Search Menu Abstract In this article, we examine whether the option value of keeping an operation alive will deter firms from exiting an industry. We find that uncertainty dissuades firms from exiting an industry, but only when the sunk costs of entering and exiting that industry are sizeable.
Moreover, we argue real option to exit find that sunk costs can be influenced by the technological intensity of 60 second binary options strategy industry, by the extent to which a firm competes on the basis of innovation, and by the firm's diversification strategy.
Introduction There is growing evidence that real managers take real options into account when making important investment decisions Busby and Pitts, However, almost all of the extant empirical research has focused on the decision to initiate an investment Li et al. Despite being theoretically well developed Dixit, real option to exit question of whether real managers employ real options logic when considering terminating an investment has received far less attention.
Neglect of this topic leaves a distinct gap in the literature because many entry decisions can be characterized as mistakes Vivarelli and Santarelli,and, consequently, many industries experience a surprisingly high rate of churn as firms enter but subsequently exit Barteisman et al. In this article, we explain how real options theory helps us to better understand the evolution of industries by illuminating the factors that influence the decision to exit from an industry.
Furthermore, we examine how this perspective challenges entrenched notions about exit decisions, and we explore how firm strategy can affect the value of real options, real option to exit, hence, the probability of exit. Real options theory yields significant insights into the exit decision because it challenges two common assumptions about industry exit.
The first is that inertia with regards to the exit decision is inefficient e. In contrast, real options theory demonstrates that uncertainty about future payoffs creates a zone of inaction where the wisest course of action is to wait until more information is gathered.
While the economic rationale of inertia in response to uncertainty has received some attention in the research on exit, very little attention has been given to how real options theory challenges a second common assumption about exit: The role of sunk costs.
The option of exercising future managerial discretion is most valuable when investment decisions involve not just considerable uncertainty, but when those decisions also entail sunk costs Coucke et al. Hence, scholars have interpreted evidence that people consider sunk costs when making an abandonment decision as evidence of biased decision-making Staw, ; Ross and Staw,and responded by devoting considerable class time and textbook pages to teaching business students to ignore sunk costs Friedman et al.
However, as we describe below, the sunk cost fallacy is premised on an outdated model of economic rationality. Real options theory shows that attention to sunk costs when considering exit is indeed entirely rational, and thus it has profound real option to exit for theory, practice, and even teaching. Absent any sunk costs, there is no economic rationale for persisting in an industry in the face of losses, as the firm could simply exit and re-enter later if conditions improve appreciably.
However, in the presence of significant sunk costs, it is rational to persist and endure some amount of losses if there is some possibility that industry profitability may improve Dixit, If conditions do improve, managers who decided to exit may very well regret that decision because the firm would have to incur those sunk costs all over again in order to re-enter. Thus, managers should consider how the confluence of significant sunk costs of re entry and the potential for improvement in the industry makes inertia optimal because persistence preserves the option of future profitable operations in the industry.
While the economic logic of this real option has started to gain some acknowledgment e. Even the popular finance textbook by Brealey et al. To be clear, real options theory would concur with the preexisting literature that the sunk cost effect is real and robust; it would simply add that this effect is also quite rational.
Friedman et al.
Thus, consistent with the view that the decision heuristics we employ evolved to be there because they generally serve us quiet well Kihlstrom,the real options logic may be rationally embedded in the real option to exit intuition Busby and Pitts, In this article, we explore how real options influence real world exit decisions.
Our empirical results indicate that while uncertainty generally dissuades exit from an industry, its effect is most pronounced in technologically intensive industries, which tend to be characterized high levels of investment irreversibility Fichman, Furthermore, we also extend real options theory by exploring how the option value of persisting in an industry may be influenced by the firm's strategy.
Specifically, we contend that the sunk costs associated with industry exit and reentry, and, hence, the option value to persisting in an industry, will be influenced by both the extent to which a firm attempts to differentiate its products by investing in innovation, and real option to exit the firm's diversification strategy. In addition to contributing to both real options theory and the broader literature on exit, these results also have weighty implication for practicing managers.
Theory and hypotheses 2. Jorgensen criticized this emphasis on current profits as too static, and emphasized that expected profits should be part of the calculus for investment decisions. According to this neoclassical perspective, managers should exit when the NPV of remaining in the industry falls below zero.
The real option to exit model is most typically operationalized via dynamic discounted cash flow DCF models, where decisions to proceed or halt an investment are updated every period by calculating revised NPVs.
While the neoclassical model has proven to be a powerful and useful framework for making real option to exit decisions Graham and Harvey,it has two major limitations. First, it fails to offer much insight into how uncertainty should influence investment decisions.
The neoclassical model argues that only systematic risk matters, but since systematic risk may affect both the expected returns and the discount rate associated with a project, its net effect on NPV is ambiguous Holland et al. A second limitation is that it is unable to explain why sunk costs that have already been incurred may influence the exit decision. Forward looking but static DCF models fail to value the potential wisdom of a managerial change of heart, and, hence, treat sunk costs as irrelevant when computing the NPV of remaining in an industry.
Exit Option Definition
However, research has shown that sunk costs do matter, and firms may persist in an industry if they have made large investments in physical or intangible assets that cannot be recovered in the event of exit Porter, ; Harrigan, If one assumes that the neoclassical model describes economic rationality, ideas how to make money easily a relationship between sunk costs and exit can only be explained by theories premised on irrationality e.
In contrast, real options theory demonstrates that when managers are uncertain about the future of an industry, it is perfectly rational to consider sunk costs when making the exit decision Dixit, Real options theory argues that it may be economically wise for even poorly performing firms to persist in an industry. Although precise valuation can be quite complex Dixit,the intuition is not.
Suppose a firm is considering abandoning an industry in which it is currently competing. As uncertainty increases, real option to exit distribution of possible future outcomes widens, the potential for significant improvement in industry conditions increases, and exiting the industry becomes less attractive.
The options logic is pertinent here because the firm can always truncate the downside by exiting later if conditions either fail to improve or deteriorate. However, a firm that exits now real option to exit wish to subsequently re-enter the industry if conditions improve significantly.
Unfortunately, a firm that exits now and re-enters later must re-incur all, or at least part, of the sunk costs of entry. Thus, a firm will be willing to incur some operating losses in order to preserve the option of future profitable operations should improve industry conditions Dixit, In order to induce exit, the losses have to exceed the value of keeping this option alive.
First, research on the sunk cost fallacy has been driven by the premise that any attention to previously incurred sunk costs is irrational. Yet, as we have discussed, this premise is derived from an incomplete model of economic rationality i. Real options theory shows that attention to sunk costs when making exit decisions is entirely rational. By Occam's razor, the real options perspective on sunk costs should be considered the default explanation because it is more parsimonious.
That is, a real options explanation real option to exit only a relatively simple assumption that decision-makers choose a certain course of action because it is wise to do so. In contrast, the sunk cost fallacy relies on the more complex assumption that people fail to act in their own best interests, which is contrary to arguments from evolutionary psychology that people generally employ useful decision-making heuristics Kihlstrom, Second, much of the research supporting the sunk cost fallacy is been based on case studies Staw, ; Ross et al.
However, anecdotes can only real option to exit that errors occur and offer no evidence of a systematic bias in the error distribution. Accordingly, anecdotes can also be used to illustrate a reverse sunk cost bias Heath, Third, as Friedman et al. Fourth, although Friedman et al.
Fifth, numerous psychological mechanisms have been proposed to explain the sunk cost effect. However, a recent study by Biyalogorsky et al. While an involvement effect would suggest that irrational biases are at work, the authors found instead that the only psychological mechanism driving persistence was biased belief updating.
Thus, the only mechanism actually found to be related to the sunk cost effect is actually consistent with rational choice.
Finally, even if a trivial sunk cost bias can be detected by laboratory experiments deliberately contrived to detect such an effect, it may be questionable whether it would persist in real world applications.
Behavioral real option to exit has found that individual cognitive biases can be largely attenuated when subjects are motivated to be accurate Kruglanski,feel that they will be held accountable for their decisions Tetlock,take more time to make their decision Webster,or even just by the routines of organizational decision-making Burgelman, ; Tetlock, Certainly, cognitive biases may real option to exit useful insights into the decision-making processes of individuals in many real-world situations.
However, given the likely time, effort and diligence invested in major decisions such as exiting an industry, in conjunction with the fleeting and minor influence of any potential sunk cost bias, we believe that real options theory provides a superior framework for considering firm inertia with regards to exit decisions.
Ansic and Pugh used laboratory experiments with students to surmise that the presence of sunk costs and exchange rate uncertainty has a negative effect on exit from foreign industries.
Real options valuation
Similarly, Tiwana et al. In terms of real world exit decisions, Moel and Tufano found that a real options model explained the opening and closing of North American gold mines between and better than the neoclassical model. However, this evidence only shows that real options can explain the decision to suspend operations, and not that real options can explain managerial decisions to exit from industries.
Stronger evidence is supplied by Campawho examined whether real options could help explain the decision to cease foreign export activities.
Unfortunately, he found only mixed evidence in support of the theory. We how to work with dealing centers that his weak results may be due to his operationalization of uncertainty, which was based solely on exchange rate uncertainty.
While this is certainly an important component in the exit decision, it is really total uncertainty which is pertinent. Hence, neglecting the uncertainty in the exported goods product market may result in an imprecise test of real options theory. Ghosal provides probably the most comprehensive test to date of the tendency for real options to influence the decision to exit real option to exit. However, his ability to control for alternative explanations was hampered by the nature of his data. Ghosal only had data on the total number of firms in each industry, and thus could only assess net changes in the number of industry participants rather than true entry and exit.
- CFOs tell us that real options overestimate the value of uncertain projects, encouraging companies to overinvest in them.
- An exit option is a stipulation within a business plan or project that allows a company to discontinue the plan with while triggering limited financial consequences.
- Using real options in strategic decision making by Chris Walters and Tim Giles of London Economics Spring To maximize a firm's value its managers must match internal capabilities to external opportunities.
- Types of real options[ edit ] Simple Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from "Investment Example".
- Они были любопытны.
- Using real options in strategic decision making
Also, lacking firm level data, he could not control for firm level factors such as performance that might induce broadly similar results. Thus, while some evidence exists to support a real options perspective on exit, much more remains to be done. In particular, while existing evidence suggests that both uncertainty Harrigan, and sunk costs Porter, influence exit, and that stock markets value the real options associated with termination decisions Berger et al.
Hence, we develop hypotheses below relating to the ability of real options to deter exit and we test our predictions on a large sample of business unit exits by public corporations.
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It is thus no surprise that studies have found that current performance, which is one of the best predictors of future performance Ball and Watts,is a powerful determinant of exit Ravenscraft and Scherer, Real options theory is intended to supplement not supplant this view by emphasizing that it is not just expected value of future profitability that matters, but that the distribution of potential future cash flows also warrants real option to exit.
With greater uncertainty, there is a greater possibility that struggling firms can turn things around. Conversely, if conditions deteriorate, the firm can always truncate losses by exiting later. Hence, greater uncertainty in an industry should, ceteris paribus, dissuade firms from exiting that industry because vmdio auto trading increases the option value of persisting in the industry.
Hypothesis 1. Greater uncertainty makes it less likely that a firm will exit an industry. Recent evidence suggests that real options are most salient to managers when other quantifiable benefits are negligible Tiwana et al. While this may represent biased decision-making in some situations Tiwana et al. When profitability is high, the option value to persisting in an industry is an immaterial consideration because it is unlikely that managers will be considering exit.
Making Real Options Really Work
However, as profitability falls, and the easily quantifiable benefits of remaining in the industry evaporate, the option value of persistence should become much more influential. Hence, we propose that the real option to exit of the industry's uncertainty on exit will depend upon current performance.
Hypothesis 2. As a firm's profitability in an industry decreases, the negative impact of uncertainty on exit from that industry will become stronger. Although uncertainty should generally dissuade exit, we have argued that sunk costs will play a critical buying a call option in moderating this relationship. If the capital committed to the industry was fully reversible, then a poorly performing firm could exit, re-deploy its capital, and reenter later if industry conditions improve.
Conversely, if the capital committed to the industry is largely sunk, then the firm cannot costlessly reverse the exit decision.
Thus, uncertainty about future conditions in the industry should matter most when entering that industry requires sunk cost investments. While sunk costs are not easily observed or measured, theory suggests that investments in technology are generally highly irreversible Fichman, Arrow argues that intangible assets have little value outside their current application because they are likely to suffer from market failure, making trade on the open market difficult relative to physical assets.
Hence, firms that compete in technologically intensive industries should generally incur higher sunk costs. Accordingly, we propose Hypothesis 3. The negative impact of uncertainty on exit will be stronger in technologically intensive industries.
Regardless of the technological intensity of an industry real option to exit it high or lowfirms vary within industries in the extent to which they attempt to compete on the basis of innovation.
Theory suggests that the stock of innovative capabilities is best built by steady, continuous investment over a period of time Dierickx and Cool, Therefore, firms that leave and subsequently re-enter will be at a competitive disadvantage relative to other would-be innovators that remained in the industry and continued to build their capabilities.
Just as Kulatilaka and Perotti point out that delaying entry can entail strategic losses, we contend that the category of sunk costs should also encompass strategic losses associated with exit.
Even if the capital committed to an industry is fully reversible, the competitive position of a firm that exits now and re-enters later may be significantly eroded because the firm would have been much more competitive had it not taken temporary leave. Whereas firms that compete on low cost by reaching economies of scale with fungible assets may suffer relatively small competitive sunk costs, these costs might be quite severe for aspiring innovators.
In addition to increasing sunk costs, innovation-based strategies may also moderate the value of the option to defer the exit decision by helping firms to learn about and act upon unfolding opportunities in the industry. However, when faced with a turbulent environment, the upside of the uncertainty distribution might well be accentuated for innovators, relative to non-innovators. An industry that is characterized by considerable uncertainty is one, by definition, in which there is a significant possibility that conditions will undergo dramatic change.
Although firms often have trouble adapting in a changing environment, innovators should generally be more capable of spotting opportunities and adapting to change Cohen and Levinthal, ; Pisano, ; Windrum, Thus, innovators may be particularly well-positioned to capture a disproportionate share of the industry's upside potential, and, hence, would be less likely to abandon such environments.
If innovator firms incur higher sunk costs and real option to exit reap an accentuated upside to the distribution of potential outcomes, then uncertainty should be a greater deterrent to exit for these firms. Hypothesis 4. The negative impact of uncertainty on exit will be stronger for firms that compete in the industry on the basis of innovation.
Firms expand in order to productively deploy underutilized resources Penrose, Although those resources may sometimes be of use in unrelated industries, they will generally be most applicable to industries that are related to existing operations Montgomery and Wernerfelt, ; Piscitello, Exiting an industry that is unrelated to the rest of the firms operations may allow a firm to refocus its operations and improve performance Hoskisson et al.
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- Джизирака кооптировали на одно из образовавшихся вакантных мест в составе Совета.
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- Making Real Options Really Work
Furthermore, synergy across business units may help a firm better capitalize on an industry's upside potential. Hence, a pure resource-based perspective implies that relatedness will amplify the tendency for uncertainty to dissuade exit.