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Risk-Return Management of the Corporate Portfolio

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Return

(5-yr annual %)



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Existing business units

Growth options



1

3



10



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0



1



2

3

Risk (VaR / PV)



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Fig. 1 Risk-return profiles of business units and growth options



4.6



Step 6: Interpretation of Results



The risk assessments from the financial risk model can now be used for a quantitative risk-return analysis of the individual business units and the overall portfolio.

Figure 1 illustrates this approach for a major US oil company that went through this

exercise based on a comprehensive Monte-Carlo simulation of the risk and return of

its existing business units and potential new growth options (Balagopal and

Gilliland 2005). The vertical axis depicts the expected 5-year annual total business

return of the different units. The horizontal axis measures the relative risk of the

units as the ratio of their value-at-risk to their present value. In this way, the existing

business units are not only compared based on their value contribution, but also

based on their specific risk. More importantly, the approach allows comparing the

risk-return profiles of existing businesses and potential new business opportunities.

As can be seen in Fig. 1, growth option 1 seems very attractive because it offers an

above average return at below average risk. Growth option 2 offers a very high

return, but also an above average risk. Options 3 and 4 were dismissed by the board

because they would expose the company to a much higher risk than the existing

businesses.

However, the risk-return analysis of the corporate portfolio should not halt at the

level of individual business units because this ignores the correlations between risk

drivers of different businesses. In order to capture the positive effects of corporate

diversification, different alternative corporate portfolios must be compared with

respect to their risk-return profiles. This is shown in Fig. 2 for the US oil company.

Portfolio A is the current portfolio of businesses, while portfolios B to E represent

alternative portfolio development options that were considered by the board. These

alternative options can now be compared based on their risk-return profiles (Fig. 2):

Portfolio B offers only a minor improvement to the current portfolio, portfolio C

promises a significantly higher return at a significantly higher risk, and portfolio D

has a somewhat higher return than portfolio C but a much higher risk. All these four



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Current portfolio

Portfolio options



Return

(5-yr annual %)



20



D



C



15



E



B



10



A



5



0



0



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2

Risk (VaR / PV)



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Fig. 2 Risk-return profiles of alternative portfolio options



portfolios are efficient in the sense that there are no alternative portfolios with a

higher return at a lower risk. In contrast, portfolio E is not efficient because it is

dominated by portfolio D that offers both a lower risk and a higher return. The

decision between the efficient portfolios will depend on the specific risk and return

appetite of the decision makers. The board of the US oil company was looking for a

major return improvement and was ready to accept a significantly higher risk, so

they opted for portfolio C.

This example illustrates how the explicit consideration of risk can enrich the

development of a corporate portfolio strategy: The attractiveness of strategic

business units and potential growth options is assessed from both a return and

risk perspective. Cluster risks and the benefits of corporate diversification are

explicitly taken into account. And significant corporate development decisions

will be in line with corporate risk appetite. Risk-return analysis is thus an important

additional instrument in the toolbox of corporate portfolio management and can

complement the more traditional analyses of market attractiveness, competitive

position and ownership advantage.

A company that applies the outlined stepwise approach has many benefits

beyond the risk-return analysis of its portfolio. On the way, the company will go

through a process of systematic risk identification and prioritization, it will define

specific indicators to measure the risk factors, it will comprehend the mode of

impact of the risk factors on the performance and value of the company, and it will

develop a better understanding of the shape and variance of risk distributions and of

the correlations between risk drivers. In this way, the company will not only

enhance its corporate-level decision making by integrating a risk perspective, but

also enhance its corporate risk management by integrating a strategic perspective.



Risk-Return Management of the Corporate Portfolio



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5 Summary and Conclusions

In management practice, there is a missing link between corporate strategy and

corporate risk management. Strategic risks are the most important causes of major

stock-price losses (Funston 2004). However, recent surveys confirm that the use

of formal risk assessment models in strategic decision making is still very limited

(see Noy and Ellis 2003a; Pidun et al. 2011). Only few companies have established

comprehensive Enterprise Risk Management (ERM) programs that go beyond the

more traditional financial and compliance related risk factors (Gates 2006). And

despite perceived relevance, explicit measurement of risk appears to play still a

relatively small role in strategic planning for most companies (Servaes et al. 2009).

Academic research on strategy and risk verifies that risk analysis should be a key

component of strategic management. The reduction of business risk by the firm can

create value for shareholders (Damodaran 2008, 320–326). Corporate portfolio

management can be an important instrument to diversify and manage risk at the

corporate level (Lubatkin and Chatterjee 1994). But there are some clear limits to

the transferability of financial portfolio theory to strategic management (Devinney

et al. 1985).

A company that follows the stepwise approach to risk-return portfolio management outlined in this chapter starts with the systematic identification and prioritization of the key risks that will influence the value of the individual businesses. It

defines specific indicators that can be used to measure the prioritized risks. It links

the risk drivers with performance and valuation metrics of the businesses in a

financial risk model. It quantifies the future expected values and probability

distributions of the different risk drivers as well as their correlations. It models

the impact of risks with sensitivity analyses, scenario analyses or full-fledged

Monte-Carlo simulations. And it uses the resulting risk-return profiles of the

business units and the overall portfolio to draw conclusions for portfolio strategy

and corporate development decisions.

Such a systematic approach will improve corporate-level strategy because it

helps management consider the inherent trade-offs between return and risk and

account for both sides of the equation in major strategic decisions. Risk-return

portfolio management allows for a like-for-like comparison of very different types

of businesses in a conglomerate and also of new acquisition and growth

opportunities. It enriches the existing toolbox of corporate portfolio management

by adding a financial investor perspective. The suggested approach will also

enhance corporate risk management by spotlighting strategic risk factors and

putting risk on the agenda of the board.

Risk is an inherently complex concept that is not intuitive for most managers.

There are two key success factors for bringing it closer to strategic management.

The first is to avoid black-boxes. Many advanced companies have recently

experimented with sophisticated risk-return portfolio approaches that worked well

in theory but were just too inscrutable for the board to base decisions upon. Risk

frameworks should be as simple as possible, but also as complex as necessary to



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avoid wrong decisions. The second key success factor lies in the process. In order to

ensure acceptance by the key stakeholders it is important to closely involve industry

experts and responsible managers in risk assessment, to educate decision makers on

mechanisms of risk effects, and to get the board involved in drawing conclusions

from risk-return analysis.

There is still a lot of work to be done in order to bridge the gap between strategy

and risk. Academic research can contribute to advancing our understanding of risk

in the context of strategic management. As Ruefli et al. observe, we lack a rich

conceptualization of risk that has been refined by cumulative research built on

multiple measures and methods. Qualitative research into managerial assessments

of risk has been limited and not well integrated into quantitative research design

(Ruefli et al. 1999, p. 168).

The challenges for practitioners may be even bigger. Companies should strive to

establish a risk-return culture in the organization that has a deep understanding of

strategic risk drivers, but is not paralyzed by risk. It should encourage managers to

deliberately accept more risk for higher returns, because prudent risk taking is the

precondition for value creation. In such an organization, corporate portfolio management means not only owning the businesses, but also the risks for which you are

the best owner (Buehler et al. 2008). Ultimately, this may lead to a paradigm shift

that resembles the evolution of thinking about the relationship between cost and

quality (Slywotzky and Drzik 2005): If corporate strategy and corporate risk

management pull together, the trade-off between risk and return may be resolved

and the company can improve in both areas.

The CFO has a prominent role in this evolution. In the past, growing emphasis on

mathematical modeling has rendered much of the risk management debate incomprehensible to those outside the finance function. The Strategic CFO has to reverse

this trend, get his or her fellow board members involved in the strategic risk

discussion and add the risk perspective to the corporate strategy discussion.



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Capturing the Strategic Flexibility of Investment

Decisions Through Real Options Analysis

Johnathan Mun



Contents

1

2

3

4

5

6

7



Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

What Are Real Options? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Real Options Solution in a Nutshell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Issues to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Implementing Real Options Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Types of Real Options Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Industry Leaders Embracing Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.1

Automobile and Manufacturing Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.2

Computer Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.3

Airline Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.4

Oil and Gas Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.5

Telecommunications Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.6

Utilities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.7

Real Estate Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.8

Pharmaceutical Research and Development Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.9

High-Tech and e-Business Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7.10 Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8 What the Experts Are Saying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

9 Criticisms, Caveats, and Misunderstandings in Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



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Abstract Business conditions are fraught with uncertainty and risks. These

uncertainties hold with them valuable information. When uncertainty and risk

become resolved or known through the passage of time, action, and events, decision

makers can make the appropriate midcourse corrections through a change in

business decisions and strategies. Real Options analysis incorporates this learning

and flexibility model, akin to having a strategic road map, whereas traditional



J. Mun (*)

Real Options Valuation, Inc., Dublin, CA, USA

e-mail: jcmun@realoptionsvaluation.com

U. Hommel et al. (eds.), The Strategic CFO,

DOI 10.1007/978-3-642-04349-9_5, # Springer-Verlag Berlin Heidelberg 2012



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analyses that neglect this managerial flexibility and risk will grossly undervalue

certain projects and strategies as well as lead to bad choices and decisions.



1 Introduction

This chapter provides the reader a cursory look at and quick introduction to real

options analysis. It explains why doing static traditional analysis alone is insufficient in a world where uncertainty and risks abound. The additional question that

should be asked is, given that risks exist, what should the firm do or what decisions

do decision makers make? Quantifying and understanding risk is one thing, but

turning this information into actionable intelligence is another. Strategic Real

Options Analysis, when applied appropriately, allows you to value risk, create

strategies to mitigate risk, and decide how to position yourself to take advantage

of risk.

This chapter was intentionally written to exclude all manner of mathematical,

financial, or analytics models and instead focus on the qualitative understanding of

the nature of strategic flexibility in making decisions. The analytical techniques

used in real options analysis cannot be reasonably included in a single chapter.

Instead, it is highly recommended that you refer to Real Options Analysis: Tools

and Techniques, Second Edition (Wiley Finance 2006) as well as Modeling Risk,

Second Edition (Wiley Finance 2010), both by the author, in order to learn more

about the theoretical as well as pragmatic step-by-step computational and mathematical financial modeling details of real options analysis and strategic risk analysis. Also, to use the Risk Simulator and Real Options Super Lattice Solver software

to easily and efficiently solve multiple types of customized risk-based strategic real

options problems. Alternatively, you can visit the author’s website at www.

realoptionsvaluation.com to download trial versions of these software and others

and obtain free Excel and analytical models, as well as watch some free getting

started modeling videos or obtain detailed case studies and whitepapers.



2 What Are Real Options?

In the past, corporate investment decisions were cut and dry: Buy a new machine

that is more efficient, make more products costing a certain amount, and if the

benefits outweigh the costs, execute the investment. Hire a larger pool of sales

associates, expand the current geographical area, and if the marginal increase in

forecast sales revenues exceeds the additional salary and implementation costs,

start hiring. Need a new manufacturing plant? Show that the construction costs can

be recouped quickly and easily by the increase in revenues the plant will generate

through new and improved products, and the initiative is approved.



Capturing the Strategic Flexibility of Investment Decisions



71



However, real-life business conditions are a lot more complicated. Your firm

decides to go with an e-commerce strategy, but multiple strategic paths exist.

Which path do you choose? What are the options you have? If you choose the

wrong path, how do you get back on the right track? How do you value and

prioritize the paths that exist? You are a venture capitalist firm with multiple

business plans to consider. How do you value a start-up firm with no proven track

record? How do you structure a mutually beneficial investment deal? What is the

optimal timing to a second or third round of financing?

Real options are useful not only in valuing a firm through its strategic business

options, but also as a strategic business tool in capital investment decisions. For

instance, should a firm invest millions in a new e-commerce initiative? How does a

firm choose among several seemingly cashless, costly, and unprofitable information-technology infrastructure projects? Should a firm indulge its billions in a risky

research and development initiative? The consequences of a wrong decision can be

disastrous or even terminal for certain firms. In a traditional discounted cash-flow

model, these questions cannot be answered with any certainty. In fact, some of the

answers generated through the use of the traditional discounted cash-flow model are

flawed because the model assumes a static, one-time decision-making process

whereas the real options approach takes into consideration the strategic managerial

options certain projects create under uncertainty and management’s flexibility in

exercising or abandoning these options at different points in time, when the level of

uncertainty has decreased or has become known over time.

The real options approach incorporates a learning model, such that management

makes better and more informed strategic decisions when some levels of uncertainty are resolved through the passage of time, actions, and events. The discounted

cash-flow analysis assumes a static investment decision and assumes that strategic

decisions are made initially with no recourse to choose other pathways or options in

the future. To create a good analogy of real options, visualize it as a strategic road

map of long and winding roads with multiple perilous turns and branches along the

way. Imagine the intrinsic and extrinsic value of having such a road map or global

positioning system when navigating through unfamiliar territory, as well as having

road signs at every turn to guide you in making the best and most informed driving

decisions. Such a strategic map is the essence of real options.

The answer to evaluating such projects lies in real options analysis, which can be

used in a variety of settings, including pharmaceutical drug development, oil and

gas exploration and production, manufacturing, start-up valuation, venture capital

investment, information technology infrastructure, research and development,

mergers and acquisitions, e-commerce and e-business, intellectual capital development, technology development, facility expansion, business project prioritization,

enterprise-wide risk management, business unit capital budgeting, licenses, contracts,

intangible asset valuation, and the like. Section 7 does not illustrate business cases

and how real options can assist in identifying and capturing additional strategic

value for a firm.



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J. Mun



3 The Real Options Solution in a Nutshell

Simply defined, real options are a systematic approach and integrated solution

using financial theory, economic analysis, management science, decision sciences,

statistics, and econometric modeling in applying options theory in valuing real

physical assets, as opposed to financial assets, in a dynamic and uncertain business

environment where business decisions are flexible in the context of strategic capital

investment decision making, valuing investment opportunities, and project capital

expenditures.

Real options are crucial in:

• Identifying different corporate investment decision pathways or projects that

management can navigate given highly uncertain business conditions.

• Valuing each of the strategic decision pathways and what it represents in terms

of financial viability and feasibility.

• Prioritizing these pathways or projects based on a series of qualitative and

quantitative metrics.

• Optimizing the value of strategic investment decisions by evaluating different

decision paths under certain conditions or using a different sequence of

pathways that can lead to the optimal strategy.

• Timing the effective execution of investments and finding the optimal trigger

values and cost or revenue drivers.

• Managing existing or developing new optionalities and strategic decision

pathways for future opportunities.



4 Issues to Consider

Strategic options do have significant intrinsic value, but this value is only realized

when management decides to execute the strategies. Real options theory assumes

that management is logical and competent, and that management acts in the best

interests of the company and its shareholders through the maximization of wealth

and minimization of risk of losses. For example, suppose a firm owns the rights to

a piece of land that fluctuates dramatically in price. An analyst calculates the

volatility of prices and recommends that management retain ownership for a

specified time period, where within this period there is a good chance that the

price of real estate will triple. Therefore, management owns a call option, an option

to wait and defer sale for a particular time period. The value of the real estate is

therefore higher than the value that is based on today’s sale price. The difference is

simply this option to wait. However, the value of the real estate will not command

the higher value if prices do triple but management decides not to execute the

option to sell. In that case, the price of real estate goes back to its original levels

after the specified period, and then management finally relinquishes its rights.



Capturing the Strategic Flexibility of Investment Decisions



73



Strategic optionality value can only be obtained if the option is executed; otherwise, all the

options in the world are worthless



Was the analyst right or wrong? What was the true value of the piece of land?

Should it have been valued at its explicit value on a deterministic case where you

know what the price of land is right now, and therefore this is its value; or should it

include some types of optionality where there is a good probability that the price of

land could triple in value, hence, the piece of land is truly worth more than it is now

and should therefore be valued accordingly? The latter is the real options view. The

additional strategic optionality value can only be obtained if the option is executed;

otherwise, all the options in the world are worthless. This idea of explicit versus

implicit value becomes highly significant when management’s compensation is tied

directly to the actual performance of particular projects or strategies.

To further illustrate this point, suppose the price of the land in the market is

currently $10 million. Further, suppose that the market is highly liquid and volatile

and that the firm can easily sell off the land at a moment’s notice within the next

5 years, the same amount of time the firm owns the rights to the land. If there is a

50% chance the price will increase to $15 million and a 50% chance it will decrease

to $5 million within this time period, is the property worth an expected value of $10

million? If the price rises to $15 million, management should be competent and

rational enough to execute the option and sell that piece of land immediately to

capture the additional $5 million premium. However, if management acts inappropriately or decides to hold off selling in the hopes that prices will rise even further,

the property value may eventually drop back down to $5 million. Now, how much is

this property really worth? What if there happens to be an abandonment option?

Suppose there is a perfect counterparty to this transaction who decides to enter into

a contractual agreement whereby, for a contractual fee, the counterparty agrees to

purchase the property for $10 million within the next 5 years, regardless of the

market price and executable at the whim of the firm that owns the property.

Effectively, a safety net has been created whereby the minimum floor value of

the property has been set at $10 million (less the fee paid). That is, there is a limited

downside but an unlimited upside, as the firm can always sell the property at market

price if it exceeds the floor value. Hence, this strategic abandonment option has

increased the value of the property significantly. Logically, with this abandonment

option in place, the value of the land with the option is definitely worth more than

$10 million. The land price is stochastic and uncertain with some volatility (risk)

and has some inherent probability distribution. The distribution’s left tail is the

downside risk and the right tail is upside value, and having an abandonment option

(in this example, a price protection of $10 million) means that you take a really

sharp knife and you slice off the distribution’s left tail at $10 million because the

firm will never have to deal with the situation of selling the land at anything lower

than $10 million. What happens is that the distribution’s “left-tail risk” has been

truncated and reduced, making the distribution now positively skewed, and the

expected return or average value moves to the right. In other words, strategic real

options in this case provided a risk reduction and value enhancement strategy



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5 Step 5: Modeling the Impact of Risks

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