A Real Options and Game-Theoretic Approach to Corporate Investment Strategy under Competition

An investment strategy encompasses a sequence of tactical investment projects, of which several may yield a low return when considered in isolation. Some low-return investment projects can actually be seen as the first links in a chain of subsequent investment decisions. The value of these projects does not derive so much from their expected cash inflows but rather from the option to invest in a follow-up project for future commercial exploitation. For example, an R&D project, the development of a new technology, or entry into a new geographical market may create future investment opportunities. In strategy, these projects are often compared with options for future company growth. Standard forecasting of the expected cash inflows implicitly assumes investing in the follow-up project, or does not take properly into account the value of flexibility to reject the follow-up project if events turn out to be unfavorable. Application of option theory can be used as an analytical tool to evaluate such flexible projects and to support the overall investment strategy. We here consider the timing of the follow-up project analogous to the timing of the exercise of a call option on a dividend-paying stock. In this investment strategy, decisions involving the creation of capacity may be postponed so that management can decide not to invest if market demand turns out to be unfavorable. On the other hand, deferral also has disadvantages since during the postponement period the firm misses the net operating cash inflows. However, the call option analogy must be seen in the context of market structure. Emerging competition or rivalry may create an incentive to invest early, as postponement of the follow-up project may result in project value erosion. This is particularly so if early investment would preempt competitive entry. This paper casts the real options approach for project timing in a microeconomic framework to analyze aspects of competition. Using game-theoretic principles, we propose various investment tactics in an oligopolistic market. Simple numerical examples illustrate solving the timing problem under competition. Given the complexity of real-world problems, we provide a prototype approach for investment timing that practitioners can adjust to their particular application. We use the expected economic rents or excess profits for forecasting the operating cash inflows. Barriers to entry or a distinct competitive advantage over existing competitors (e.g., econom