Joint Ventures and the Option to Expand and Acquire

Joint Ventures and the Option to Ex-pand and Acquire

Bruce Kogut (1991)Management Science, 37(1): 19-33.

Jae Kyun Yoo

Foundations of Strategy Research (Fall 2013)

• Undergrad: U.C. Berkeley (Political Sci-ence)

• Masters: Columbia University (Interna-tional Affairs)

• Ph.D.: M.I.T. Sloan• Assistant, Associate, Chaired Professor at

Wharton• Currently Chaired Professor at Columbia

University

Introduction

• The task of building a market position and competitive capabili-ties requires lumpy and non-trivial investments.

Bruce Kogut (1991)Joint Ventures and the Option to Expand and AcquireManagement Science, 37(1): 19-33.

• It is beyond the resources of a single firm to buy the right to expand in all potential market opportunities.

• A partner, especially one which brings the requisite skills, may be sought to share the costs of placing the bet that the oppor-tunity will be realized.

Joint Ventures• Due to its benefits of sharing risk and of reducing overall in-

vestment costs, joint ventures serve as an attractive mecha-nism to invest in an option to expand in risky markets.

Focus - The exploration of the link in the timing of the ac-quisition of joint ventures and of the exercise of the option

to expand.

• To exercise the option to expand requires further commitment of capital, thus requiring renegotiation among the partners.

• One possible outcome is that the party placing a higher value on this new capital commitment buys out the other.

Real Option Perspective

• Firms engage in cooperative ventures as buffers against uncertainty (Pfeffer & Nowak, 1976) and that managerial discretion is severely limited by environmental volatility (Hannan & Freeman, 1977; McKelvey & Aldrich, 1983).

• Joint ventures are designed as mechanisms to exploit, as well as buffer, uncertainty.

• Joint ventures are investments providing firms with the dis-cretion to expand in favorable environments, but avoid some of the losses from downside risk.

Real Options Theory


Real Options

• Joint ventures are real options… in terms of the economic op-portunities to expand and grow in the future.


• An alternative or choice that becomes available with a busi-ness investment opportunity. Real options can include oppor-tunities to expand and cease projects if certain conditions arise, amongst other options. They are referred to as “real” because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into ac-count real options can greatly affect the valuation of potential investments. Oftentimes, however, valuation methods, such as NPV, do not include the benefits that real options provide. - In-vestopedia

Real Options (cont.)


• The value of any investment can be broken into the cash flows stemming from assets as currently in place and those stem-ming from their redeployment or future expansion (Myers, 1977).

𝑉 𝐽=𝐹 𝑗 ( 𝐾 ,𝜋 )+𝑂 𝑗 ( 𝐾 ,𝜋 )

Value of the venture as estimated by the jth

firm

Value of the assets

in their current use

Valuation of the future growth op-portunities

Pindyck (1988)K: investment

: current value of an uncertain state variable

Joint Ventures as Real Options

Two options why joint ventures can be viewed as analogues.

Waiting to invest – It pays to wait before committing resources.

• Joint ventures resolves partly the tradeoff between buying flexibility now and waiting to invest and focus later (Werner-felt & Karnani, 1987).

Expanding production – Investment commitment is necessary in or-der to have the right to expand in the future.


• When the market for the technology or new product is proven, the option to acquire is likely to be exercised.

Timing of Exercise


• The acquisition is justified only when the perceived value to the buyer is greater than the exercise price.

Value of the op-tion to acquire

Value of the jth firm of purchasing

the remaining shares in the ven-

ture

Price of pur-chasing the remaining

shares

and <1 and is the current share owned by firm j

¿

Timing of Exercise (cont.)


• The timing of the exercise of the option to terminate the ven-ture by acquisition is influenced by two considerations: the ini-tial base rate forecast underlying the valuation of the business and the value of the venture to each party as realized over time.

The venture will be acquired when its valuation exceeds the base rate forecast.

Selection Cues and Market Valuation

Two time-varying specifications of the market cues relevant to the acquisition decision is considered.

Short-term annual growth rate

Annual residual error from a long-term trend

These two variables are proxies for changes in the unobserved state variable that determines the value of the joint venture.

• The likelihood of an acquisition should increase with positive movements of the proxy variable.


¿

¿

Statistical Results


Managers are sensitive to a long-term intra-industry base rate which serves as a standard by which to eval-uate annual changes.

Termination by Dissolution


If joint ventures are designed as options, then as long as the investment is sunk and the operating costs are moderate, downward movements should not lead to dissolution.

Conclusion

Joint ventures are designed as options.


Factors that increase the likelihood of an acquisition.• Unexpected increases in the value of the venture.• The degree of concentration in the industry.

Firms may profit from uncertainty.• A more flexible production process or organizational design (Pi-

ore & Sabel, 1984).• Investments in joint ventures which serve as platforms for pos-

sible future development.

Joint Ventures and the Option to Expand and Acquire

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