Principles of ManagementUnit I Article ReviewPLEASE READ THE INSTRUCTIONS AND ATTACHMENTS IN DETAIL!I have attached 2 articles from our library that focuses on the importance of Planning. Which should
Academy of Strategic Management Journal Volume 17, Issue 2, 2018
1 1939 -6104 -17-2-190
RATIONALE FOR THE DEVELOPMENT STRATEGY
OF SMALL BUSINESS ORGANIZATIONS USING THE
REAL OPTIONS METHOD
Natalia Morozko, Finance University under the Government of the Russian
Federation
Nina Morozko, Finance University under the Government of the Russian
Federation
Valentina Didenko, Finance University under the Government of the Russian
Federation
ABSTRACT
In most small business organizations, there are no wel l-founded strategic decision s,
while production and economic activities are accompanied by significant risks and uncertainties.
Small organizations do not use modern methods to justify flexible management decisions. Under
the circumstances, the need to adopt strategic decisions that ensure a stable financial condition
of the organization, prospects for increasing the value of business, is growing. In this paper, it is
proposed to use real options, with the help of which it becomes possible to make alternative
decisions in choosing the most rational variant of development. The proposed binominal model
allows us to explore the dynamics of various options for the development of a small organization,
to predict changes in financial results. With the help of the Bayes criterion, a calculati on of the
optimality of the adopted development strategies is proposed.
Key words: Development Strategy, Small Organizations, Real Options .
JEL Classification: G32, L26, O21
INTRODUCTION
Modern corporations have ample opportunities to develop development strategies with an
alternative choice of different options. For small businesses such opportunities are limited.
According to Russian legislation, small business organizations include enti ties with a staff of up
to 100 people, the volume of proceeds from the sale of goods (works, services) to 800 million
roubles . This shows the significant economic potential of this type of business. However, a
significant number of small organizations, acc ording to statistics, function on the market from
one to three years. This situation is due to the lack of sound strategic decisions, uncertainty and
accompanied risks in production and economic activities.
The functioning of companies based on the financi al strategy allows you to choose the
appropriate areas of development in a changing environment. A tactical decision is recognized as
rational if it is aimed at achieving the main strategic goal -improving the welfare of owners
through maximizing the value of the organization. The use of the financial strategy allows
ensuring the effective development of the organization, in which the mechanism of economic
development of the organization is realized on the basis of mobilizing the internal potential and Academy of Strategic Management Journal Volume 17, Issue 2, 2018
2 1939 -6104 -17-2-190
the p ossibility of manoeuvring financial resources. Strategic management of the organization can
be considered as the management of its value. The advantage of the value model is the
consideration of managerial flexibility. Management flexibility is based on th e dynamics of
development, which is expressed in taking into account possible changes in the strategy,
depending on the transformation of the operating conditions.
Management flexibility in changing conditions, the presence of uncertainty is most
adequatel y provided when using real options. A real option allows you to use business situations
or implement an investment project to use changing situations to increase the value of your
business. The effectiveness of the application of real options under conditi ons that are
transformed is confirmed by the use in the activities of many companies, ensuring the flexibility
of management decisions.
A study of developments on the application of real options in the development strategy of
small businesses showed that a t the present stage such problems are not completely resolv ed. In
this article Torani, Rauss er & Zilberman (2016) ( develops a stochastic dynamic model of the
adoption of solar PV in the residential and commercial sector und er two sources of uncertainty -
the price o f electricity and cost of solar) . In development Mun (2002) ( real options are a useful
tool to guide a firm's strateg ic planning and can create or enhance a firm's value) . In development
Trigeorgis & Reuer (2017) provides a review of Real Options Theory (ROV) in strategic
management research, review the fundamentals of ROV and provide taxonomy of this research.
In other studies ( Kent Baker, Shantanu Dutta & Samir Saadi), it is noted that flexible
management decisions in business practice are not wi dely used: Only 16.8% of enterprises in
Canada use real options in the budgeting of capital. Research (Bar tolomeu Fernandes, Jorge
Cunha & Paula Ferreira) showed the effectiveness of using real options when justifying
investments in the energy sector. A nu mber of authors Mei & Clutter (2015) in this study, the
real options approach are applied to analyse the timberland market. Integration of cooperation
between large and small companies in the field of innovation is aimed at using real options in
these proc esses, noted in other developments (David, Duane Ireland & Charles). In the work of
Trigeorgis & Driouchi (2017) note that a contribution is made to the theory of multinationality
and real options, considering the role of solid heterogeneity in realizing t he real options for
multinational corporations. The authors (Ahammad, Leone, Tarba, Glaister & Arslan, 2017)
investigate the factors influencing the share of equity ownership sought in cross -border mergers
and acquisitions (CBM&As). Drawing on real options theory and Transaction Cost Economics
(TCE) they address and hypothesize key factors linked to commitment under exogenous
uncertainty and the separation of desired and non -desired assets’ influence on share of equity
sought by acquiring firms in CBM&As. I n the study by Moschieri & Mair (2017), within the
framework of corporate entrepreneurship, they quote "data on how partial alienation can be
considered as real variants". Chen, Shen, Xue & Xi a (2017) are investigating the ( models the
toll -adjustment mecha nism as a real option to assess the value of flexibility of the right (but not
obligation) to toll adjustments . Aretz & Pope ( 2017) reviews ( Real Options Models of the Firm,
Capacity Overhang and the Cross -Section of Stock Returns) . Rau & Spinler ( 2017) no te that ( In
light of low profitability and frequent alliance changes, the optimal choice of investment
approach is addressed. This is achieved by comparing the performance of three investment
approaches: Real options analysis and individual and col lective discounted cash flow) .
Lawryshyn, Collan, Luukka & Fedrizzi (2017) note in their work ( that the cash flow is used as
an input in the continuous -time real opt ion of valuation of each patent) . Academy of Strategic Management Journal Volume 17, Issue 2, 2018
3 1939 -6104 -17-2-190
When investigating the applicability of real options in a small business, it is necessary to
take into account the characteristics determined by the type of economic activity. The
development strategy of small business organizations using the real options method allows
taking into account risk situations in the activities of organizations.
The purpose of this study is to develop a methodology for determining the effectiveness
of the application of real options (ROV) by small business organizations in condit ions of
uncertainty and risk.
The hypothesis is increasing the flexibility of the management decisions taken to justify
the development strategy of small business organizations using the real options method.
METHODS
Methods for making flexible management d ecisions based on real options are justified in
high -risk situations. Real options for evaluating investments in the development of new drugs
have been used by the pharmaceutical company Merck for many years. Another company
Texaco, using an optional real method, estimated the oil fields in the initial stage of
development , where the level of risks is much higher than at the stage of operation. Increased
risks were accompanied by the evaluation and development of a strategy for the development of
oil fields in the North Sea by British Petroleum. The method of real options was used to estimate
the value of many companies.
The use of real options in Russian practice is not enough. In individual firms, the real
option method is used in valuation: Pricewaterhous e Coopers Standard & Poor's, Baker Tilly ,
Rus Audit. At present, the process of using this method for choosin g investment options begins
in Russia.
In the areas of activity where changing factors negatively affect financial results, the
method of real opti ons is most in demand. Therefore, the management of companies chooses
alternative ways to increase the value of business, while the flexibility of management decisions
is seen as an asset that should be taken into account in business value.
The valuation m ethod for real options is used mainly by large companies, in the small
business there is no experience of applying this method. Although it is in small business, this
method is in great demand. Small businesses are more exposed to risk situations than larg e
corporations and need flexible financial decisions. For small businesses, it is especially important
to take into account the positive factor of managerial flexibility, which will increase the
attractiveness for investors. Reflect this factor in the eval uation can be based on the method of
real options. The use of real options allows you to analyse the functioning of a small
organization as a set of interrelated investment projects, which affects the increase in flexibility,
the rationale for the goals.
Adopting flexible management decisions using real options affects the reduction of losses
and the increase in the value of assets. Under conditions of uncertainty and changing operating
conditions, the methodology for determining alternative strategi c solu tions is significant for the
manag ement of a small organization. The application of methods of real options is due to the
following features:
1. The management of the firm can change management decisions with the appearance of new
information influencing the investment evaluation;
2. The dependence of the asset value on the value of other assets;
3. The occurrence of certain conditions affects the cash flows generated by the asset under consideration; Academy of Strategic Management Journal Volume 17, Issue 2, 2018
4 1939 -6104 -17-2-190
4. The arrival of the latest information can change the uncertainty in making an investment decision.
The uncertainty of the options for the future development of a small organization
determines the use of the real option method. The use of option methods does not provide
accurate forecasts of development, but offers alternative options in t he face of uncertainty and
the presence of risks the concept of real options complements the theory of financial options and
extends it to the sphere of economic analysis of investment efficiency in conditions of
uncertainty and ris k. With the help of ROV for non -financial assets, it is possible to overcome
the shortcomings of traditional calculations using the reduced cost method (NPV). Based on the
method of real options, it becomes possible to quantify the potentials existing in t he project and
include them in the evaluation of the effectiveness of the investment project. The net cash flow
of an investment project using management options can be calculated as follows:
Where : NPVexp (expanded NPV) -strategic net cash flow using real options; NPVtr
(traditional NPV) -net cash flow calculated using the traditional method without the use of real
options; ROV -Real Options Value .
When new information is received, the optional method allows you to change st rategic
plans to reduce losses and get the most revenue. With the use of real options, it is possible:
Postponement of the adopted direction of development to the time of information change;
reduction or suspension of negative processes that may occur in t he implementation of the
adopted direction of development; transformation of financial strategy in correspondence with
changed situations; use of new development financing potentials and appropriate adjustment of
capital structure. Preference for certain d irections of the strategy is realized in accordance with
the adopted development goals and therefore, the efficiency of functioning is increased.
Consider, for example, the calculation of the value of a real option based on the data of
the small business organization XYZ. The organization expects to invest 150 million roubles to
purchase a new production technology and in one year plans to receive a n income from the use
of this technology in the amount of 175 million roubles . In this situation, with a probability
forecast of 50%, there are two options: Positive (income from use will grow to 200 million
roubles ). And negative (income from use will be reduced to 110 million roubles ). A small
organization can work for another year using the old technology, that is, it can postpone the
acquisition of a new technology for one year. We accept the current discount rate of 8%. Based
on this data, we calculate NPV (net present value):
According to the requirements of investment analysis, the project is adopted with a
positive NPV. The considered company XYZ accepts these investment conditions. We will
calculate the options for a posit ive and negative investment of funds with an assumed probability
of 50%.
Expected value of NPV for positive forecast:
NPV exp NPVtr ROV 1
175 NPV= -150=12 MM rub
1+0.08 Academy of Strategic Management Journal Volume 17, Issue 2, 2018
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Expected NPV for negative forecast:
Calculations showed that after the first year, if the positive forecast is confirmed, the firm
invests in a new technology, if not; XYZ will work on the old technology. If you delay the
acquisition of a new technology for one year, the firm will receive an income of 16.5 million
roubles . When investing in the current period, the company's income will be -12 million roubles .
You can calculate the value of the option with the possibility of changing the investment
condition s and without this change (16.5 -12= 4.5 million roubles ). When using calculations using
the discounted cash flow method, the current information is taken into account, when calculating
an investment, the optional method takes into account changing information.
The present situation on the exp erience of applying real options in Russian practice is
also due to the fact that there is no methodology for applying real options in various conditions.
Analysis of various scientific sources on the study of the concept of real options reveals that in a
significant part of the development there is not considered a specific methodology for using the
option method.
MODEL
In the evaluation of financial options, the well -known Black -Scholes models, the Cox -
Ross -Rub instein model, the Merton model and others are used. The analysis of the models
allowed distinguishing the key characteristics of real options: The possibility to use the option in
a specific changing situation; the adoption of managerial decisions in ac cordance with a given
goal; the possibilit y of accounting for uncertainty and risk. The Black -Scholes model allows you
to calculate a real option based on two approaches:
For the European call option:
For the European put option:
12
-150 200 0.5 + =16.5 MM rub
1+0.08 1+0.08
12
-150 110 0.5 + =-22 MM rub
1+0.08 1+0.08
-r T-t 12 C S,t =SN d -Ke N d 2
1
ln S/K + r+ σ /2 T-t
d=
σ T-t 21d =d - σ T-t -r T-t 21 P S,t =Ke N -d -SN -d Academy of Strategic Management Journal Volume 17, Issue 2, 2018
6 1939 -6104 -17-2-190
Where : C(S, t) -The current value of the call option at the moment t before the expiration
of the option;
P(S, t) -The current value of put at the moment t before the expiration of the option;
S -Current price of the underlying asset;
N(x) -is the distribution function of the standard normal distribution;
K-is the exercise price of the option;
(r) -risk free interest rate;
(T -t) -is the time until the expiry of the option period (option period);
-yield volatility (the square root of the variance) of the underlying asset.
The Black -Scholes option evaluation model is applicable in cases where operations are
performed continuously and in a very short time. The use of the Black -Scholes model to assess
the market value of a real option under the conditions of the Russian economy is problematic,
since the model includes the standard deviation of the asset's yield, which is difficult to estimate
objectively. It should be noted that the scope of the Black -Scho les model is European options.
By analogy with European options, the Black -Scholes model for making a managerial decision is
executed in the future at a predetermined date. Greater volatility in the modification of prices f or
the underlying asset may distort the calculation using the Black -Scholes model. Therefore, in
order to evaluate real options, in our opinion, a binomial model should be used.
The basic idea of the binomial model includes modelling the movement of the value of
the underlying asset using the binomial law. The model introduces the assumption of a change in
the value of the underlying asset in two directions: With the probability "p" there is an increase
in value or with a probability of "1 -p", a decrease in value occurs. Thus, the stochastic modelling
in time of the value of the underlying asset is carried out. With an increase in the number of
considered periods of time, a binomial tree is obtained (Figure 1).
FIGURE 1
DECISION TREE OF THE THREE -STAGE BINOMIAL MODEL
Calculations in the implementation of the binomial model are carried out in a number of
stages. Initially, a lattice of an asset basis is constructed based on the product of the current value
of the asset and the growth rate and the reduction criterion. At the lattice sites, the most
approp riate solutions are determined and then they determine the effect that the chosen solutions
can have on the results of the design in question. Next, an opti on valuation lattice is created Academy of Strategic Management Journal Volume 17, Issue 2, 2018
7 1939 -6104 -17-2-190
based on the backward induction method. Then, the final nod es of the lattice are evaluated and
the intermediate nodes are evaluated from right to left. The most suitable solution is selected at
each lattice site. At this sta ge, you can determine the value of real options by subtracting the
management solution from the calculated effect, taking into account the options of the basic
effect without.
Using the binomial method, we introduce the assumption of discreteness and
bound edness of the number of links. As a rule, the number of links corresponds to the frequency
of making meaningful management decisions. The grid points reflect key moments in the
decis ion -making process: Reduction /increase in production, the adoption of a ne w project, the
abandon ment of the project and others. If the business situation changes continuously, the time
intervals between the nodes should be shortened and the number of links in the binomial lattice
should be increased. In this case, the model unde r consideration i s continuous, but not discrete,
as in most cases.
According to the binominal pricing m odel, the Call option (or Put -does not matter) can
take one of two values: Either U is the "maximum" or D is the "minimum" value. The calculation
is made by the following formula:
In the considered formula, the components are calculated as follows:
Where : S0-is the exchange price of the asset on the date of the option agreement
conclusion ;
E -the price, at which the option is executed ;
r -risk free annual interest rate of the financial market ;
t -is the time from the purchase of the option to its execution (measured in years) ;
The price of an option is a certain fraction of the value of an asset on the date the contract
is entered into. For an investor, there are only two probabilities:
1. The investor receives an in come that is calculated as (u*S -X).
2. As a result of the transaction, the investor loses the funds invested in the purcha se of the option (d*s -x).
The technique of constructing a binomial model is more cumbersome than the Black -
Scholes method, but it allows obtaining more accurate results when there are several sources of
uncertainty or a large number of decision -making dates, which is typical fo r small business
organizations.
Calculation of the binomial model is possible in almost all programs for professional
statistical analysis of data such as SPSS, SAS, R and others.
The binominal model thus formed allows predicting the dynamics of management
decisions of small business organizations that correspond to specific values of the initial
indicators.
0
ρ-d u-e C= Χ ΧS ρ u-d t
0 0 0
D U E d= ;u= ;e= ; ρ= 1+r S S S Academy of Strategic Management Journal Volume 17, Issue 2, 2018
8 1939 -6104 -17-2-190
RESULTS AND DISCUSSION
The proposed procedure for making flexible management decisions using real options
includes:
1. Analysis of the proposed project.
2. Identification of the type of risk.
3. Risk assessment.
4. Formation of a management strategy in a risk situation.
5. Embedding real options in decision making.
With the use of real options, it becomes possible not to strictly carry out the planned
tasks, but, taking into account the changing conditions, to search for the most rational
management decisions at the moment in time. Appropriate behavior is characteriz ed by the
adoption of managerial decisions in accordance with the theory of expected utility.
To evaluate the effectiveness of the chosen strategy on the basis of the binomial model, it
is proposed to use the Bayes criterion for income generation. Let us analyse the criteria for
choosing optimal strategies on the example of th e small organization XYZ under consideration.
The choice will be made based on the use of the Bayes criterion (Table 1). The indicator
B of the efficiency of the strategy S by the Bayes criterion is the mathematical expectation of
the income of the itch line, taking into account th e probabilities of all possible business
conditions:
The optimal among the pure strategies based on the Bayes criterion for wins is the
strategy Si* with the maximum average winnings
The exponent is called the price of choice in pure strategies by the Bayes criterion.
Table1
THE MATRIX OF OPTIMAL STRATEGY SELECTION
T1 T2 T3 T4 T5 Bi P1=0.2 P2=0.1 P3=0.3 P4=0.1 P5=0.2
S1 150 170 200 210 160 160
S2 140 180 190 160 150 149
S3 210 160 180 200 150 162
S4 130 110 180 210 160 144
S5 170 180 200 180 130 156
According to the calculations, =162 million roubles -the price of choice in pure
strategies by the Bayes criterion.
n
i ij i j=1
B Q = v q ,i=1,m *iiB =maxB ,1 i m *iB *iB Academy of Strategic Management Journal Volume 17, Issue 2, 2018
9 1939 -6104 -17-2-190
In substantiating the development strategy of small business organizations using the real
options method, the following scheme is proposed:
1. The definition of critical control points in the binominal decision tree;
2. The situation of exercising the right to exercise the option;
3. Selection of real options most suitable for the management decision in question;
4. The way of modelling real options of the management decision;
5. Performance evaluation of the effectiveness of the use of the real options method for risk management
based on the Bayes criterion.
The ap plication of ROV helps to view the company's activities as a set of interrelated
investment projects, which allows for greater flexibility and faster achievement of targets. To
substantiate the strategy for small business development, it is recommended to use the following
types of real options:
1. Option to choose the time of project implementation.
2. Option to suspend.
3. Option for a phased investment.
4. Option to reduce the scale of the project.
5. Option to change the final product.
6. Option to change resources.
The method of real options involves the construction of a scheme in which a
chronological sequence of i nvestment decisions is outlined and new opportunities are identified
that need to be carefully examined before taking on the following investment -related
com mitments. Thus, the firm is able to determine the sequence of capital management decisions
that will be made as the process develops, not at the beginning, when many key factors are still
unknown.
Real options are used where the objective is to reduce risk s, but not to receive high
returns. The application of the theory of real options allows you to evaluate in monetary terms
the company's opportunities and the dangers facing it. The main force of real options lies in their
strategic application: They can become the fundamental basis of any company's development
strategy, but especially important for small business organizations. In this case, there are a large
number of calculation formulas and ready -made programs, in which it is sufficient to substitu te
parameter values and then the option price is calculated, which can be interpreted as the cost of
the investment project and the strategy as a whole.
CONCLUSION
The use of real options allows justifying the development strategy of a small
organization. In this case, the stochastic behaviour of the value of an asset over time is simulated.
The binomial approach assumes a phased implementation of calculations. Apply ing the binomial
method to estimate the value of real options, the most rational decision in strategic development
is chosen. Evaluation of the optimality of the adopted development strategy can be calculated on
the basis of the Bayes criterion. The above examples of calculations demonstrate the simplicity
and visibility of the proposed methods in the practice of small businesses. The advantage of the Academy of Strategic Management Journal Volume 17, Issue 2, 2018
10 1939 -6104 -17-2-190
real option method is that this method can be used in all situations where there is uncertainty and
risk. T he traditional approach of perfo rmance assessment does not take into account changing
business conditions, which is the main drawback of this method.
In the presence of changing factors of the external environment of the enterprise, the
methodology for det ermining the directions of activity when an event occurs is of considerable
value. It is from this point of view that the theory of value evaluation of options is important for
the management of small business organizations. This is the practical significa nce of the method
of real options, so that even loss -making projects can turn out to be pr ofitable -both in terms of
final calculations and in reality. Real options create competitive advantages for small businesses.
An effective financial strategy in the f ace of limited financial resources reduces the risks of
uncertainty. It gives organizations the opportunity to find and discover new opportunities that
can distinguish them from other firms and create a competitive advantage. Real options can
provide more differentiation mechanisms for firms operating under less favorable conditions.
Analysis of the conducted studies on the use of real options in conditions of uncertainty
and risk has shown that there are no developments on the use of real options in the ma nagement
of small business organizations. The proposed approach is authors from the point of view of the
binominal model on the basis of the choice of a real option and evaluation of the optimality of
the adopted strategy.
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