ADDITIONAL UNIQUE OPPORTUNITY RECOGNITION
So far, we have devoted most of our discussion to single options provided by resources (e.g., to defer/not defer decision, to enter/not enter). We now turn our attention to the more realistic context where resources provide multiple choices to firms.38 One might imagine a situation where one option, such as, for example, the option to delay a purchase, might create several opportunities for management to take corrective actions. Management might, for example, assess changes in variables such as oil prices, environmental guidelines on drilling, technological advancements of drilling, increased willingness of investors to fund new projects, and so forth, which might lead to more accurate valuations. In that case, the option might have also created opportunities for management to positively act beyond the initially identified purchasing decision. Deferring purchase decisions, for example, may have provided the firm with opportunities to further consider the appropriate mix of debt and equity to finance the purchase of the oil field. As such, an option might in reality create more than one opportunity for management to identify new options.
Similarly, the option to delay the purchase of an oil field may also enable managers to reconsider and make changes to other projects. For example, the firm may consider the purchase of an oil field and also the development of an alternative fuel source. The purchase of that alternative fuel project may be strongly dependent on future oil prices (as is the oil field purchase); if oil prices decline, the development of the alternative fuel source may be delayed because consumers are less willing to switch. If oil prices increase, consumers are more likely to demand an alternative fuel source. In this case, the option to wait and see before having to decide whether to purchase the oil field might impact multiple projects.
Options on discovering additional options refer to what Geske39 labels "compound options," or simply, options on options. Often, unique knowledge provides the option to discover a multitude or cascade of subsequent choices. The growth of Wal-Mart provides an example of such an option cascade.40 Wal-Mart has operated in discount retailing for over four decades, and in that time has expanded into pharmacy, financial services, toys, electronics, groceries, optometry, warehouse stores, and so forth. The platform on which it based such expansion was itself built from the knowledge of operations it acquired over that period, knowledge of (regional) buying habits of its current and future customers, as well as the ability to alter its knowledge/processes to changing circumstances. In short, learning by Wal-Mart cascaded into a series of subsequent opportunities. The initial option Sam Walton exercised to open his first "five and dime" store now appears to be much more valuable than anyone originally anticipated. Often unique options translate into value that is unanticipated by outsiders (and insiders). One important implication is that outsiders (including public equity markets) are incapable of "efficiently" valuing or assessing the competitive threat of option-producing companies.
UNIQUE DISCOUNT RATES
Traditional valuation methods such as NPV or internal rate of return use discounted cash flows as the basis for their valuation of a cash-producing asset. Essential to these valuation methods is the market risk-adjusted cost of capital rate r at which the cash flows are discounted,
where CF is the net cash flow in each period, respectively, t is the time period of the cash flow, i represents one of a sequence of cash flows to the investment, and I CO represent the initial cash outlay (i.e., the initial cash investment to purchase the asset that will subsequently generate cash flows). Consequently, the interest (or hurdle) rate is negatively correlated to the NPV of the investment opportunity; an increase in r will lower the NPV, and vice versa.
Real option strategy allows managers to exploit change. Therefore, such strategies are meant to reduce investment risk in terms of the discounted value of the asset; newly available information will help managers identify advantages (or disadvantages) of a project and improve (or stabilize) cash flows. Effective implementation of option reasoning may also limit downside risks as iterative investment reduces money at risk. Furthermore, flexibility recognition and unique knowledge will allow firms to more easily identify and pursue alternative paths should the focal investment prove to be ineffective (e.g., Pfizer's entry into the male impotence market). Consequently, utilization of a real option perspective should reduce the perceived risk (and attendant discount rate) of the project. We would therefore expect to see lower market risk-adjusted cost of capital rates (discount rates) for firms that effectively implement real options strategies. Due to its negative correlation with NPV, the lower interest rate will result in a higher discounted value for a specific investment stream.
Therefore, in addition to the effect additional opportunity recognition (discussed in the preceding section) has on valuation, option savvy companies should also uncover additional value due to reduced investment risk. Option recognition allows the identification of a series or portfolio of opportunities over which to spread risk.41 It also allows for the accrual of additional information with which to make investment decisions.42 Accordingly, option cultivation entails reduced hurdle rates, which in turn, elevate discounted cash flow values. Option-producing firms should, therefore, realize additional value due to this "reduced perceived risk" as well.
