Staged Investment Example

Real Options Valuation (ROV) can be applied in most strategic decisions. Herein, we show a simple application of ROV by considering a firm’s decision to invest in two stores in a foreign country.This analysis can, however, be extended to different types of investments.

In this example, we show two important messages of ROV. First we show how a negative Net Present Value (NPV) does not imply that investment should not be made. There may be strategic gains of investment that are not considered in the NPV, but are internalized by ROV. And second, we show how a positive NPV does not imply that the firm should invest in full capacity. There may be strategic gains by making staged investments, which again are only considered by ROV.

Assumptions:

The assumptions herein presented are for exposition purposes. In real life, we consider much more complex and realistic contexts to improve accuracy and create value for our clients.

Investment is completely irreversible:once the firm opens a store, the investment in the store is sunk.
The firm has three alternatives. It can open one store, two stores, or not invest. This year's decision:

Invest in one store

Invest in the two stores

Not Invest

-2M€
1.1

= -1.82M€

After Information is revealed, there is certainty about future demand

NPV per store next year
after opening one store

NPV per store
this year

3M€

High
Demand
NPV

Expected

NPV

Low
Demand
NPV

= 2.73M€

3M€
1.1

0.5M€

-2M€

Standard analysis suggests the firm should open both stores in the first year. The NPV is 0.5M€ to open one store, and 1M€ to open the two stores. But standard analysis again ignores the strategic component: it ignores the option of the firm to only invest in a second store if the first one confirms high demand.

If the firm opens only one store this year, it has a NPV of 0.5M€, and has the option to open a second store next year. The firm will only open the second store if demand is high. The probability it happens is of 50% and in that case the NPV is 2.73M€. Thus the option is worth 1.37M€, and the economic value to open only one store in the first year and test the market is 1.87M€, which exceeds the NPV to open two stores in the first year.

The optimal strategy for the firm is, thus, not to open the two stores this year; the firm should seize its strategic power by opening one store this year, gain information about the market, and open a second store next year if demand is high.

The firm will only open the second store in the second year if demand is high. Discounted to the present (1.82M€) and multiplied by the probability that the stores have high demand in the foreign country (50%), the value to open a second store next year is 0.91M€. Thus, the economic value to invest in one store is - 0.5M€ (NPV one store this year) + 0.91M€ (value of the real option to expand) = 0.41M€, which is positive: The firm should open one store, gain information about the market, and open a second store if demand is high.

This simple example shows how the NPV ignores strategy and flexibility, misguiding decision makers. ROV, on the other hand, integrates strategic thinking into Business Valuation. ROV valuates the value of strategy and flexibility. In the next case, we contrast again the NPV with ROV. In the next case, however, the NPV is positive because investment is smaller.

What if investment=7M€?

Analysis:

Should the firm invest in one store, invest in two stores, or not invest?

Standard analysis suggests the firm should not invest. The NPV is -0.5M€ to open one store, and -1M€ to open two stores.

But standard analysis ignores the strategic aspect of the investment decision: the firm has the option to open one store in the first year, test the market, and then open the second store in the second year if demand is high. How much is this option worth?

Investment per store= 8M€. The NPVs, then, are:

If the demand of a store is high, then the demand of the remaining stores is also high. The same applies for low demand.
The firm has no other alternative to gain additional information about the demand of their stores. To gain additional information about demand, the firm has to open at least one store.
Discount rate = 10%. Thus, in present terms, the DCFs are:

The firm can test the market: Once the firm makes opens a store, it obtains information about the demand of their stores in the foreign country.

The firm is unaware of the demand of its products because of cultural differences between the home country and the foreign country, which increases investment uncertainty.
We assume, however, that the firm knows that the Discounted Cash Flow (DCF) is 10M€ per store if demand in the foreign country is high. If demand is low, the DCF is 5M€ per store.
The firm also knows the probability that demand is high. With a 50% probability it is high, and with a 50% probability it is low. This, together with the previous assumption, implies that the expected DCF is 7.5M€.