Strategic Real Option

Real Options Analysis and Strategic Decision Making

Edward H. Bowman

(deceased) formerly at The Wharton School, University of Pennsylvania

Gary T. Moskowitz

Edwin L. Cox School of Business, Southern Methodist University, P.O. Box 750333, Dallas, Texas 75275–0333 gmoskowi@mail.cox.smu.edu

Abstract

The real options approach is frequently advocated as an approach that offers a positive and radical reassessment of the value of risk and exploration. We examine a recent case where Merck used the real options approach to justify an investment in an R&D project. This case is used to highlight some of the problems associated with using real options. We note that the assumptions incorporated in most standard option valuation models can conflict with the conclusions reached by strategic analysis. As a result, users of real options models should understand the quantitative aspects of these models, and may often need to create a customized model for each situation. The difficulty of developing customized models may explain, in part, the limited use of the real options approach in strategic analysis.

(Real Options; Decision Making; Research and Development; Strategic Analysis)

The investment decision represents a stylized description of the critical process by which organizations commit resources to future growth. Though such decisions are subject to a variety of internal pressures (see Cohen et al. 1972), companies nevertheless portray the investment decision as the outcome of a formalized process that employs explicit rules of valuation. It is unlikely that these rules are language games without real consequences (Astley 1985). Indeed, the teaching of financial methods is a pivotal component in the education of a MBA student. Organizational theories and financial theories of investment valuation are rarely considered in tandem. Yet, they both have shared common treatments of risk as undesirable. Traditional corporate finance theory suggests that firms should use a...