Can real-options analysis improve decision-making? Promises and pitfalls

Academy of Management Executive

Volumn 18, Issue 4, 2004, Pages 60-75

  Janney, Jay J ^a   Dess, Gregory G ^b  

^a UNIVERSITY OF DAYTON   (United States)

^b UNIVERSITY OF TEXAS AT DALLAS   (United States)

Author keywords

[No Author keywords available]

Indexed keywords

EID: 11044226918     PISSN: 10795545     EISSN: None     Source Type: Journal    
DOI: 10.5465/AME.2004.15268687     Document Type: Review

References (28)

1. The earliest insights on this topic emerge from Frank Knight's efforts to define a meaningful difference between risk and uncertainty. Knight, F. 1921. Risk, uncertainty, and profit. New York: Harper and Row.
2. McGrath, R. G. 1997. A real options logic for initiating technology positioning investment. Academy of Management Review, 22(4): 974-996.
3. McGrath, op. cit.
4. Berger, P. G., Oiek, E., & Swary, I. 1996. Investor valuation of the abandonment option. Journal of Financial Economics, 42: 257-287.
5. Bottoron, P. 2001. On the practical application of Real Options Theory. Thunderbird International Business Review, 43(3): 469-479.
6. Huber, G. P. 1991. Organizational learning: The contributing processes and literature. Organization Science, 2(1): 89-115.
7. Bruce Kogut was among the first to explore corporate-level real options, with his work on internal joint ventures. Kogut, B. 1991. Joint ventures and the option to acquire and expand. Management Science, 37: 19-33.
8. McDonald, R., & Siegel, D. R. 1986. The value of waiting to invest. Quarterly Journal of Economics, 101: 707-727.
9. For an early but valuable treatment on this topic, see Bowman, E. H., & Hurry, D. 1993. Strategy through the option lens: An integrated view of resource investments and the incremental-choice process. Academy of Management Review, 29: 74-85.
10. One of the better discussions on the various limitations to formally modeling real options comes from work by Dixit and Pindyck. For reasons of parsimony, we discuss only one of the four elements whereby valuations can be mis-specified. Dixit, A. K., & Pindyck, R. S. 1995. The options approach to capital investment. Harvard Business Review, 73: 105-113.
11. One of the authors formerly worked as a financial analyst for the Federal Government. The parties could not agree on the appropriate discount rate for capital investments-so an executive decision (A-11) was made to use 7 per cent, "because historically that rate has been used in the past." At least it was consistent.
12. On the uncertainty involved in the PDA drug-approval process, the FDA has provided many valuable reports, including the following: From test tube to patient: New drug development in the United States. FDA Consumer, Special issue, January 1995.
13. Agency theory suggests that managers might engage in adverse selection, where they promise what they cannot provide, and moral hazard, where they pursue their own interests because those efforts cannot be easily monitored. John Hendry provides an insightful extension on this concern. Hendry, J. 2002. The principal's other problems: Honest incompetence and specification of objectives. Academy of Management Review, 27(1): 98-113.
14. There have been some good efforts to link a real-options perspective with managerial decision-making, such as escalation of commitment. Russell Coff and Kevin Laverty provide an especially insightful analysis of the topic. Coff, R. W., & Laverty, K. J. 2001. Real options on knowledge assets: Panacea or pandora's box. Business Horizons, 73: 79.
15. For understanding the differences between how managers say they approach decisions and how they actually do, March and Shapira's work is among the best. March, J. G., & Shapira, Z. 1987. Managerial perspectives on risk and risk-taking. Management Science, 33 (11): 1404-1418.
16. McGrath, R. G. 1999. Falling forward: Real options reasoning and entrepreneurial failure. Academy of Management Review, 24(1): 13-30.
17. Coff & Laverty, op. cit.
18. Zardkoohi, A. 2004. Do real options lead to escalation of commitment? Academy of Management Review, 29(1): 111-119.
19. The tragedy of the commons describes a situation where users of a good aren't responsible for its maintenance, leading to overuse. It originated to explain the benefits of property rights and why privately held lands suffered less erosion than publicly held grazing lands. Staw, B. M., & Ross, J. 1987. Behavior in escalating situations: Antecedents, prototypes, and solutions. Research in Organizational Behavior, 9: 39-78.
20. March & Shapira, op. cit.
21. Grenadier, S. R., & Weiss, A. M. 1997. Investment in technological innovations: An option pricing approach. Journal of Financial Economics, 44: 397-416.
22. Ironically, this didn't always eliminate escalation of commitment. Two of the major criteria for considering a closure were the impact on the local community and the outlay cost for closure. As a result, some bases which suffered higher operational costs remained opened, even though the overall cost to the Department of Defense was greater.
23. Royer conducted a study of two major firms that had technological programs with very long durations and concluded that exit champions shortened decisions by several years Royer, I. 2003. Why bad projects are so hard to kill. Harvard Business Review, 81(2): 49-56.
24. Nahapiet, T., & Ghoshal, S. 1998. Social capital, intellectual capital, and the organizational advantage, Academy of Management Review, 23(2): 242-266.
25. In addition, firms and societies which accept failure see more exploration attempts. Our perspective in this article could have important implications for networks that exist within society as well as beyond the boundaries of the firm. See, for example, McGrath, R. G. 1999. Falling forward: Real options reasoning and entrepreneurial failure. The Academy of Management Executive, 23(2): 242-266.
26. We note the concern that all of these approaches have been described as being real options. As more and more types of decisions are considered to be options, it can lead managers into several of the pitfalls we described. We think they are also valuable tools, and a better understanding of each should lead to improved decision-making.
27. For an insightful perspective, see Kogut, B., & Zander, U. 1992. Knowledge of the firm, combinative capabilities, and the replication of technology. Organization Science, 3(3): 383-398. Such resources often represent specialized knowledge that can, in turn, be used to generate future opportunities. Thus, managers should strive to take into consideration the cumulative effects of learning associated with the application of real options-as opposed to considering each one in isolation.
28. Shane, S., & Venkatraman, S. 2000. The promise of entrepreneurship as a field of research. Academy of Management Review, 25: 217-226.