Nelson Ferreira

Jayanti Kar

Lenos Trigeorgis

Between 1995 and 2001, annual revenues for the U.S. commodity chemicals industry fell from $20 billion to $12 billion, while companies’ operating profits fell on average by 26% a year. The collapse was in large measure caused by a tight economic environment and a rising dollar. But outside forces were only part of the story—industry players also made some very poor decisions. Managers were only too eager to invest excess cash in new capacity, fearing that competitors’ growth would outpace their own. As the new capacity came online, it exacerbated the pressures on prices and profitability.

euHx23CfjZ421mJvaLs+TqnoxmJjdvPZt0lXj3hJLN6KMZSqKW+zl2DNR965yJyQ1U7ZvIi39NvsMeLYSFYxXspOZKyCg3awuav+Ej0Wa4tff8VTtsVdMg7PCOo8dNoUxf1mrWFhx0Eswm2Vz5YfFMnE9kN3UDRweYxeAjubcVh1LfJ0XgmKg65szG8ZhZGo

Reprint: R0903H
All companies making big-budget investment decisions face the same basic dilemma: On the one hand, they must make timely, strategic investments to prevent rivals from gaining ground. On the other, they must avoid tying up too much cash in risky projects, especially during times of market uncertainty. The traditional valuation methods&#8212;namely, discounted cash flow and real options&#8212;fall short in resolving this dilemma. Neither one, on its own, properly incorporates the impact of demand and price volatility in an industry while also taking into account additional investments that the firm and its competitors may make.
In this article, Nelson Ferreira, an associate principal at McKinsey &#038; Company in S&#227;o Paulo; Jayanti Kar, an associate at McKinsey &#038; Company in Toronto; and Lenos Trigeorgis, a professor of finance at the University of Cyprus and the president of the Real Options Group, present a valuation tool that overcomes the shortfalls of those analytic approaches. The tool, called option games, combines real options (which predict the evolution of prices and demand) and game theory (which captures competitors&#8217; moves) to quantify the value of both flexibility and commitment, allowing managers to make rational choices between alternative investment strategies. Option games will be of particular value to companies facing high-stakes decisions, such as those involving millions of dollars in capital investment, in a volatile environment in which their moves and those of their competitors clearly affect each other.

Option Games:&nbsp;The Key to Competing in Capital-Intensive Industries

Reprint: R0903H All companies making big-budget investment decisions face the same basic dilemma: On the one hand, they must make timely, strategic investments to prevent rivals from gaining ground. On the other, they must avoid tying up too much cash in risky projects, especially during times of market uncertainty. The traditional valuation methods—namely, discounted cash flow and real options—fall short in resolving this dilemma. Neither one, on its own, properly incorporates the impact of demand and price volatility in an industry while also taking into account additional investments that the firm and its competitors may make. In this article, Nelson Ferreira, an associate principal at McKinsey & Company in São Paulo; Jayanti Kar, an associate at McKinsey & Company in Toronto; and Lenos Trigeorgis, a professor of finance at the University of Cyprus and the president of the Real Options Group, present a valuation tool that overcomes the shortfalls of those analytic approaches. The tool, called option games , combines real options (which predict the evolution of prices and demand) and game theory (which captures competitors’ moves) to quantify the value of both flexibility and commitment, allowing managers to make rational choices between alternative investment strategies. Option games will be of particular value to companies facing high-stakes decisions, such as those involving millions of dollars in capital investment, in a volatile environment in which their moves and those of their competitors clearly affect each other.

Option Games: The Key to Competing in Capital-Intensive Industries

Summary.

Partner Center