Valuation of Real Options Under Competition

Valuation under Competition |

Term Paper – Valuation & Real Options – under Prof. Abhilash Nair, IIM Kozhikode |

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12/12/2010

12/12/2010

Executive Summary

Table of Contents

Background 2

Lumpy Investment Decisions 3

Capacity Expansion Models 3

Staged Investment Models 3

Analysis 3

Conclusion 7

References 8

Background

Valuation of projects in a competitive environment is quite different from that under monopoly. Moreover the timing and influence of competitors is more than a random process. These are governed by certain variables like opportunity cost, demand, competitive advantage, rate of return and so on. Competition has to be a primary factor in estimating the value of an investment project, thus the effect of a competitor’s entry on the projected cash flows needs to be taken into consideration. Quantitative approaches to competitive losses have been studied by Trigeorgis, Smit, Ankum & others. Our term project thus analyses the existing research in this field and then applies it to a real world situation, the pricing of spectrum for mobile services in India. It is to be noted in this context that the influence of competitor’s move on cash flows is substantial. The option to be valued has a changing probability of competitor’s entry (with time). Hence the valuation method should incorporate the effects of competition.

Although a number of papers have been presented which value competitive advantages resulting from patents or other forms of exclusivity, general study on the effect of timing of competitor entry and its overall effect on the value of the option is a field that deserves more attention. This is because, as already mentioned, the effect of a competitor’s entry in the fifth and fifteenth year considerably alters the value of the option.

Through this paper, we have attempted to apply game theoretic concepts in the binomial option pricing model.

The market moves are carefully studied with respect to the excess...