chapter 4

• Reasons for Strategic Planning:

  • Choosing a course of action designed to achieve a particular objective
  • Affords opportunities to change course after the initial direction has been selected
  • Ability to pursue a particular strategy can depend on whether financing can be found
• Framework of Strategic Planning:

  • Describe real options as decision trees (or game trees)
  • Identify the objective and the strategic alternative for achieving it
  • Use investment valuation to compare alternative strategies
• Interactive Components of Strategy:

  • Financial Strategy
  • Product Market Strategy
  • Organizational Strategy
• Types of Strategy:

  • Financial strategy
  • Product-market strategy
  • Organizational strategy
• Financial Strategies:

  • Securing investment from Venture Capitalists (VCs) is crucial for startups and emerging companies
  • Attracting VCs requires a well-structured and comprehensive financial model
• Henry Ford and The Model T:

  • Perceived the vast market for low-priced automobiles
  • Recognized that high-volume mass production would reduce costs
  • Solved the financing problem
  • Focused on assembly rather than manufacturing
  • Used trade credit to finance inventory
  • Sold to dealers for cash
• What Makes a Plan or Decision Strategic:

  • Consequential
  • Both active and reactive
  • Not costless to reverse
• Financial Strategy:

  • Financing choices that are costly to reverse or change involve sunk investments in arranging the financing
  • Firm’s financing choices may credibly commit the firm to a particular course of action observable by competitors, suppliers, customers, employees, and stockholders
• Use of Financial Contracts:

  • Financial strategy includes choices like using financial contracts to address or overcome informational asymmetries between entrepreneurs and investors
• Deciding on the Objective:

  • Assumed objective is to maximize the entrepreneur’s return
  • Three-step process:

  1. Estimate the net present value (NPV) for each alternative

  2. Adjust the NPV by assigning values to qualitative considerations important to the entrepreneur

  3. Select the strategy that yields the highest adjusted NPV to the entrepreneur
• Adjust the NPV by assigning values to qualitative considerations important to the entrepreneur
• Select the strategy that yields the highest adjusted NPV to the entrepreneur
• The decision should be rational, based on the expected right choice given the information known at the time
• Strategic planning for new ventures involves considering product-market strategy, organizational strategy, and financial strategy simultaneously
• Example: Calorie-free ice cream technology:

  • Product market strategy: high-margin/slow growth or low-margin/high growth
  • Organizational strategy: manufacture only (one-level) or manufacture and market (integrated)
  • Both strategies have implications for financial strategy
• Financial implications of product-market and organizational strategic choices:

  • Slow growth with one-level entry: NPV = $40
  • Rapid growth with one-level entry: NPV = $120
  • Slow growth with integrated entry: NPV = ($20)
  • Rapid growth with integrated entry: NPV = $70
• Recognizing Real Options:

  • Strategic planning is not a one-shot exercise
  • Passage of time brings deviation from forecasts and new information
  • Opportunities to abandon, expand, or redirect the venture (real options)
  • Select the strategy that offers the highest expected value considering the venture's real options
• Option Basics:

  • An option is the right, but not the obligation, to make a decision and take an action in the future
  • The value of an option depends on the market price of the underlying asset, volatility of the price, time to option expiration, and time value of money
  • The cost to acquire an option is called the "premium"
• Call Option on a Share of Amazon Stock:

  • Gives the holder the right to buy the underlying stock at a predetermined (exercise) price
• Put Option on a Share of Amazon Stock:

  • Gives the holder the right to sell the underlying stock at a predetermined (exercise) price
• Comparisons Between Real and Financial Options:

  • Real options are similar to financial options but differ in important ways
  • Real option markets are not complete and often interdependent
  • The real option premium may bear little relation to the value of the option
• Some Common Types of Real Options:

  • Wait/Learn
  • Expand or contract
  • Switch inputs or outputs
  • Abandon
• Strategic Planning and Decision Trees:

  • Decision trees are a good way to conceptualize strategic alternatives involving real options
  • Decision trees impose discipline on the evaluation process and are used to evaluate connections between decisions today and the future value of the venture
• Decision Tree Techniques:

  1. Focus on the most important choices

  2. Reason forward to construct the tree

  3. Keep track of what is known and unknown at each node

  4. Evaluate choices recursively, starting at the last decision point

  5. Prune the tree

  6. Select the branch of the tree with the highest expected NPV
• An Illustration:

  • Entrepreneur is considering investing in a new restaurant with uncertain demand levels
  • Decision options: build a large restaurant, build a small restaurant, or don't build
  • Outside investor provides balance and gets equity based on investment amount
• Total restaurant PV conditional on size and demand:

  • See table for PV values based on size and demand levels
• Evaluating the Venture As an Accept-Reject Decision:

  • Consider the project as a simple accept-reject decision with mutually exclusive alternatives
  • Decision tree notation: squares represent decision points, circles represent uncertainty, triangles are terminal nodes
• The Wait/Learn Option:

  • Waiting is a call option on building the optimal size restaurant
  • Waiting increases the likelihood of competitor entry, affecting the PV of the restaurant options
• Multicellular organisms require specialised exchange surfaces for efficient gas exchange of carbon dioxide and oxygen due to a higher surface area to volume ratio
• Entrepreneurs can build small now, learn about demand, and then decide whether to expand
• Expansion costs $200,000, with total cost being $800,000
• Investor provides $200,000 for expansion, receiving one percent equity for each $20,000 invested (10% for expansion)
• Total investor share is 30% with expansion
• Value of expansion option = $278,000 - $191,500 = $86,500
• Best choice: build small with expansion option
• Decision-trees do not explicitly incorporate the reactions of rivals
• Game Theory involves a set of players, an order of play, information available, actions, and payoff schedule
• Nash Equilibrium is a set of strategies where each player's strategy is optimal given the others'
• Strategic games commonly played by entrepreneurs include the business plan, strategic partnering, control, and information disclosure
• Decision trees and game trees assess tradeoffs between maintaining flexibility and committing to a limited course of action