Dilemmas in Exercise Decisions for Real Options on Core Competencies

Dilemmas in Exercise Decisions for Real Options on Core Competencies
Author(s): Coff, Russell and Laverty, Kevin
Year: 2002
Paper Number: GBS-OM-2002-002
Goizueta Department: Organization and Management

Abstract

This article explores potential dilemmas for firms applying real options heuristics to guide investments in core competencies. The financial options analogy misses some critical strategic issues faced in exercise decisions. First, unlike financial options where competitive markets constantly provide information about asset value, uncertainty about the value of a core competence may persist even when the exercise decision must be made. This is compounded by a second factor - the asset's initial state (integrated or isolated) initiates a path-dependent process. When options are initially integrated, firms may be biased to exercise options that should be killed. In contrast, when options are initially isolated, firms may be biased toward killing even promising options. In this way, an options heuristic may lead firms to build large portfolios of options that become locked in, or incur the costs of establishing options that cannot be exercised. We suggest research on ways to structure options and manage the decision process to mitigate these potential problems.