Strategic Management & Competitive

Advantage: Concepts and Cases

Sixth Edition, Global Edition

Chapter 6
Flexibility and Real Options

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Learning Objectives

6.1 Define strategic flexibility and real options.

6.2 Specify the conditions under which strategic flexibility
and real options will be valuable for firms.
6.3 Identify when strategic flexibility and real options can
be a source of sustained competitive advantage.
6.4 Identify the organizational challenges associated with
implementing strategic flexibility and a real options
strategy.

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The Strategic Management Process

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Business Level Strategies

Options:
1. Cost leadership
2. Product differentiation
Both these require focus and commitment
3. Strategic flexibility
Maintaining multiple strategic options simultaneously—
the opposite of focus and commitment

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What Is Strategic Flexibility?
A firm has strategic flexibility when it can choose among
several strategic options
Netflix
• Began as a mail-order DVD rental service in 1997.
• Online streaming service: offers popular movies, TV
shows, and documentaries users can watch over the
internet.

Southwest Airlines’ acquisition of AirTran

• Route expansion
• Geographic expansion

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Real Options and Real Assets

A real option exists when a firm has the ability, but not
the obligation, to invest in real assets of some type.
Real assets are tangible resources that can have an
impact on a firm’s production, including land, buildings, raw
materials, finished goods inventories, distribution systems,
information technology and so forth.

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 Intel Capital
Intel founded in 1968, the computer chip maker, given that
Intel competes in the fast-changing computer industry, it
wanted to have strategic flexibility.

Intel Capital:
• Intel Capital founded in 1991 as the venture capital arm
of Intel.
• Goal: make small investments in promising technologies
• $12.2 billion invested in 1,480 companies worldwide till
date
• 627 companies have either gone public or have been
acquired (mid-2017)
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 Table 6.1 Types of Flexibility with Examples
Type of Flexibility
The option to defer
The option to grow
The option to contract
The option to shut down and restart
a business
The option to abandon
The option to expand
Example
An oil company leases land for potential exploration
instead of buying it.
A firm builds a plant with the ability to add capacity at
low cost.
A firm hires contract and temporary employees
instead of full-time employees.
A firm outsources distribution to a firm that distributes
the products of many firms instead of outsourcing
distribution to a firm that distributes only its production.
A firm builds a manufacturing plant that employs only
general-purpose machinery.
A firm invests to create one product because that
investment could lead to the development of other
products in the future.
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Competitive Advantage

If a strategic flexibility strategy meets the VRIO criteria…

Is it Valuable?
Is it Rare?
Is it costly to Imitate?
Is the firm Organized to exploit it?
…it may create competitive advantage.

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Risk
A decision-making setting is said to be risky when:
• the outcome of that decision is not known with certainty,
• but the possible outcomes associated with that decision
are known, and
• the probabilities associated with each outcome are
known.

Example: Playing the slot machine at a casino

When you play a slot machine at a casino, you don’t know if
you are going to win, but at least you know what the
possible outcomes are (you win or you lose).

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Incorporating Risk in Strategic Decision-
Making

• The Capital Asset Pricing Model (CAPM) incorporates

risk by using β (historical returns of a diversified portfolio
of stocks)
• Present value analysis incorporates risk via the discount
rate
– Low discount rate = low risk
– High discount rate = high risk

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Uncertainty

A decision-making setting is said to be uncertain

when:
• the outcome of that decision is not known with certainty,
• the possible outcomes associated with that decision are
not known, and
• the probabilities associated with the outcomes are not
known.
Example: Non-franchise Hollywood movies

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Uncertainty and Present Value Analysis
Why does it not work?
• Under conditions of uncertainty, cash flow projections are
simply unreliable
• Under conditions of uncertainty, the riskiness of the cash
flows generated (the discount rate) cannot be reliably
anticipated
• The present value approach assumes that decisions about
strategies and their implementation are made all at once
– In reality, strategic choices are often made over time, in
a staged manner

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Table 6.3 Characterizing the Value of a
Real Option Subjectively
Attribute of a Real Option
Exercise price (X)
Cash flows generated (S)
Time to maturity (T)
Risk-free interest rate (rf)
Uncertainty about future flows  2 
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Effect on Value of Real Option
The lower the exercise price, the
greater is the value of a real option.
The higher the cash flows generated
by exercising an option, the greater
is the value of a real option.
The longer the time to maturity, the
greater is the value of a real option.
The higher the risk-free interest rate,
the greater is the value of a real
option.
The greater the uncertainty about
future cash flows, the greater is the
value of a real option.
Quantitatively Valuing Strategic Flexibility

1. Recognize real options

2. Describe a real option using financial option parameters
3. Establish a benchmark
4. Calculate option value metrics
5. Estimate the value of the option from a Black-Scholes
option pricing table
6. Compare full present value with the benchmark value

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Figure 6.1 Categorizing Your Register of
Opportunities

Source: R. G. McGrath and I. MacMillan, The Entrepreneurial Mindset. (Boston: Harvard Business
School Press, 2000).
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Table 6.7 Real Options under Technical
and Market Uncertainty

Positioning options Technical uncertainty is high: Take multiple

Scouting option
Stepping-stone options
Source: R. G. McGrath and I. MacMillan, The Entrepreneurial Mindset. (Boston: Harvard
Business School Press, 2000).
small positions in alternative technologies
and wait until technological uncertainty
resolves, then invest.
Market uncertainty is high: Put several new
offerings in consumer hands to gauge their
reactions; once consumer preferences are
clear, invest.
Technical uncertainty and market
uncertainty are high: Avoid fixing on a
particular design or set of features early;
fail fast, fail cheap; learn fast, and try again.

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Strategic Flexibility and Sustained
Competitive Advantage

• Flexibility and real options related to

– History
– Path dependence (Chapter 3)
• Previous path determines future path
• Costly to turn back from a fully invested path
• Makes sense when real options facing a firm are path
dependent

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Organizing to Implement Strategic
Flexibility

• Vertical Integration reduces flexibility

– Market exchanges and strategic alliances are better
• Organizational structure, management controls, and
compensation practices need to be flexible
• Highly bureaucratic systems are inconsistent with
flexibility

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The Human Side of Flexibility

Company Layoffs
H-P 30,000
Cisco 14,000
Wal-Mart 17,500
Intel 12,000

• Employees treated as temporary or contract workers

• Increases organizational flexibility but is not costless

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