as an attractive mechanism to invest in an option to

expand into risky markets.

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

closely related to the time the venture acquisition is completed.

International joint ventures (IJV hereafter) function as an attractive foreign market

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

environments, and so forth (Tong et al, 2007).

By the nature of business environments, IJV’s often occur in the context of

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
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after making a limited investment and thus exploit rather than avoid, the sources of

uncertainty.

In joint venture agreements, it is common practice to give first rights of refusal to

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

(Gilroy and Lukas, 2005).

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

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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

the results with those obtained under the non-cooperative options.

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

sources: agency issues, different cultural environments, or different interpretations by the

allied parties. This study will deal with this issue.

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

therefore, a source of asymmetry emerges. Combining the asymmetry present in these

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investments and the imperfect information scenarios that appear in business environments

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

produce the final model.

II. INTERNATIONAL JOINT VENTURES AS STRATEGIC GROWTH

OPTION: FEATURES AND ASSUMPTIONS

As stated in the introductory paragraphs, an acquisition or divestment for an IJV is

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

exercise price. Evidently, this is analogous to a financial option.

In a joint venture, its terminal value is given by the following expression:

Wi = Max [Ci – P, 0] (23)

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

MNC purchases by making the IJV investment. In turn:

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 P = (1-s)S + Ii (24)

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

completed once Ci ≥ (1-s)S + Ii.

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

literature (e.g. Hull, 1998).

While the possibility of analyzing IJV’s utilizing cooperative game theory is

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).

An important assumption in which the model is developed is related to the

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
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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 

represents the stochastic component.  follows a geometric Brownian motion according to

expression (3):

d(t) = (t)dt + (t)dz,

where  and  are constants corresponding to the instantaneous drift and to the

instantaneous standard deviation, dt is the infinitesimal time increment and dz is 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

volatility, respectively. The riskless rate will be denominated as r, and a necessary

assumption present in the literature (e.g. Dixit and Pyndick, 1994) is that  must be less

than r in order for finite solutions to exist.

Another important assumption is related to the expectations related to investment

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

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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

imperfect information is to develop it according to a perfect information context. The next

subsection will do so by being based on previous work, particularly, the work by Gilroy

and Lukas (2006).

III. INTERNATIONAL JOINT VENTURES AS STRATEGIC GROWTH

OPTIONS: A PERFECT INFORMATION SCENARIO

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

stake s to the local partner.

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

with the sale of the s stake to the local partner.

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

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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:

CMNC = (1 – s){DJV/(r – ) + [U(DJV)/(r – ) – P]}(/U)for  < U 

CMNC = (1 – s)DJV/(r – ) – P for larger values of .

As in previous chapters,  is the result for the following expression:

 = ½ - /2 + [(/2 – ½)2 + 2r/2]1/2

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

standard NPV rule, since the option will already be exercised.

Also, the threshold U is obtained according to the following expression:

U = (1 - s)/( – 1)P(r – )/DJV (27)

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:

TJV = [-s/2(2B/(2 – 1)s)1-2](/L)2 for  ≥ L (28)

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

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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:

2 = ½ - /2 - [(/2 – ½)2 + 2r/2]1/2 (29)

The corresponding divestment threshold L that appears in expression (28) is the

result of the following calculation:

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.

Thus, the acquisition or divestment decisions may in turn be affected by imperfect

information.

IV. INTERNATIONAL JOINT VENTURES AS STRATEGIC GROWTH

OPTIONS: INTRODUCING IMPERFECT INFORMATION

In the context of international joint ventures, imperfect information appears as a

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

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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

regards to the abandonment or put option.

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,

as compared to a certain standard I.

Thus, from its own standpoint, the necessary cost that result in order to pursue the

acquisition are:

P = (1 –s)S + LI + (1 – )HI (31)

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

chapters III and IV.

i {L,H} and i (0, ∞)

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

“self-esteem” and/or a relatively low value of L as compared to H, the expected

investment costs may be lower than those for the perfect information scenario. Evidently,

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the acquisition threshold results in a lower value and therefore, it would evolve into an

“early” investment, since the option to wait is ex-ante less valuable.

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

value of the option to wait increases.

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

for future research.

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,

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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

this context has been seldom analyzed.

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

investment thresholds by both academics and practitioners in true business environments

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

the one presented for the call option expressions.

Another important assumption present throughout this chapter is that there is an

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

is no input from imperfection anomalies.

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 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

than other strategic investments.

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 CHAPTER 6

GENERAL CONCLUSIONS AND SUGGESTIONS FOR FUTURE RESEARCH

Stemming from the literature, an important gap is revealed in the understanding of

strategic investments under uncertainty. It is quite evident that today’s business

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

necessity for investing important resources in technology and R&D as trends in

contemporary business contexts.

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

lack thereof) to informational sources, or lack of quality in the informational content; is an

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element that must also be considered in the valuation and strategic processes. In the present

dissertation, informational asymmetries have been applied to investment costs, project

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

uncertainty under the assumptions of “real” projects as compared to financial options.

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

theory accomplish the goal of “handling” the complexities of imperfect information in a

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

to be able to incorporate the essence of imperfect competition in industries and provide a

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

assumed a symmetric firm context.

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

could be considered counterintuitive but that reflect “true” business events.

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 Chapter III develops the basic framework and assumptions towards the construction

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

equilibrium are introduced from the informational standpoint: a separating equilibrium

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

preempt larger firms with presumably lower costs to strategic investments.

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.
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 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.

Another important limitation of this study is in the treatment of imperfect

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

games are utilized.

Chapter IV “specializes” in the acquisition scenario. Under this scenario, two

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
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larger ones to acquisitions. In this chapter, it is suggested that imperfect information may be

part of the reason behind this observed phenomenon.

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

obtained for the acquiring firm.

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

divests from its own share.

By building on the model proposed by Gilroy and Lukas (2005), this study

introduces an imperfect information scenario to the discussion. If the realization of a

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.

Once imperfect information is introduced, the effect it produces on these thresholds

is discussed. Under the assumptions of this chapter, imperfect information and the degrees
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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

contribution to the emerging literature on the topic.

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

proposed in chapter III.

Finally, empirical studies must be developed to provide support to the theoretical

findings and predictions of these models. Incorporating imperfect information to the

empirical analysis of specific phenomena seems to be a better reflection of contemporary

business environments, and may be helpful in explaining some of the anomalies present in

the literature.

101
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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.

Following Dixit and Pyndick (1994), we can utilize dynamic programming

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:

rV2()dt = D01dt + E[dV2()] (A1)

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

following differential equation:

rV2()= D01 + d/d V2() + 1/222d2/d2V2() (A2)

The general solution for this differential equation follows the general form:

V2() = D01/(r-) + A11 + A22 (A3)

A1 and A2 are constants to be determined with the help of boundary conditions,

while b1 and b2 are the solutions to the following quadratic equation:

1/22( -1) +  – r =0 (A4)

From this expression:

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 1 = ½ - /2 + [(/2 – ½)2 + 2r/2]1/2 (A5)

and 2 = ½ - /2 - [(/2 – ½)2 + 2r/2] 1/2 (A6)

It can easily be observed that expression (A5) 1, while expression (A6) 0. In

order to find the values for the constants A1 and A2, boundary conditions must be observed.

Thus, the following boundary conditions must be met:

V2* (0) = 0 (A7)

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

constant A2=0. The other two boundary conditions are:

V2*(2*) = 2*D11/(r-) – I2 (A8)

d/dV2*(*) = D11/(r-) (A9)

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

threshold * and the corresponding value V2* are obtained as follows:

2*=[/(-1)]I2(r-)/(D11-D01) (A10)

and

V2 = D01/(r – ) + [*(D10 – D01)/(r – ) – I](/*)for  ≤ * 

V2 = D11/(r – ) for larger values of .

where  = 1 in expression (A5).

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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

investment project. However, under imperfect information, no firm is sure of whether it is

the low or the high cost firm.

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

becoming leader or follower).

Formally, the latter threshold may be the smallest solution to 2 = 0, where:

2() = V2L() – V2F() (A11)

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).

When imperfect information under a pooling equilibrium is introduced, the

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

firm sends a credible signal that it is the low cost one.

Therefore, as long as the realization of  lies in the interval described by expression

(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

firm from the investment.

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 BIOGRAPHICAL SKETCH

Eduardo Drucker was born in Monterrey, Mexico in 1962. He obtained his

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

University. Currently, Eduardo Drucker works as the COO in Comercial Encanto, SA de

CV in Monterrey, Mexico.

Permanent Address: Antillas 427, Col. Vista Hermosa, Monterrey, Nuevo León 64620,

Mexico.

This dissertation was typed by the autor.

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