Executive Decision-Making under KUU Conditions

CHAPTER 11

Executive Decision-Making under KUU Conditions: Lessons from Scenario Planning, Enterprise Risk Management, Real Options Analysis, Scenario Building, and Scenario Analysis

Marilyn L. Taylor Department of Strategic Management University of Missouri KS, USA

Karyl B. Leggio Henry W. Bloch School of Business and Public Administration University of Missouri at Kansas City Kansas City, MO, USA

Lee Van Horn The Palomar Consultant Group CA, USA

David L. Bodde Department of International Center for Automotive Research Clemson University Clemson, SC, USA

Abstract This chapter provides overviews and comparisons of major concepts and methodologies from the fields of finance and strategic management. This chapter draws on the field of finance for enterprise risk management (ERM), real options analysis (ROA), scenario 153

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building (SB), and scenario analysis (SA). These techniques and processes are compared to scenario planning (SP), a concept and methodology from strategic management. SP is a strategic management methodology used extensively by senior executives since its application at Royal Dutch Shell in the late 1960s and early 1970s. ERM is a broad approach that has recently become more pervasive in use with the increasing emphasis on improving governance processes in companies. ROA has come into use since the late 1980s as a decision-support tool under conditions of higher uncertainty. SB is a decisionsupport tool for developing quantitative or qualitative descriptions of alternative outcomes. SA, a sub-set of SB used in finance and accounting, is a means of establishing internally consistent sets of quantitative parameters used as inputs for modeling investment alternatives. This chapter draws on the KUU (Known, Unknown, and Unknowable) framework to demonstrate the commonalities and differences among these approaches and calls for their synergistic use.

Introduction Boards of Directors, Executives, and Strategic planners all have fiduciary responsibilities for oversight in a corporation. To carry out these responsibilities they must more fully understand how to identify, evaluate, and manage the risks and uncertainties facing the corporation. Yet the complexity of many industries makes this task difficult. Every firm has multiple risk factors that in the short term contribute to the variability in the firm’s earnings, and in the long term can determine the firm’s survivability. A thorough understanding of these risk factors will enhance the abilities of Board members and executives to anticipate competitive, environmental, regulatory, and legislative changes and their impact upon the firm. Firm executives and Board members are increasingly being called upon to be responsible for meeting financial expectations, managing risk to stabilize earnings, and increase the firm’s potential survivability. In this era managing the firm’s risk and the firm under conditions of uncertainty becomes critical.1 The fields of strategic management and finance have contributed much in this regard. Yet practitioners and theorists in these two fields have often been at odds with one another, each trumpeting the shortcomings of the other field – the traditional dichotomy being strategy’s emphasis on the long term and qualitative approaches, and finance’s emphasis on the short term and quantifiable approaches. This chapter uses the KUU framework to point out commonalities and differences. Commonalties include objectives and purposes. The commonalities and differences provide opportunities for synergistic use that both fields can draw upon. This chapter argues that reciprocal appreciation and appropriate synergistic use of available decision-making and analysis tools will assist executives in coping with the inevitable acceleration of uncertainties in the twenty-first century. The first section draws a process from the field of strategic management – SP. SP is a process for dealing with total company long-term risk. The process has historical roots in military applications before its striking results in assisting Royal Dutch Shell executives in coping with the discontinuity of the 1

See Alessandri et al. (2003).

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1973–1974 oil crisis. This chapter turns in the next four sections to the field of finance for overviews of ERM, ROA, SB, and SA. The sixth section compares SP with these four finance tools and methodologies using the KUU framework. The chapter’s final section calls for increased synergistic use and integration of tools and methodologies drawn from strategic management on one hand and finance on the other.

I Driving for Strategic Flexibility Using SP “… chance favours only the prepared mind.” Louis Pasteur2 Drawn from the field of strategic management, SP is a qualitative process for dealing with long-term uncertainty at the firm or business unit levels. SP is about envisaging potential futures and developing strategies to assist organizations in dealing with these potential futures. The process is thus about managing risk and uncertainty and exploiting opportunities. SP involves understanding both internal and external factors. It incorporates trends, national and global phenomena, the environment, and other factors that may not appear specifically relevant for today’s decisions, but could potentially impact significantly on future outcomes for the firm. Thus SP is a process tool for helping organizations to consider future possibilities, plan for uncertainties, and prepare contingent plans in order to be better prepared for whatever may transpire. Through the SP process, executives can undertake “forward thinking” to consider future potentialities and how they might impact their organizations. However, detailed planning for the future is fraught with potential for errors. The further out in the future we envisage the fuzzier it becomes. Traditional strategic planning (i.e., for the next 1 to 3 years), takes primarily a linear approach. That works well in a stable environment but does not prepare the organization for discontinuities (i.e., significant changes). The further out planners go in the future the less useful the traditional techniques. Thus, what to do? One process that arose in the late 1960s from a group of strategic planners at Shell Oil’s London headquarters was SP. SP’s Origins and evolution SP was originally developed for military applications. As used by the military during WWII, SP was based on Herman Kahn’s work at RAND and later at his own Hudson Institute. However, after WWII these war-planning scenario processes were adapted by companies as a business-planning tool. Application of SP in the corporate world dates to the 1960s and early 1970s when Royal Dutch Shell adopted the military technique to enhance the firm’s strategic flexibility under conditions of uncertainty. A strategic planning team led by Pierre Wack encouraged executives throughout the firm to utilize the process to generate alternative plausible scenarios regarding the longer-term future of the external

2 More, H., “Strategic Planning Scenario Planning or Does your Organisation Rain Dance?” New Zealand Management (Auckland), 50(4), May 2003, 32–34.

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environment.3 By 1972 the approach had been implemented worldwide throughout Shell. Simplified, the process involved constructing plausible scenarios of the future environment and then designing alternative strategies that would be appropriate under those scenarios. Wack was not alone in undertaking the adaptation of SP into corporate application. Ian Wilson at GE and Peter Schwartz at SRI International were both working at redefining the scenario approach. They redefined scenarios as alternative outcomes of trends and events by a target year regardless of the precise sequence of events. Their scenarios were descriptions of future conditions rather than accounts of how events might unfold. Thus scenarios offered firms a set of distinct alternative futures thus emphasizing that the business environment was uncertain, events were potentially discontinuous, and the future could evolve in totally different ways. The scenarios provided a context for developing long-term corporate strategic plans as well as near-term contingency plans.4 Following WWII the planning process had evolved. For the 10 years following the War, Shell had concentrated on physical planning (i.e., scheduling of increases in long-term production capacity to meet the ever-increasing demand). From about 1955 to about 1965 the firm moved to an emphasis on financial planning, primarily on a project basis (i.e., capital budgeting of long-term assets such as tankers, depots, pipelines, and refineries). In 1965 the firm’s planning began focusing on coordinating details of the whole chain activity of moving petroleum from the group to the retail outlets. Shell’s planning approaches certainly evolved over these two decades. However, like other companies during this time period, the planning emphasis in the fairly stable environment had been primarily on “more of the same.” However, in the late 1960s the firm’s executives determined that even a 6-year time horizon was too short. Efforts focused on finding ways of exploring what the competitive environment for the firm might look like as much as 30 years hence (i.e., in the year 2000). Wack was familiar with Herman Kahn’s developments in SP for the military and helped work out a SP approach to meet Shell executives’ concerns. The SP process proved itself when Organization of the Petroleum Exporting Countries (OPEC) formed in 1973 and decreased wellhead production thus creating a shortage of petroleum. Of all the major petroleum firms, Shell was best positioned at the time in terms of strategic flexibility, clearly a result of having embraced SP firm wide. In short, Shell had already identified its strategic options for discontinuous conditions.5 The firm’s executive network was emotionally ready to tackle the difficult circumstances and its contingent plans were in place even as other firms groped for approaches. Many major firms have adopted SP over the past three decades. Somewhat out of favor in the 1980s, SP began to be used more extensively in the 1990s. However, full-blown SP 3

See Hamish More, “Strategic Planning Scenario Planning or Does your Organisation Rain Dance?” New Zealand Management (Auckland), 50(4), May 2003, 32–34 and Mintzberg, H., “The Rise and Fall of Strategic Planning”, Harvard Business Review, 72(1), 107–114. 4 Millett, S.M., “The Future of Scenarios: Challenges and Opportunities,” Strategy and Leadership (Chicago), 31(2), 2003, 16 (See also by the same author: The Manager’s Guide to Technology Forecasting and Strategy Analysis Methods (*Battelle Press, 1991) in which Millett aims to acquaint all levels of management with the various extant methodologies for considering the future. The scenarios approach is included. 5 Pierre, W., “Scenarios: Uncharted Waters Ahead,” Harvard Business Review, 63(5), September to October 1985, 72–89.

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approaches are expensive. Estimates of cost, range upwards of half million dollars or more. SP exercises require facilitation and in depth, intuitive knowledge of the industry. These two aspects of adeptness at the process and content expertise are seldom found in one person. The consultants who have both kinds of expertise and who are available are expensive. In addition to the costs of consultants, SP must have the intensive involvement of senior executives – expensive time indeed. Senior executives are used to relying on their experience and intuition for making decisions. The SP process requires creativity and imagination and suspension of the tendency to assign probabilities to outcomes. It encourages a dialog among the executive team to provide opportunity for more systematic examination of the exogenous variables that impact these decisions.

What is SP? Understanding SP requires first defining what a scenario is. A scenario is a description of a possible future outcome that can be used to guide current decision-making. In some sense it is a map of the future with each map having internal consistency and integrity.6 Experts in the SP process suggests the creation of three to no more than five scenarios. The technique is used most appropriately at the corporate or strategic business unit levels. The process of establishing the scenarios generally involves the following phases: ●

Identification of critical factors affecting the external environment for the firm (i.e., driving forces).7

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Selection of significant forces (or sets of forces).

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Utilization of the forces to establish scenarios.

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Writing of “stories” or “scripts,” (i.e., outlining of characteristics of the resulting scenarios).

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Establishing signposts (i.e., leading indicators suggesting that the environment might indeed be going in the direction of a specific scenario).

SP is long term in its orientation and puts emphasis on identifying variables external to, but highly impactful on the firm. The variables are qualitatively assessed8 in terms of their impact and their inter-relationships. Thus the most impactful external forces might be depicted in the four cells of a two by two matrix (i.e., four scenarios). If impactful and highly related, variables are grouped on a continuum to make up one side of a matrix and another group makes up the other axis of a matrix. A pure SP exercise discourages any discussion of the probability of a particular scenario’s occurrence. Why? Because the purpose is to hold all scenarios plausible. The word plausible does not mean equally likely, but it does mean likely enough that it is worth decisionmakers’ time to think through the implications of each scenario and consider what the

6

See footnote 2. The SP process essentially creates a dialog regarding the opportunities and threats in the classic SWOTs model. 8 The raw input, however, might be extensive quantitative input. 7

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firm’s contingent strategy should be. In some sense, accepting the scenarios may require suspension of disbelief in order to examine “wild card futures” (i.e., to consider factors that are most impactful and most uncertain). In this process establishing probabilities is tantamount to prioritizing the scenarios. Doing so risks politicizing the process, that is, that the sets of executives most likely to benefit from a scenario are more likely to advocate the likelihood of it occurring. Using plausibility as the legitimizing criterion helps to mitigate the tendency to politicize the process. An application of SP in the electric power industry A set of scenarios for the electric power industry is depicted in Appendix A. In this exercise the participants were asked to: ●

Establish a strategic question.

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Identify the critical dimensions that would impact upon the question (and then).

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Create “stories” or “scenarios” that were plausible and internally consistent.

The question chosen by this group was what the firm should do regarding nuclear power generation given that the firm was part owner in a major facility. In the scenario matrix the dimensions were grouped as no nuclear acceptability (i.e., combining social and political factors) and cost of alternatives (predicated among other factors on technology advances). The four identified scenarios were given the names “Fossil Heaven,” “Greenville,” “Diversification,” and “Nuckies Rule.” Once the scenarios are written the executive group could then begin the process of creating strategies that are appropriate to the scenarios.9 SP benefits and drawbacks SP has its advocates and detractors. Advocates argue SP is really about making decisions today but point out that SP is used to systematically define long-term uncertainties with the ultimate purpose of assisting managers to design contingency plans and thus build flexibility into the strategic future of the firm. The SP process encourages contingent strategic thinking or, another way of putting it, is that SP encourages long-term firm-level flexibility. The process encourages managers to envision plausible future states of the environment in which their organizations operate and think long term about how their organizations might take advantage of opportunities and avoid potential threats.10 What are the benefits of using the SP process? Numerous are cited by executives, consultants, and internal staff facilitators. The benefits tend to cluster around: (a) expanded

9

Actual application of SP varies immensely in practice. What is described here is the classical approach. However, many consultants shorten the process, changes the steps, or include techniques they have developed in house. 10 Kent, D., Miller, H. and Waller, G., “Scenarios, Real Options and Integrated Risk Management,” Long Range Planning (London), 36(1), February, 2003, 93.

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mutual understanding of potential environmental discontinuities, (b) greater teammanship as a result of the process and developing a common language, and (c) increased nimbleness of the firm that already has articulated contingent plans. In short, the SP process brings two major benefits germane to our discussion. First it helps in identifying the long-term uncertainties and risks that impact on the firm as a whole. Second it assists the executives in defining their alternatives (i.e., increasing their flexibility in responding to uncertainties). And, in so doing SP contributes to the firm’s ability to survive under hostile conditions and to position itself to more proactively exploit munificent environments. In other words, SP contributes to strategic understanding of long-term exogenous variables and the design of contingent strategies or options. SP offers organizations the opportunity to envision the future and prepare contingency plans to address the uncertainties. It helps to challenge existing “maps of future possibilities, to explore what might possibly happen, and to prepare contingent plans for whatever might transpire”. In short, it prepares organizations for possibilities.11 The process represents a very qualitative real options approach to long-term strategy design. On the other hand detractors point out the “blue sky” thinking that can result from SP – contingency plans with dubious application in a too distant future. The firm’s shareholders clamor for bottom-line results in the form of dividends and market capitalization growth – those are the short-term realities compared with SP’s nebulous contributions to survivability. II Moving to Firm-wide Awareness with Enterprise The ERM

“It’s not what we don’t know that causes trouble. It’s what we know that ain’t so.” Will Rogers ERM programs have been increasingly implemented in companies as they confront twenty-first century risks and respond to the increasing demands for effective governance in the wake of the difficulties in such firms as WorldCom, Tyco, and Enron.12 There are strong arguments that the level of risk attendant modern corporations will intensify in coming years, not diminish.13 These include risks in areas where forces are contributing to considerable change as well as increasing business environmental turbulence, that is, areas of high uncertainty (see Exhibit 11.1).

11

See footnote 2. See Barton et al. (2002). 13 See Mandel (1996). Mandel is the economics editor for Business Week. He argues that four factors – uncertainty of rewards, ease of entry, widespread availability of information, and rapid reaction to profit opportunities – are driving the intensifying risk (as reported in Barton). 12

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Exhibit 11.1. Forces contributing to increasing change, risk, and turbulence in the business environment ● ● ● ● ● ●

● ● ● ●

Technology The Internet Worldwide competition Global blocs and trading agreements Deregulation Organizational structural and culture changes resulting from downsizing, reengineering, and mergers Changing demographics, especially aging populations Higher customer expectations for products and services Increases in purchasing power in heretofore lesser developed countries Movement to service economies

Source: Adapted from Thomas L. Barton, William G. Shenkir, and Paul L. Walker, Making Enterprise Risk Management Pay Off: How Leading Companies Implement Risk Management (Upper Saddle River, NJ: Prentice-Hall PTR, 2002).

Within companies risk management has heretofore been handled in “silos” or “compartments” (i.e., within specific areas or domains such as insurance, technology, financial loss, and environmental risk). Under the old approach various risks were considered in isolation. The new approach, enterprise (wide) risk management, represents the efforts by an increasing number of companies to undertake risk management across the enterprise on an integrated and coordinated basis. The approach is additive, aggregative, and holistic as it identifies the existence of, and appropriate responses to, the several and joint impacts of risks across the organization. In so doing, companies aim to create a culture of risk awareness throughout all levels of the organization. As one set of practitioner authors put it, “Farsighted companies across a wide cross section of industries are successfully implementing this effective new methodology.”14 They are doing so because stakeholders are demanding that companies identify and manage the risks that attend the firm’s chosen business model. Risk management has been traditionally thought of as managing the company so as to avoid or mitigate events or actions that “will adversely affect an organization’s ability to achieve its business objectives and execute its strategies successfully.”15 As a Dupont executive put it, “Risk management is a strategic tool that can increase profitability and smooth earnings volatility.”16 Microsoft reportedly uses SA (see next sections) within its ERM to identify its significant business risks. This includes thinking of risks in broader terms. For example, 14

“…a new model-enterprise-wide risk management – in which management or risks is integrated and coordinated across the entire organization. A culture of risk awareness is created. (P) Farsighted companies across a wide cross section of industries are successfully implementing this effective new methodology (Barton, T.L., Shenkir, W.G. and Walker, P.L., Making Enterprise Risk Management Pay Off: How Leading Companies Implement Risk Management (Upper Saddle River, NJ: Prentice-Hall PTR, 2002), pp. 1–2). 15 Economist Intelligence Unit, written in cooperation with Arthur Anderson, Inc., Managing Business Risks – An Integrated Approach (New York: The Economist Intelligence Unit, 1995), p. 2 as reported in Barton, T.L., Shenkir, W.G. and Walker, P.L., Making Enterprise Risk Management Pay Off: How Leading Companies Implement Risk Management (Upper Saddle River, NJ: Prentice-Hall PTR, 2002), p. 2.

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considering risk in the narrow sense as the company insures a building incorporates the potential loss of the value of the building. In an ERM approach the risk must be thought of more broadly (e.g., in terms of its potential interruption of the business). The risk management group initiates thinking about the possible scenarios and includes consideration of the experiences of other firms (i.e., a form of benchmarking). The process then considers not only the appropriate level of insurance given the market or replacement costs of the building, but also the broader effects and their ramifications. The process uses face-to-face contact between business units using cross-functional task forces, team meetings, or brainstorming sessions to identify the risks, consider the broader system effects, and identify appropriate alternative responses. The purpose is to establish a heightened awareness and a continuous process of dynamic self-assessment for both identifying and addressing risk. Critical steps include identification of the risks, evaluation of the severity of the risks, as well as innovative approaches to managing the risks and their potential impacts. In some instances the impact of risks can be quantified. For example, many companies have extensive historical databases on credit risk, either internally generated or access to external parties’ assessments. However, companies readily acknowledge that some risks are not quantifiable and that the impacts can only be qualitatively identified and perhaps ranked. For example, operating risks may not be so easily quantifiable. First steps in ERM programs are the inventorying of risks throughout the company, the estimated effects on the unit and company generally, and the current approaches in place for dealing with the risks.17 ERM approaches place significant emphasis on more rigorously identifying, ranking, considering the impact of these kinds of risks, and designing approaches managing them. The initial stages are additive. However, by moving to more systematically quantify, rank, or qualitatively consider the effect on the total company, ERM programs establish a basis for an integrated approach to total ERM. This might include establishment of an ERM committee or task force at the corporate level with responsibility for reporting to the board on a regular basis. How does an organization move to total organizational awareness of risk management issues? Certainly approaches vary. However, the following appear to characterize most approaches: involvement of a broader array of decision-makers, adoption of common approaches and “languages” across the corporation, broader sharing of information, and continuous involvement of the organization’s chief risk management officer (i.e., the CEO). It is not that risks were not previously managed before the advent of ERM programs. Rather, in today’s environment risk management has become more salient. Thus, a broader array of company programs and policies are being monitored more systematically and seen in a more integrated manner as risk management approaches. The purpose is to both exploit opportunities and manage the risks attendant the pursuit of those opportunities. The process explicitly recognizes the fiduciary responsibility of a broader set of players throughout the enterprise. This shift in governance philosophy and organizational

16 Barton, T.L., Shenkir, W.G. and Walker, P.L., Making Enterprise Risk Management Pay Off: How Leading Companies Implement Risk Management. (Upper Saddle River, NJ: Prentice-Hall PTR, 2002), p. 2. 17 See, for example, Leggio, K., Taylor, M. and Young, S., Enterprise Risk Management at GPE (North American Case Research Association, November 2003).

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culture is often accompanied by structural changes such as the appointment of a Chief Risk Officer (CRO) and the establishment of risk-management committees at the corporate and unit levels.18 An important issue is that the process is continuous, not periodic. These structural changes contribute to focusing the organization’s attention on managing its multiple risks on a continuous basis. Traditional approaches to managing risk include accepting (e.g., self-insuring), transferring (e.g., buying insurance from a third party), or mitigating the risks (e.g., building in options; undertaking maintenance more frequently) as well as monitoring and control systems. Increasingly risk management refers to the management of companies’ drive to create, protect, and enhance the short- and long-term value of the firm. Managing risk is more than protecting shareholders from downside risk; risk management can be a powerful tool for improving business performance since risk arises from missed opportunities as well as from threats to earnings stability.19 To do so company executives must seek opportunities where the possibilities for profits and growth are greatest (i.e., where the potential for profitable growth is greatest). However, these are generally the arenas where uncertainty and risks are most attendant. In short, to carry out their fiduciary responsibility in today’s environment, executives must simultaneously seek out uncertain and high-risk situations to generate growth while simultaneously mitigating the results from that pursuit. The CEO must carry the responsibility as the chief risk management officer, but in actuality decision-makers at all levels in the organizations must be attuned to seeking new opportunities while managing and overseeing the risks that attend the effort. In this sense ERM has close links with SP in purpose. ERM is a total company process or program whose purpose is to identify the potential sources of system risks or aggregation of sub-system risks, to assess those risks (degree of importance and likelihood of occurrence), and to design the alternative action systems for responding to them. III Quantifying Flexibility Using ROA The increasing use of ROA as a decision-making process is undeniable. The enthusiasm of some practitioners is clear, as one set of authors argued, “In 10 years, real options will replace Net Present Value (NPV) as the central paradigm for investment decisions”20 (see Appendix B for a comparison of ROA and NPV). Finance practitioners and theorists have developed ROA as a means to value decisions made under conditions of uncertainty. In general, ROA can be applied to decisions where the investment can be staged so that the incremental investments are predicated on outcomes from the prior stage, where the initial investment can be small, where the firm is not locked into making the future investments,

18

For Example, Chase Manhattan has a Risk Policy Committee as a Board of Directors standing committee and five company-wide committees focusing on credit, market, capital, operating, and fiduciary risks (see Barton, p. 48). 19 See Lam (2000) and Laarni (2001). 20 See Copeland and Antikarov (2001).

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and conditions are uncertain. The technique has increasingly been found valuable in contributing to more rigorous examination of strategic and operational decisions where outcomes are path dependent. The assumptions underlying the theory may significantly limit the application of ROA as a means of quantifying investment outcomes, but the richness of the discussion that is an integral part of the analysis remains undampened. What is ROA?21 ROA is a financial options theory applied to business decisions. Indeed, the Black–Scholes approach has migrated in recent years from application to stock options to applications to ROA (i.e., the valuation of strategic and operational investment alternatives). A great deal can be gained by developing an understanding of such decisions through the ROA perspective. The theory recognizes that there is value in companies making limited initial investments that permit them to retain flexibility to take future action and possibly incur a gain.22 One way to think about the connection between financial options theory and ROA is that a financial call option gives the right, but not the obligation, to buy an asset at a predetermined price on or before a given date. The same applies in strategic decisions that can be multi-staged. At each stage the decision-maker can make an investment in order to obtain the ability, but not the obligation, to make the decision to invest at the next stage. Exhibit 11.2 below summarizes the analogous characteristics of stock options and strategic investments viewed from an ROA perspective. Exhibit 11.3 summarizes ROA alternatives and aspects of this approach. Coined by Stewart Myers of MIT’s Sloan school, the term real options is based on the principle that there is value to waiting for more information when faced with a series of linked investments, and that this value is not reflected in the standard discounted cash flow models used for capital investment decisions, such as payback, net present value, or internal rate of return (IRR).23 The concept is an extension of options theory which underlies the securities market transactions described above. However, in real options, the underlying asset is not a security, but rather investment in an asset or a business opportunity (i.e., investment in a “real” asset). Many strategic investments have characteristics of securities options decisions, that is, an investment that made today gives the decision-maker the flexibility to make a future decision (e.g., make additional investment, reduce investment, or abandon the project). In many instances more information is acquired during the interim time that gives the decision-makers a clearer picture for assessing whether the future outcomes have positive value or not. A major link between options theory as applied in the securities market and strategic investment opportunities for companies is that investment decisions are often modular and can be 21

This section is drawn heavily from Leggio, K., Bodde, D. and Taylor, M., “The Application of Banking Models to the Electric Power Industry: Understanding Business Risk in Today’s Environment,” Oil, Gas and Energy Quarterly, 52(2), December 2003, 20-1-14 and Taylor, M., Leggio, K., Coates, T.T. and Dowd, M.L., “Real Options Analysis in Strategic Decision-Making,” Presentation to ANZAM/IFSAM VI World Congress, Gold Coast, Queensland, Australia, 2002. 22 See Kroll (1998). 23 See Reary (2001).

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Financial Options

Real Options

The financial option aspect on the left is analogous to the characteristics of business investment decisions on the right Call option on a stock Future investment decision Current value of the stock Expected present value of future cash flows Strike price Expected (future) investment cost Time to maturity of the option Time until the investment opportunity no longer exists Volatility Dividend on a stock (i.e., the values foregone by the option holder in avoiding exercising the option right) Risk-free interest rate

Variability in the project’s returns Cost of keeping the investment opportunity alive (e.g., values paid by the option holder to avoid making the full investment) Risk-free interest rate

Source: Adapted from Botteron (2001).

Exhibit 11.3. Real options alternatives and characteristics ROA alternatives ● ● ● ●

Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility option

ROA characteristics ●

●

Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life. Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions

deferred. In short, strategic investments often come in the form of embedded options, that is, a series of options within the same decision stream. When strategic decisions are modular, or can be treated with modularity, the decision-maker has flexibility and this flexibility itself has value. Putting it another way, the decision-maker has the option to invest – she can exercise that option now or later – very much like financial options. In many strategic decisions, there are several options embedded. Maximizing the value of the opportunity involves making the decisions to invest at the right time. A strategic decisionmaker has the flexibility to buy, sell, or exercise options now or at some time in the future. ROA can assist strategic decision-makers by providing analyses leading to decisions and, importantly, by shedding greater light on underlying factors in the opportunity itself as part of the process of undertaking the analysis. How do real options provide answer to managerial issues? As one writer in this field puts it, “First real options provide a strategic answer as they force the manager to set up an opportunity register (i.e., identify a set of investment alternatives). Second, the pricing of these options will help the manager to quantify the opportunities attached to each project. Third, the solving of the real options’ price will indicate to the manager the optimal investment timing for the project.”24

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Rather than viewing a particular decision as a series of projected cash flows to be discounted, the project’s value can be viewed as a “portfolio of options.”25 This view is particularly valuable for strategic decisions where the investments will be made in multiple stages, for example, investments such as R&D, purchase of natural resources, entry into a new market, and diversification including purchase or development of companies. Thus, Botteron argues, “The advantage of real options used in a multi-stage valuation is the ability to take into account future strategic decisions. These types of investments are analogous to compound options: each stage completed gives the firm an option to complete the next stage.”26 A multi-stage investment is usually structured so that after each investment stage, a company’s decision-makers can choose to increase the investment in the project, delay it, or even abandon the project. The future decisions for additional investments are contingent on the outcomes of the previous stages. For example, in the pharmaceutical industry the decision to abandon or further invest in an R&D project is often associated with outcomes of the various drug-testing stages. ROA is relatively new, an advanced technique that links strategy and finance. Compared to traditional tools such as NPV, ROA provides management with improved facility for dealing with uncertainty and thus helping managers solve complex investment problems (see Appendix B for a comparison of NPV and ROA). ROA draws strategic decisionmakers into a process designed to enhance their insights into issues such as: ●

timing of their investments;

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relative value of multiple-staged investments;

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identification of risk factors and ways of managing them;

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flexibility (i.e., what management can do to maximize the value of strategic investments).27

Future risks include factors such as changes in consumer tastes, regulations, government approvals (e.g., of New Drug Applications), currency exchange rates, or commodity prices, as well as technological breakthroughs – all these factors, and more, can make significant differences in strategic choices. Further, the outcomes of these uncertainties can be managed using an ROA approach. The choice to invest in full stream production of a controversial new product may be linked to the results of test marketing. However, test marketing involves investment in: (a) development of the concept, (b) prototypes, (c) sufficient inventory for test marketing, (d) marketing analysis, and so on. ROA encourages strategic decision-makers to more clearly map the stages in the investments that will need to be made, provided the results from each prior stage signal a “green light” for the next one, that is, a series of embedded 24

Botteron, P., “On the Practical Application of the Real Options Theory,” Thunderbird International Business Review, 43(3), 2001, 472. 25 Botteron, P. “On the Practical Application of the Real Options Theory,” Thunderbird International Business Review, 43(3), 2001, 476. 26 Ibid. 27 Adapted from Botteron, P. “On the Practical Application of the Real Options Theory,” Thunderbird International Business Review, 43(3), 2001, 475.

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options. Further, at each stage the strategic decision-makers can choose to invest, wait, or abandon the activity. The investment at each stage is an investment in another option. That is, at the end of each stage, the decision-maker can decide to exercise (or not exercise) the option to make the additional investment to continue with the strategic alternative. Where has ROA been used? Applications of ROA have appeared in industry, in the academic research literature, and in teaching. Applications in industry: The relative advantages demonstrated in ROA applications more clearly capture strategic aspects of the decisions that management confronts. ROA advantages have led to increasing application of the approach. The example of the pharmaceutical industry was given above. For what kinds of decisions do experts use ROA? Both McKinsey and KPMG International have groups that specialize in the use of ROA. KPMG International, for example, has helped companies apply ROA to: ●

R&D choices, especially in the early stages;

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mergers and acquisitions/alliances;

●

management of patents, licenses, and brands.

In addition to pharmaceutical firms mentioned above, to date the technique has been used to evaluate investments in strategic opportunities in a variety of firms including mining, petroleum, electric power companies, television programming28 and hi-tech ventures. Options theory has been found to have value when managers are confronting a strategic investment opportunity that has a great deal of uncertainty.29 However, when using real options, managers must have the ability to react to the uncertainty and alter the planned activity.30 Under conditions of uncertainty traditional NPV analysis undervalues the project. ROA allows managers to incorporate the value of flexibility to adapt to changing environments.

28

McKinsey found that applying options theory to TV-programming decisions could improve the returns from programming investments. McKinsey argues that application of real options theory is effective because of the high uncertainty of outcomes and costs of a program series. This article suggests that TV executives informally exercise options whenever they cancel under-performing shows or modify schedules in other ways. The article argues that the executives in this industry must institutionalize the process of recognizing, evaluating, and exercising the options embedded in the TV-program decision. McKinsey’s underlying argument is similar to that raised in this article. Baghin, J., “Black-Scholes Meets Seinfeld,” McKinsey Quarterly, (2), 2000, 13–16. 29 See Coy (1999). Coy observes that real options theory is a revolutionary concept emerging in corporate finance. He argues that real options theory’s basic premise is that when the future is highly uncertain, it pays to have a broad range of options open. Thus, the value of ROA accrues to executives who retain flexibility. Coy points out that real options theory is too complex for minor decisions and not useful for projects that require a full commitment now. Rather, the value of an option lies with management’s ability to incur a relatively small amount of cost now and retain the ability to decide later whether to make additional commitment. See also Alleman (1999). Note that Coy’s arguments underlie the commonalities between SP and ROA. However, we are arguing that SP is more useful with the Unknown and pushing the boundaries of the Unknownable because of its generation of qualitative scenarios by creatively employing executive knowledge, judgment, and intuition. ROA, in its strictest sense, uses SA (i.e., quantified scenarios or distributions of data).

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Within companies where ROA is being used, it is finding broader and broader uses.31 Indeed, options models are becoming mainstream tools for financial practitioners around the world.32 The academic research literature: ROA concepts have been applied in a widening variety of situations noted in the literature including: ●

toeholds pursued by minority shareholders;

●

small acquisitions made in order to enter new technology or business areas;

●

capital investment decisions;

●

valuation of R&D and technology;

●

development and introduction of new products;

●

understanding environment, ownership, and performance relationships;

●

capital budgeting;

●

real asset investments;

●

natural resources investments;

●

valuation of government subsidies;

●

various kinds of investment alternatives in the electric utility industry including mergers and acquisitions;

●

new venture startups;

●

pursuit of maximizing value derived from entrepreneurship activities;

●

analysis of the value of decision-support systems.33

Options theory and, more recently ROA, have received attention in economics, finance, and accounting classrooms for some time. Indeed, finance specialty courses focusing on risk

30

Indeed a recent Economist article argues that managers do not like the capital asset pricing model (CAPM) because it “ignores the value of real life managers.” In contrast the real options approach “places managers at its very core.” CAPM requires establishing projections that are close approximations of the ultimate cash flows and a correct discount rate. The model can use only known information and the resulting uncertainty is reflected in excessive discount rates. CAPM ignores the capability of management to exercise managerial prerogatives to build flexibility into their decision-making process. For example, under conditions of uncertainty (e.g., drilling oil wells, searching for new pharmaceuticals) management usually keeps multiple alternatives active while continuing to invest. CAPM on any one of the alternatives would kill most of the individual projects because of the high discount rates required. (“Economics Focus: Keeping all Options Open,” Economist, 352(8132), August 14, 1999, 62.) 31 See Herath and Park (1999). 32 See Merton (1988). 33 See Bulow et al. (1999); Laamanen (1999); Busby (1997); Angelis (2000); Boer (2000); Lounsbury (1993); Roberts and Weitzman (1981); Herath and Park (1999); Li, M. et al. (1998); Dastgir (1998; 1995); Pinches and Lander (1998); Trigeorgis (1996); Rao, R.K.S. et al. (1980); Brennan and Schwartz, 1985; Mason and Baldwin, 1988; Competition in Electricity…, 1990; Leggio et al. (2001); Leggio, K. and Chan, H., “Valuation of Portlandia Ale Startup as a Portfolio of Growth Options” (Leggio, K./Hooilin IS Sum02/1002 Hooilin Presentation – Valuing a Startup) The University of Missouri at Kansas City, Privately distributed; McGrath (1999); Kumar (1999).

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management and ROA are increasing. However, only recently has the concept begun to be applied in strategic management classrooms. A review of leading U.S. strategic management texts yields at most a few paragraphs dealing with options and only cursory mention of ROA. The first two strategic management texts to devote more than a few sentences to one or two paragraphs to ROA appeared only recently.34 To date no strategic management cases have been known to use ROA as an analysis technique in the instructors manual (or teaching note), although a small body of cases in corporate finance has begun to emerge.35 Thus, there is considerable opportunity to extend the concepts into the strategic management area and perhaps into other disciplines such as Strategic Marketing and Human Resources Management. ROA caveats Use of options pricing theory was revolutionary for financial markets – ROA is proving to be as much of a stretch for strategic decision-makers. Experts expect that “the application of real options thinking to corporate strategy to be an active area of inquiry over the next few years.”36 As the above discussion suggests, the ROA approach offers significant advantages for both decision-makers and researchers alike. There are caveats, however. For example, measuring the volatility can be a challenge with real options. How does one actually develop a measure of volatility? There are no easy answers. The critical step is to examine the primary sources of uncertainty. Indeed, this step is of critical value in developing a better understanding of the venture. Where there is prior experience, for example with drilling of oil wells or pricing of commodities, the investor may have defensible data. For many strategic decisions there is little prior experience and thus no reliable historical data to provide guidance. One approach is to apply simulation analysis to the present value of the underlying asset to estimate the cumulative effect of the many uncertain variables. Another solution used in practice is to estimate volatility on the basis of the performance of a selected portfolio of comparable stocks, under the assumption that the volatility of this portfolio is reflective of the volatility of the opportunity being explored. “Finally we could turn the question around as follows: How large would volatility need to be in order for the project to generate shareholder value? Sometimes it is easier to assure ourselves that our volatility is at least some threshold level than to estimate it precisely.”37 Although increasingly used in making decisions within companies, ROA has not yet accumulated a history. Management’s judgment whether better decisions have been made using ROA, as contrasted to what would have been made using NPV or other decision techniques, is yet future. Developing decision-makers’ understanding of the approach 34 See Dess, G., Lumpkin, T. and Taylor, M., Strategic Management: Creating Competitive Advantage (Burr Ridge, IL: McGraw-Hill, Inc., 2004) and the Annual Update section in Hill, C. and Jones, G. Strategic Management: An Integrated Approach, 5th Edition (Boston: Houghton Mifflin Company, 2001), pp. 7–11. 35 See, for example, the work of Robert Bruner at the Darden School at the University of Virginia (http:// faculty.darden.edu/brunerb/) including the recently completed case “Enron: 1986–2001” by Samuel Bodily and Robert Bruner. 36 See Amram and Kulatilaka (1999). 37 See Hevert (2001) p. 3.

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remains the major obstacle. Understanding and measuring volatility also remains an obstacle. NPV approaches simply do not appropriately value highly uncertain, actively managed projects. Strategic decision-makers have been in search of better approaches. Learning option valuation approaches takes significant organizational commitment, but ROA is well within the capabilities of motivated managers. Comparing ROA, SP, and ERM In the last decade, finance practitioners and researchers have developed ROA as a way to value investments under uncertainty. SP and ROA have complementary strengths and weaknesses as tools for managers making strategic investment decisions under uncertainty. Ideally these two approaches are combined in an integrated risk management (i.e., ERM) process. This process involves scenario development, exposure identification, formulated risk management responses, and implementation steps. A corporate-level perspective on managing risk that takes into consideration the full range of exposures across a firm’s portfolio of businesses as well as its operations is advocated. Most of the ROA literature has a predominant emphasis on quantitative analysis. However, this chapter argues that there is significant value in the qualitative assessment of real options.

IV Analysis of Uncertainties through SB Scenarios can be used, of course, for various purposes in organizations. We have already described the process of constructing or building qualitative scenarios in SP in the sense of firm-level long-range planning. Quantitative scenarios are valuable in capital budgeting projects, and other internal, project-based situations. As used in the latter processes, SB is often referred to as SA (see next section). The parameters of various operational and strategic decisions can be examined qualitatively, quantitatively, or in combination through the building of scenarios, a process we refer to as SB. In an SB process, critical risk factors or uncertainties, internal or external to the unit which the decision effects, are identified. These can be evaluated and used to construct the two axes of a matrix. Each of the four quadrants then represents a possible outcome for the decision. The process is similar to SP, but can be applied internally or externally and can be shorter term than SP’s emphasis on the long-term total business strategic choices. An SB example As an example, we choose the decision by the National Ignition Facility (NIF)’s scientist decision-makers to consider using one vendor or two vendors for a critical component.38 The NIF was operated by the Livermore Labs, managed by the University of California under a Department of Energy contact. The critical external factors for this decision were the ability of each vendor to successfully provide the key component, a component that

38

See Alessandri et al. (2003).

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Exhibit 11.4. SB for the NIF decision to fund one versus two glass vendors Company X: Development of the glass manufacturing application and quality of output

O u t c o m e s

Successful

A. “Bullseye” (Possible, and provides NIF with future flexibility of choice of lower-cost provider)

B. “X Scores” (Likely, but leaves NIF dependent on one supplier)

Unsuccessful

C. “Y Scores” (Likely, but leaves NIF dependent on one supplier)

D. “Complete Flop” (Highly unlikely, but leads to Livermore Lab’s loss of the NIF project and possible loss of the University of California’s Department of Energy (DOE) contract to manage the national laboratory, and significant disadvantage to the nation in not being able to test its nuclear weapon supply or undertake nuclear research)

Successful

Unsuccessful

Company Y: Development of the glass manufacturing application and quality of output

Outcomes

required a radical innovation in manufacturing technology. In considering two vendors there were four possible outcomes as depicted in Exhibit 11.4: ●

Both vendors could succeed (Quadrant A: “Bullseye”).

●

Vendor A could succeed and Vendor B fail (Quadrant B: “X Scores”).

●

Vendor B could succeed and Vendor A fail (Quadrant C: “Y Scores”).

●

Neither vendor could succeed (Quadrant D: “Complete Flop”).

In this instance NIF’s decision-makers used their own backgrounds and general experience to make an assessment of the outcome for each vendor. They estimated there was a greater than 50% probability that each individual vendor likely would be able to satisfactorily undertake the development of the radical innovation in manufacturing process and deliver the critical component. Thus, overall, the decision-makers’ intuitive assessment was that Quadrant I was possible, that II or III were likely, and that IV was highly unlikely.

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171

The NIF scientist decision-makers estimated that investment in one vendor’s development costs would be $12 million and that two things could happen. The vendor could develop a quality production process successfully on budget and on schedule. However, they felt there was a significant chance that the vendor could fail. They knew that vendor failure would seriously delay the overall project. There was also significant concern that the entire project will be cancelled. On the other hand, if they invested in two vendors, both of them could succeed. If both vendors succeeded the project would be successful and NIF would have the flexibility of choosing between two vendors in the future. To proceed with two vendors doubled the cost (i.e., an incremental investment of $12 million). Given that the entire project’s estimated cost was $1.5 billion, the incremental investment to preserve the entire project was warranted. The NIF decision-makers chose to invest in parallel development by two vendors. The discussion above demonstrates that NIF’s decision-makers valued flexibility. Indeed, in general when two managers are looking at two different projects, they prefer the project that has greater flexibility. Management is often willing to spend additional funds to design in flexibility. A question that certainly arises is how managers can justify pursuing projects with higher costs but more flexibility. By appropriately designing the contract with each vendor and building in milestones and progress payments, NIF could build in the flexibility to abandon if development with a vendor was not progressing as expected. However, it was clearly more expensive to fund parallel development, and while future benefits could be qualitatively described, they were difficult to quantify. The benefits were, in short, highly uncertain. Today, most executives and academics recognize that, when market conditions are highly uncertain and managers have decision flexibility, the traditional financial analysis tools for making strategic and operational decisions are not adequate decision-making tools. At a qualitative level, strategic decision-makers can use scenarios to define projects and to push the boundaries of what the possible outcomes of the project might be. However, from a financial analysis perspective, scenarios are very difficult to use to quantitatively value flexibility. Quantitative valuation is limited by identification of the values that the variables making up the scenarios can take and by the assignment of probabilities to the possible scenarios. Thus, the benefit from using scenarios is far more from the process of developing the scenarios (i.e., SB).

V Driving for Quantification – SA In the fields of finance and accounting SA is the use of internally consistent sets of data used for quantitatively evaluating alternative outcomes. For example, in establishing pro formas analysts will generally include projections of revenue growth and other parameters deemed critical for the income statement and balance sheets to yield most likely, best possible, and worst case scenarios. The qualitative designator “most likely” generally designates the mean/median of the distributions of the underlying variables deemed critical by the analyst (with the accompanying necessary assumption that the variables are normally distributed, or nearly so) while the best possible and worst case are qualitatively established toward the tails of the distribution. SA is ubiquitous and the term is used to denote alternative, internally consistent sets of quantitative assumptions that are expected to impact the outcomes.

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Managing Enterprise Risk Exhibit 11.5. Comparison of scenarios as used in SP, SB, and SA

SA as used in:

Time frame

Qualitative/ quantitative

Variables/level of Analysis

(a) SP

Long term

Qualitative

Multiple/firm level

Firm level. Qualitative identification of plausible future scenarios of highly uncertain external factors and design of appropriate firm-level strategies

(b) SB

Moderate

Qualitative/ quantitative

Multiple/ project

Project level under conditions of uncertainty. Qualitative identification of factors external to the project and prediction of outcomes for the project. Quantitative estimates of the likelihood of the scenarios occurring

(c) SA

Short

Quantitative

Multiple/ project

Project level (e.g., sensitivity analysis in pro formas or discounted cash flow (DCF) analyses)

Typical applications

SA has application in short-term decisions where there is risk, but the uncertainties are not high. In short, the underlying parameters are expected to be continuous and the data can be forecasted. Significant advances have been made in quantitative risks assessment processes. However, SA is not as applicable where the underlying time series of data are likely to be discontinuous (e.g., a radical change in technology that obsoletes manufacturing capabilities). A major difficulty with SA is that it can be used to project data sets with risk, but is less useful under conditions of significant uncertainty. Indeed, one of the difficulties with SA is that quantification of variables yields outputs from the modeling options that are seemingly certain, but which may be fraught with serious errors. SA is a sub-set of SB and can be used as a tool in ROA and ERM. Using SA indicates the firm is operating in an environment where variables are knowable and relatively speaking, less uncertain. Exhibit 11.5 summarizes scenarios as used in SP, SB, and SA. VI Applying KUU to SP, SB, ERM, ROA, and SA – A New Way of Thinking about Uncertain Variables and Risk We turn our attention to a new notion – KUU and consider the processes (SP, ERM, ROA) and tools (SB and SA) within its framework (see Exhibit 11.6). What do we know – what is certain? Either the issue is short term (but by definition does not apply to SP) or it has been stable in its performance and there is nothing to expect it will change.

Executive decision-making under KUU conditions

173

What is Unknown? Certainly longer-term states of unstable factors are less predictable and thus the predictability of their future states is less certain. Unknowable? What do we just not see as impacting on our system? The word system was chosen very carefully here. Often the factors that are unknowable are: (a) outside our system as defined and thus they are unexpected when they impact on our system because they simply were not on the radar screen or (b) so unpredictable that we simply do not know where the outcome might be – we can identify the factor, we just cannot identify the plausible states. In using the various programs and processes for managing risk and uncertainty, executives are responsible for moving the Unknown to the Known and the Unknowable as least to the Unknown. Current mandates underscore even more sharply than before that we proactively address this set of issues. How can we apply the KUU concept? SP incorporates these notions implicitly and explicitly. SP helps us to understand the sources of uncertainty and think through the actions to reduce the risks of taking inappropriate action. SP is not as concerned with the Known – if a factor is known it is unlikely to have a range of possibilities that we would not assume are equally probable (i.e., for the purposes of discussion). The Unknown is where SP focuses – on factors that have a range of possibilities and, again, for the purposes of the process assumed to be reasonably equally likely or probable, that is, if one thinks of outcomes as a continuum of some nature, the groups of executives have chosen four nodes on a distribution assumed to have an equal distribution of probability over the range being considered. What about the Unknowable? – Obviously, “simply” by choosing the factors on the axes, the executives are judging the factor/set of factors to be more highly uncertain and also critical (i.e., important to survival). SP, adeptly facilitated, can stretch the imagination as much as humanly possible to consider what other factors, perhaps those currently unknowable, that might have significant effect. What about ROA? It is much the same as SP in terms of understanding the outcomes of decisions taken at each stage of the analysis (i.e., the time modularized decision). The process is less concerned with the known, and rather works explicitly with the unknown. The facilitated process pushes to include what might otherwise be unknowable into at least the unknown. What about ERM? We come to the same conclusion. ERM is a process intended to capture quantitatively and qualitatively the KUUs in each of the critical functional areas of the firm and design contingency plans to minimize negative effects of that scenario (e.g., just in case the scenario entitled “The Pits” in Exhibit A-3 really does occur!). In this sense ERM is a process for bringing the Unknown into the Known, and perhaps the Unknowable into the Unknown chapter. Obviously by choice of current business model executives have implicitly made the assessment that a specific scenario is most likely (a “no–no” for the SP process as strictly defined,

174

Exhibit 11.6. Relating KUU and SP/SB/ERM/ROA/SA ● ●

←

Technique/ Process Hi

R I S K

Relationship to KUU

Lo

Uncertainty

Known

Unknown

→

Hi

Unknowable

SP

SP focuses on the longer-term futures where there is greater uncertainty and therefore higher risk (e.g., regulatory change; world political conditions). While SP deals with the Knowns as a foundation, its emphasis is on the Unknowns. Through pushing the boundaries using dialog and consensus building, SP establishes plausible descriptions of the Unknowns and, potentially, the Unknowables

X

XXX

XX

ERM

A process of inventorying the risks throughout the firm. It deals primarily with the Knowns (e.g., databases of counterparty credit histories), the Unknowns (e.g., the future projections of expected behaviors based on past credit histories), and could potentially deal with the Unknowables

XX

XXX

?

ROA

ROA assumes future flexibility exogenous to the decision-makers (see, e.g., Daniel A. Levinthal (Wharton), “What is not a Real Option: Considering Boundaries for the Application of Real Options to Business Strategy,” Academy of Management Review, January 2004). Thus, it necessarily deals with the Knowns and the Unknowns (i.e., Monte Carlo simulation of expectations)

XX

XXX

?

Managing Enterprise Risk

●

What does KUU have to do with SP/SB/ERM/ROA/SA? What do SP/SB/ERM/ROA/SA have to do with KUU? SP/SB/ERM/ROA/SA relative usefulness in dealing with KUU

SB

SA

Legend for application to KUU: X
applies somewhat; XX
applies moderately; XXX
applies strongly; ?
not sure.

XX

XX

X

XX

X

?

Executive decision-making under KUU conditions

Lo

It would seem that ROA has more difficulty with the unknowables since (by definition) unknowables may be subject to qualitative identification, but not quantification SB is not the same process as SP since SP is generally used to focus on the environment exogenous to the firm and the scenarios thus generated as a basis for generating possible contingent long-term strategies Thus SB is defined here as the use of scenarios which may include qualitative or quantitative parameters or both. The scenarios from SB may be internal to the firm, or external, and are generally short term and used for investment or capital budgeting decisions which may be of a strategic or operational nature While SB deals primarily with the Knowns, the Unknowns, and can also deal with the Unknowables SA is essentially a sub-set of SB in which the variables can be quantified. As defined in this chapter, SA consists of establishing internally consistent and selected sets of quantified predictions of the values that future variables will take. Thus it deals with the Knowns and can only partially deal with the Unknowns, and has at best limited ability to deal with the Unknowables

175

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Managing Enterprise Risk

but an effective approach to proactively minimize enterprise risk). And, from a system approach, the examination of the approaches at the sub-unit level permits a higher-order body, for example, the team of senior executives (dominant coalition) to think through whether there is sub-optimization in order to assure the (presumably very) dominant coalition known as the Board of Directors to make sure that the firm as a whole is (at least defensively) managing “total ERM.” Of course, the executive team wants to formulate a “robust strategy,” that is, one that ensures the company’s survival regardless of which scenario occurs. The strategic management domain since its inception has focused on the executive as the “hero” assisted by analytic techniques. Some of these techniques, such as SP, are more qualitative in nature and rely on experience, judgment, and intuition. Some are more quantitative techniques such as ROA and SA, and most recently ERM. The quantitative techniques are reinforcing of and supportive of SP. In some sense SP establishes the longterm hypotheses about the future against which executive observations of U(nknown) and U(knowable) signposts/milestones and strategic and operational choices are tests of those hypotheses while ROA, ERM, and SA are short-term hypotheses used to ascertain whether the Ks and Us continue to hold. Thus, overall we see that strategic management and finance are both about management of uncertainty, mitigating risk, and enhancing profitability in the short run and survivability in the long run. We can see the comparabilities in the techniques and, increasingly, in the processes. And, we remain convinced that by dialogs across the strategic management – finance boundaries we can provide each “side” a more effective bundle of skills, tools, and processes. VII Conclusions Certainly new ideas do not arrive full-blown in organizations. Incorporation of the concepts presented in this chapter will require consideration by multiple levels in organizations, not just the dominant coalition. Steps include gaining advocacy of senior executives, keeping the language simple, and breaking a new concept or process into “Trojan mice”.39 ROA has been developed over the decade of the 1990s and provides complementary strengths and weaknesses as compared to SP as managers make strategic investment decisions under uncertainty. In an integrated risk management approach these two techniques can be combined. The process involves scenario development, exposure identification, formulating risk management responses, and implementation steps. The discussion in this chapter encourages a corporate-level perspective incorporating consideration of the range of exposure across a firm’s portfolio of businesses. This chapter illustrates qualitative assessment of real options.40 How do these strategic and finance techniques, methodologies, processes, and programs relate to the KUU framework? The critical contingencies are the degrees of the uncertainties and the expectation as to whether, over time, current uncertainties will or can become 39

Daveport, T.H. and Prusak, L., “The Practice of Ideas: Identifying, Advocating and Making It Happen,” Babson Insight, 2003. (Note that this article is adapted from the authors’ new book, What’s the Big Idea: Creating and Capitalizing on the Best Management Thinking (Boston, MA: Harvard Business School Press, 2003.)) 40 See footnote 10.

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certainty. From a business perspective one might invoke “good old SWOTs” (strengths, weaknesses, opportunities, and threats) and consider that SP, SB, ERM, ROA, and SA are ways of examining and designing responses to OTs (i.e., those factors external to the firm). The commonalities41 are worthy of consideration. They include commonality of objectives, overlaps, and interconnections. They focus on the same basic objectives: All the approaches discussed in this chapter have the same end goal in mind – future viability of the firm. SP is concerned with long-term future Unknowns while ERM/ROA/SA are concerned with identification and quantification and emphasizes profitability and firm value, generally a shorter-term perspective. Further, the ROA and ERM process (which utilize SB and SA) clearly encourage broadened participation in dialog and discussion.42 There are tremendous overlaps among SP, ERM, and ROA: SP is essentially going through a process of examining the plausible states of critical OTs43 and then figuring out what might be the most appropriate action to take, that is, how to deploy Ss (or core competences) and mitigate Ws44 (i.e., what changes in strategy should take place). That is a very simplistic description of a process that has undergone 30 or more years of development. One of its most heralded stories, as noted earlier, is enabling Shell to respond more nimbly to the 1973–1974 Oil Crisis than competitors. SP, simplistically thinking, starts with an inventory of the Knowns and then moves on to the future outcomes, or plausible states that the environment can take. SP is usually thought of in terms of a process for identifying longer-term plausible future states and is usually coupled with contingency planning (i.e., what should we do if that future state occurs and what is our current best alternative?) Thus SP goes through a process an outcome of which is generating strategic alternatives that are possible for addressing each outcome. Going through the process of dialog to gain agreement on the descriptions of those plausible long-term futures followed by discussion of the appropriate action to meet the broadest challenge of those future is the most critical aspect of the process. It is the discussion and the arrival at consensus that are critical – in short the participants involved in the process come to a better common understanding of the range of the future situations that might develop. Depending on how the process is structured, the participants might also go the extra step of developing a better understanding of the appropriate 41 Taylor et al. (2003) and Taylor, M., Leggio, K., Coates, T. and Dowd, M.L., “Real Options Analysis in Strategic Decision-Making,” Presentation to ANZAM/IFSAM VI World Congress, Gold Coast, Queensland, Australia, July 10–13, 2002. 42 Diane Lander makes the point that primary benefits of ROA come from the process and not necessarily the end valuation. 43 Note that the term scenario is often used to mean the decisions made and outcomes associated with. It is also used to mean the results of financial/accounting sensitivity analysis (i.e., best, worst, and most likely scenarios). In this section I am referring to Exogenous Uncertainties that impact on the firm. Strategic management often uses PEST as a set of categories to capture these (e.g., political, environmental (physical environment), social, and technological). 44 Although our unit of analysis is the firm, SP can apply at a country level regarding changes in policy or at a department level regarding operations.

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response to each scenario. In short, the process yields contingency plans. SP provides us with the nodes on the distribution of the outcomes.… It is a categorical scale to be sure. SP is a process, a process which permits executives to work out a common understanding of the possible interactive effects of at least two factors or sets of factors in the environment. Once the players in the process have come to a common understanding of four “points” or “scenarios,” then for each of those scenarios, it is more likely that that same set of players can come to concurrence as to what to do should that scenario begin to happen. Note that we are dealing with possibilities not with probabilities, with plausibility not guesstimates of whether the scenario might happen. Stories are told about executives who have gone through a SP process together and then meeting in the hall and saying things like, “Well it looks more likely that ‘The Pits’ is where things are going …have you been preparing…?” It looks simple, doesn’t it? It’s not – gaining consensus is only achieved through a carefully facilitated process – indeed most observe that the process is at least as valuable as the outcome. What are the interconnections? The discussions within the SP, ROA, and ERM processes especially enable executives to establish a range of combinations of possible future states and possible actions. In short, the executives are going through a form of a total ERM process. At the very least they have identified the actions that would be inappropriate given that scenario, and they have agreed ipso facto on the alternative scenarios. As an extra stage, they can then concur on “leading indicators” that signal whether a scenario might possibly be occurring. The contingency plans are better understood as alternative actions. In short, the firm’s executives, at least, have built a broad-based understanding of their environment and the way that their company should be positioned to appropriately address that environment to increase its chances of survival – a truly total ERM approach. Another way of thinking about it is that the executives going through the process have used a qualitative process of truncating their loss alternatives (i.e., an outcome at which ROA is aimed). Thus we see that the fields of strategic management and finance have developed tools and processes that have commonalties. The tools discussed in this chapter are among those that assist executives in identifying and managing uncertainties, mitigating risks, and exploiting opportunities. The biggest problem in crossing the borders between the disciplines is that for a long time we have been trying to quantify strategy factors. That is appropriate. As finance and strategy come together, the finance perspective especially emphasizes quantifying inputs and outcomes. However, instead of trying to force quantification of strategic factors, we should be taking more of a qualitative approach with the financial tools and concepts. The intent thus is to extend the boundaries of K (i.e., what we know), U (i.e., what we don’t know), and U (what we currently cannot know). As well-known psychologist Eric Fromm put it, “The quest for certainty blocks the search for meaning. Uncertainty is the very condition to impel man to unfold his powers.”45 In strategic management and finance we need to mitigate our concerns for our differences and try to pull things together to integrate the two fields in theory, in research, and in practice so that we can expand our understanding and in the process become more successful at mitigating negative outcomes in the short run, help our organizations profitably pursue opportunities in the medium term, and seek appropriate survival alternatives in the long term. 45

Fromm, E., Man for Himself: An Inquiry into the Psychology of Ethics (Routledge, London, ISBN: 978-0-41521020-1 and 0-415-21020-8, 1999).

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Appendix A SP in the power industry – a look at nuclear The four exhibits (A-1 to A-4) that make up this appendix summarize an exercise examining Medium Sized Power Company (MSPC)’s nuclear power alternatives and the long-term uncertain factors that impact on the decision regarding the firm’s business model. In this exercise the participants were asked to undertake three steps: 1. Establish a strategic question (see Exhibit A-1). 2. Identify the critical dimensions that would impact upon the question (see Exhibit A-2). 3. Create “stories” or “scenarios” that were plausible and internally consistent (see Exhibit A-3 and A-4). This group chose the question: what the firm should do regarding nuclear power generation given that the firm was part owner in a major facility. After identification, the critical dimensions were grouped in the scenario matrix as no nuclear acceptability (i.e., combining social and political factors) and cost of alternatives (predicated among other factors on technology advances). The four identified scenarios were given the names “Fossil Heaven,” “Greenville,” “Diversification,” and “Nuckies Rule”. Once the scenarios are written, the executive group sketched their conceptual understanding of the application of scenarios (Exhibit A-4) and used the earlier steps as a basis for creating strategies that are appropriate to the scenarios.46

Exhibit A-1. Focal question for scenario exercise Should MSPC expand its nuclear power capabilities? YES: (a) Purchase remaining stake in existing nuclear facility currently jointly owned Creek (b) Merge nuclear facility with a similar nuclear capability owned by another firm (c) Purchase existing or new unit NO: (a) Liquidate current holdings in nuclear power

46

Actual application of SP varies immensely in practice. What is described here is the classical approach. However, many consultants shorten the process, changes the steps, or includes techniques they have developed in house.

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Managing Enterprise Risk Exhibit A-2. Uncertainties to consider for scenarios

●

Social and political acceptability of nuclear power generation – Environmental →Global warming – Federal and state policy →Regulation versus deregulations – Media and movies →Social pressures – Perceptions and viability of renewable power sources – Safety and danger of nuclear plants (e.g., waste issues) – Nuclear accidents (Three Mile Island)

●

Technology changes – Hydrogen – Fuel cells

●

Cost and volatility of other energy sources – Coal – Natural gas – Wind – Solar – Oil – Hydroelectric

Exhibit A-3. Scenario dimensions

No nuclear acceptability • Renewable model grows in strength as both nuclear and other energy sources become unfavorable and costly • Strong power base for environmentalists

• Regulatory activity that increases cost for nuclear • Accidents or recorded safety reports • Reasonable regulation on CO2 and abundant fossil fuel sources

“Fossil Heaven”

Low cost of

“Greenville”

High cost of “Diversification”

“Nuckies Rule”

• Low cost of alternative sources • Washington in favor of nuclear capabilities Nuclear • Favorable public perception of nuclear acceptability

• CO2 regulation and high costs of fossil fuels • Washington in favor of nuclear capabilities • Improved treatment of nuclear related capital investments • Favorable public perception of nuclear power • Restriction to fossil fuel sources • Stiff regulations on emissions • Creation of new nuclear capabilities

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Exhibit A-4. Scenarios

Wildcard

Y A

Scenarios

B

Area of plausible future

C Wildcard

X

Today

Areas of future

Future

Appendix B What advantages does ROA have compared to NPV? Like NPV, the purpose of ROA is to quantify today’s value of future opportunities. NPV and its counterpart IRR remain the most frequently used management valuation tools for major investment decisions. Even when not explicitly used, NPV usually underlies the basic thinking process behind strategic choices. However, NPV has been greatly criticized on several bases including: (a) its arbitrary choice of a discount rate, (b) the risk adverseness inherent in the choice of the discount rate, and (c) its non-recognition of management’s prerogative to make decisions as the strategic investment evolves. To apply the NPV managers need to know four elements: 1. Discount rate (adjusted to reflect the risk level). 2. Amount of investment or cash outflows (usually assumed as committed, even if expended at various time intervals). 3. Time period for completion. 4. The amount of the cash inflows. In ROA managers need to know five elements about the investment opportunity: 1. Discount rate (risk-free rate). 2. Exercise price is the amount of the investment that the investor can, but does not necessarily have to, make at the conclusion of the next phase. 47 47 In other words, the amount the investor purchases the right, but not the obligation, to make – provided the investor makes the first investment (i.e., buys the option).

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3. Time to expiration (i.e., the time interval before the next investment decision must be made and the capital outlays undertaken). 4. Value of the underlying asset (i.e., the present value of the cash inflows). 5. The volatility, a measure of how uncertain the future value of the opportunity is. For this discussion let us look at two examples, the mid-1990s example of the development of a D-Xerox machine and a second example of large pharmaceutical company acquiring a small pharmaceutical startup. Example #1 – The D-Xerox machine: The D-Xerox machine is a piece of equipment that looks like a Xerox machine but has, rather, the ability to remove all vestiges of copier deposits from paper. The paper can be reused, but, more importantly, sensitive information is permanently erased, a more secure alternative than shredding sensitive documents. The invention is ready for beta testing. The inventor is well aware that the first 2 years of user acceptance will determine success of the venture and that there is considerable uncertainty regarding the extent of user acceptance. The business plan calls for an investment outlay over the next 3 years that can be modularized, that is, the first year can consist of building a limited number of prototypes and seeking and managing beta sites, the second year can involve marketing activities and larger-scale assembly, while the third year calls for more intensive investment in marketing and manufacturing capabilities. In addition, the investment calls for phased inventory buildup of disposable supplies for the equipment. The business plan also outlines plans for other applications for the underlying technology. Compare the D-Xerox situation to a call option in the securities market. Obviously, the option will be exercised only if the stock price is above the strike price on the option’s expiration date. Otherwise, the holder of the option will allow the option to expire as worthless. The D-Xerox venture is really a series of call options (i.e., investment modules or phases). Phase One is the cash inflows and outflows associated with the investment in the prototypes and beta sites – clearly an expected negative outcome! Phase Two is essentially a call option on the future cash outflows and inflows from the scaling up phase, probably also a negative outcome. Phase Three is the future cash outflows and inflows from the greater activity envisioned from scaled-up marketing and manufacturing. However, the expenditures for Phase Two will only be made if the experience in Phase One indicates that the outcomes from the future investment will be positive. Further into Phase One, the Phase Two (and perhaps Phase Three) outcomes are likely to be clearer to management than they are at the beginning of the investment in Phase One. Similarly the investment in Phase Three is contingent upon the outcomes in Phase Two, and could be modified significantly if additional technology breakthroughs are forthcoming. With its heavy weighting of earlier outcomes, standard NPV techniques would properly value Phase One, but the flexibility inherent in future phases is not well addressed with the NPV approach. It is more appropriate to evaluate Phases Two and Three using ROA. NPV, in essence, ignores the reality that the future Phase Two and Phase Three capital outlays are subject to managerial discretion. Thus, NPV rule would undervalue the total value of this opportunity. In using NPV entrepreneurs and managers may be systematically rejecting

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opportunities that really deserve further exploration.48 “Traditional valuation tools do not quantify strategic options embedded within an investment project and, therefore, may produce inadequate indications of the timing of an investment.”49 Traditional NPV analysis of such multi-staged strategic investment decisions generally leads to negative valuation of these situations and thus the decision not to undertake the initial investment. Example #2 – Acquiring a pharmaceutical startup company: As a second example take the possibility of a large pharmaceutical firm such as Merck confronted with the possibility of acquiring BioHope, a small company that has been developing a drug for Alzheimers. The drug appears to have promise and, if successful, could provide sales of several billions of dollars per year and profits of nearly 1 billion. Merck could purchase BioHope today for $600 million. BioHope still has to complete Phase One clinical trials in human patients for its Alzheimers drug and if successful, then incur the larger and larger expenses for Phases Two and Three. In short, if Merck purchases BioHope for $600 million, over the next 10 years Merck would still have to expend another $500 million to take the drug through clinical trials and the Food and Drug Administration (FDA) approval process. Past history indicates there is about a 10% chance the drug can be brought to market. Can this decision be modularized in such a manner that ROA can be applied? The situation has characteristics analogous to those of financial options, the upside potential is huge and the uncertainties are huge. Making an irreversible commitment to the venture through acquisition involves significant opportunity costs. How can Merck structure a series of sequential investments in such a manner that the company can participate in the potential upside while minimizing short-term commitments? The goal would be to gain more information, thereby reducing uncertainty, and making subsequent investments on the basis of the increasing body of knowledge. Merck could offer BioHope an options contract. One structure for the contract would be for Merck to pay $10 million immediately and the remainder spread over 10 years with each payment dependent on the successful completion of the next phase that the payment is funding. The milestone payments could be structured to get larger as BioHope’s drug got closer to market and uncertainty about the ultimate outcomes is reduced. However, Merck would reserve the right to terminate the contract if the BioHope drug did not successfully pass any of its milestones. This situation is an options contract. Why? Because Merck would invest only a relatively small amount to have the opportunity to participate in the BioHope drug’s upside potential. Merck’s downside risk is limited to the milestone (option) payments made at any one point in time. In each “module,” Merck is able to wait for more information before committing additional investment. Merck thus maintains its strategic flexibility since the company is able to consider and pursue other ventures should appropriate opportunities arise. It is true that there is a price. In the final analysis Merck will have to support more than half of the developments costs and incur the costs of manufacturing, sales, and marketing in order to get a royalty on the drug. However, the contract provides significant potential for Merck, and the deal is a good one for BioHope also. 48

See Hevert (2001) p. 2. See Botteron (2001) p. 472.

49

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Traditional NPV would be appropriate if the investors (i.e., Merck), were reasonably confident of the cash flow projections in BioHope’s business plan. NPV would take into consideration the sum of the discounted value of all the cash flows expected for the venture over the foreseeable future. However, given the uncertainties, it is likely that Merck would find that the NPV was negative since earlier net cash outflows are weighted more heavily. Thus, the expectation would be to reject the investment in BioHope. NPV, however, neglects an important critical contingency – if the Merck executives make the initial investment, they retain the right, but not the obligation, to learn more about the technology, market, operations, and future applications. Such learning leads to an accumulation of acquired knowledge. Making the initial investment buys the option to make additional future expenditures to scale up the venture based on this additional knowledge. Further, NPV does not take into consideration management’s prerogative to modify the strategy, delay, or even terminate the venture should management’s enhanced understanding and new information suggest that a change in strategy is needed. As one NPV critic has noted “Standard NPV analysis … treats all expected future cash flows as if they will occur, implicitly assuming a passive management strategy.”50 The passivity accusation is not, strictly speaking, correct. Better put, standard NPV assumes that the management strategy will continue as in the original plan and does not recognize management’s ability to modify its actions contingent on acquired information and understanding (i.e., management’s flexibility). As it turns out Merck was one of the first company to apply a real options perspective to evaluating strategic decisions like the BioHope opportunity. Merck, and other pharmaceutical companies have increasingly found ROA useful in tackling strategic investment decisions of this nature. ROA offers significant advantage over NPV analysis under conditions of uncertainty. Where expectations or predictions of future values are certain (i.e., there is no volatility in the underlying value of the asset), the NPV model will yield the same results as ROA and, given its greater simplicity, should be used. General observations, however, underscore that the world is becoming more complex – not simpler – and thus we can expect tomorrow’s uncertainties to be greater. The overall situation suggests that ROA will continue to demonstrate greater value for application in an increasingly volatile environment. Strategic decision-makers need to take note of the volatility measure, the only piece of data required for valuing a real option that is significantly different than the elements required for a NPV analysis. Volatility is explicitly recognized as a key driver of value in ROA. Indeed the greater the volatility, the greater the value of the option, a concept that is difficult for many strategic managers steeped in the NPV approach to grasp. In the NPV approach, high volatility is recognized through the use of higher discount rates. Higher discount rates lead to lower values for the investment. In ROA, higher volatility is linked to higher value. There are at least three reasons why:

50

●

Since greater volatility creates a wider range of possible future values for the opportunity.

●

As strategic decision-makers can actively manage the investment in taking continuous cognizance of these future values and add value on an ongoing basis, an aspect

See Hevert (2001) p. 2 (Emphasis added).

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explicitly recognized in ROA but not in NPV where the all-or-nothing decision is assumed to be made at one point in time. ●

As the strategic decision-makers will only exercise their options to make the future investments if the value of the opportunity exceeds the exercise price. Greater uncertainty on the downside will not hurt them. They clearly will not make the investment (i.e., exercise their option). However, greater uncertainty (i.e., spreads of values) on the upside produces greater excess of opportunity over the required investment (i.e., exercise price). Thus, there is a correspondingly greater option value under conditions of greater uncertainty.

Another set of ROA scholars-practitioners has suggested that the major advantages of ROA are as follows: First, option valuation is based on objective inputs and a precise list of which inputs are needed and which are not. Those inputs are used in a way that produces market values and the real options approach guides the user on where to look and why. Experienced users of the real options approach see the patterns, the types of options, and the important sources of uncertainty. Second, the real options approach provides a framework for revising expectations. In the real options approach, investments are managed over time. The optimal exercise of managerial options requires frequent scans of the environment and updates of important information. Although it is impossible to always avoid the sin of omission, the disciplined thinking about the consequences of uncertainty in the real options approach can help.51 In addition, significant value can accrue to a firm during this process in the form of organizational learning. NPV cannot include the variety of strategic possibilities – new information, changing market conditions, new technologies, and the simple fact that many uncertainties become less uncertain as time goes by. The traditional NPV analysis is appropriate for valuing strategic opportunities in which: a. The decision to be made is once for all (i.e., there are no future nodes at which the investment could or would be modified). b. The future situation is expected to be stable. c. The strategy and operational modus operandi will hold fairly constant. However, these criteria characterize few strategic decisions. Rather strategic decisions typically are: a. Multi-staged (i.e., the decision can be modified, delayed, even reversed at a future point). b. Increasingly made under conditions of uncertainty (i.e., the future is not expected to be stable). c. Actively managed since managers, given their fiduciary responsibility on behalf of owners of the investment, will make modify their actions in order to maximize the value of the investment in the future, including cease the activity completely if necessary. 51

See Amram and Kulatilaka (1999) p. 45.

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