CHAPTER 5 A Strategic Framework for Competitive Scenarios. Much of the original success and application of the real option concept was driven by the insight that traditional NPV analysis undervalues embedded growth options. In fact, the DCF methodology was accused of inviting management to use hurdle rates exceeding the cost of capital. | A Strategic Framework for Competitive Scenarios GAME THEORY AND REAL OPTIONS Much of the original success and application of the real option concept was driven by the insight that traditional NPV analysis undervalues embedded growth options. In fact the DCF methodology was accused of inviting management to use hurdle rates exceeding the cost of capital. According to the reasoning at the time this drove many attractive but very risky investments into negative NPV figures and discouraged management from investing in innovative but risky projects. Ultimately a decline in R D spending was lamented and it was feared that the decline jeopardized the competitive advantage of . industry across many Misuse of DCF in short was made responsible for the decline of American industry. Subsequently McDonald and Siegel Dixit and Pinyck Majd and others generated the insight that on the other hand NPV valuation motivates making investments in very uncertain and risky projects too early and ignores the premium that should be paid for committing and thus giving up flexibility the option premium. And yet as of today the body of the real option work is biased towards the analysis of decision scenarios in which the owner of the option is in a monopoly position. Here by definition strategy has no role and the actions of the monopolist do not impact on price or on market structure. Obviously few scenarios in the real world meet these criteria. The majority of managerial decisions are influenced by strategic considerations that include possible competitive entry or the value of preemption. Creating or having flexibility in these situations can be of great value to any given firm. How can one identify the right timing of an investment When can one afford to delay without losing a valuable strategic position or market share And when does one have to invest early and accept the higher 133 134 REAL OPTIONS IN PRACTICE risks in order to create a strong strategic position How does .
