Strategic Investment
Strategic Investment
Real Options and Games
Han T. J. Smit
Lenos Trigeorgis
Princeton University Press
Princeton and Oxford
Copyright © 2004
by Han T. J. Smit and Lenos Trigeorgis
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Library of Congress Cataloging-in-Publication Data
Smit, Han T. J., 1967–
Strategic investment : real options and games / Han T.J. Smit and Lenos Trigeorgis.
p. cm.
Includes bibliographical references and index.
ISBN: 0-691-01039-0
1. Options (Finance) 2. Investments. 3. Game theory. I. Trigeorgis, Lenos.
II. Title.
HG6042.S63 2004
332.64'53'015193—dc22 2003066385
British Library Cataloging-in-Publication Data
is available

This book has been composed in Univers and Sabon.
Printed on acid-free paper.
pup.princeton.edu
Printed in the United States of America
10 987654321
Contents
List of Figures xi
List of Tables xvii
List of Boxes xix
Acknowledgments xxi
Introduction: Strategic Investment as Real Options
and Games
xxiii
I.1. Introduction: About This Book xxiii
I.2. Real Options and Games: Linking Corporate Finance
and Strategy xxiv
I.3. An Overview of the Book xxviii
Part I: Approaches to Strategic Investment
Chapter 1
Corporate Finance and Strategic Planning:
A Linkage
3
1.1. Introduction 3
1.2. The Market Value of Growth Opportunities 5
1.3. From NPV to an Expanded (Strategic) NPV Criterion 8
1.4. Value Drivers of NPV, Flexibility Value, and Strategic Value 13
1.4.1. Value Drivers of NPV 14
1.4.2. Drivers of Flexibility or Growth Option Value 21
1.4.3. Drivers of Strategic Value and Strategic Moves 24
1.5. Value Creation in Strategic Planning 32

1.6. Conclusions 33
Chapter 2
Strategic Management: Competitive Advantage and
Value Creation
35
2.1. Introduction 35
2.2. Views of Value Creation of the Firm 38
2.2.1. Industry and Competitive Analysis 40
2.2.2. Strategic Conflict and Game Theory 43
2.2.3. Internal, Resource-Based View of the Firm 45
2.2.4. Dynamic Capabilities 49
2.2.5. Options and Games: A Linkage Approach 51
2.3. Competitive Advantage and Industry Evolution 53
2.3.1. Competitive Advantage in the Early and Growth Stages 54
2.3.2. Competitive Advantage in Mature Businesses 58
2.3.3.Creative Destruction and Adaptation as Source of
Advantage
60
2.4. Portfolio Planning of Growth Opportunities 68
2.4.1. Boston Consulting Group Matrix 70
2.4.2. Exercise Timing of Options: The Tomato Garden Analogy 72
2.4.3. Real-Options Growth Matrix 76
2.5. Conclusions 90
Chapter 3
Corporate Real Options 93
3.1. Introduction 93
3.2. Options Valuation 94
3.2.1. Basic Nature of Options 98
3.2.2. From Financial to Real Options Valuation 100
3.3. Overview of Common Real Options 106

3.3.1. The (Simple) Option to Defer 110
3.3.2. Options to Expand or Contract 114
3.3.3. The Option to Abandon for Salvage or Switch Use 116
3.3.4. The Option to Temporarily Shut Down 119
3.3.5.
Options to Switch Inputs or Outputs 122
3.4. Prototype Examples: Valuing an R & D Program and a Mining
Concession 123
3.4.1. Valuing a Research and Development Program 124
3.4.2.
Valuing a Mine Concession (License) Using Certainty-Equivalent
Valuation
127
3.5. An In-Depth Case Application: Valuing Offshore Oil Concessions
in the Netherlands 134
3.5.1. Stages of Offshore Petroleum Development on the Dutch
Continental Shelf
134
vi Contents
3.5.2. Valuation Based on Replication in Financial Markets 138
3.5.3. Main Insights 149
3.6. Summary and Conclusions 154
Appendix 3.1. Binomial Option Valuation 156
Chapter 4
Games and Strategic Decisions 163
4.1. Introduction 163
4.2. The Rules of the Game 171
4.3. A Taxonomy of Basic Games 181
4.3.1. Time to Launch under Competition (Symmetric Innovation
Race)

184
4.3.2. Asymmetric Innovation Race and Preemption 186
4.3.3. Simultaneous Innovation Race When the Opponent’s Capabilities
Are Unknown
189
4.4. Competitive Reactions in Quantity versus Price Competition 191
4.4.1. Quantity Competition 191
4.4.2. Price Competition 198
4.4.3. Type of Competitive Reaction: Strategic Substitutes versus
Complements
200
4.5. Two-Stage Games: Strategic Value of Early Commitment 202
4.5.1. Direct versus Strategic Effects of Investment Commitment 203
4.5.2. Strategic Effect, Tough or Accommodating Positions, and Type of
Competition
205
4.6. Summary and Conclusions 208
Appendix 4.1. A Chronology of Game Theory Developments 210
Part II: Competitive Strategy and Games
Chapter 5
Simple Strategic Investment Games 217
5.1. Introduction 217
5.2. A Road Map for Analyzing Competitive Strategies 218
5.3. One-Stage Strategic Investments 222
5.4. Two-Stage (Compound) Options: The Case of Proprietary
R&D 226
5.5. Two-Stage Investments with Endogenous Competition 229
5.5.1. Competition in Last (Production) Stage: Contrarian versus
Reciprocating Competition
229

5.5.2. Competition in Innovation Investment: Time-to-Market Races and
Strategic Alliances
242
Contents vii
5.6. Cooperation in the First Stage: Joint R & D Ventures 247
5.7. Summary and Conclusions 251
Chapter 6
Flexibility and Commitment 255
6.1. Introduction 255
6.2. The Basic Two-Stage Game 258
6.2.1. Equilibrium Quantities, Prices, and Payoff Values 260
6.2.2. Valuation of Competitive Strategies 262
6.3. Numerical Examples of Different Competitive Strategies under
Contrarian versus Reciprocating Competition 268
6.3.1. Competitive R & D Strategies under Quantity Competition 268
6.3.2. Goodwill/Advertising Strategies under Price Competition 278
6.4. Summary and Conclusions 285
Appendix 6.1. Reaction Functions, Equilibrium Actions, and
Values in Different Market Structures under Quantity or Price
Competition 289
Chapter 7
Value Dynamics in Competitive R & D Strategies 295
7.1. Introduction 295
7.2. Literature on R & D Options 296
7.3. The Basic Two-Stage R & D Game 298
7.4. Critical Demand Zones/Sensitivity 300
7.5. Technical R & D Uncertainty, Stochastic Reaction Functions, and
Asymmetric Information with Signaling 309
7.5.1. Technical R & D Uncertainty (under Symmetric Information) 309
7.5.2. Imperfect/Asymmetric Information and Stochastic Reaction

Functions
311
7.5.3. Signaling Effects 313
7.6. Learning Experience Cost Effects 315
7.7 Competition versus Cooperation in R & D 319
7.8 Summary and Conclusions 322
Part III: Applications and Implications
Chapter 8
Case Applications 329
8.1. Introduction 329
8.2. Strategic Games in Consumer Electronics 346
viii Contents
8.2.1. Winner Takes All versus Strategic Alliances in the Launch of Video
Recorder Systems
346
8.2.2. The Competition versus Coordination Game of the High-Density
Disk
350
8.3. Buy-and-Build Platform Acquisition Strategies 352
8.3.1. Classifying Acquisitions Based on Options and Games 353
8.3.2. Growth Option Value in a Buy-and-Build Strategy 356
8.3.3. Competition in a Buy-and-Build Strategy 360
8.4. Infrastructure Investment: The Case of European Airport
Expansion 366
8.4.1. Infrastructure Investment and Aviation Developments 367
8.4.2. Infrastructure Valuation as an Options Game 370
8.4.3. Implementation in the Case of Schiphol Airport 382
8.5. Conclusions and Implications 389
Chapter 9
Continuous-Time Models and

Applications
393
9.1. Introduction and Overview 393
9.2. Continuous-Time Version of Smit-Trigeorgis Framework 396
9.2.1. Equilibrium Output and Values 397
9.2.2. Strategic Entry Decisions 401
9.2.3. Equilibrium Entry and Critical Demand Thresholds 405
9.2.4. Benchmark Cases: Symmetric Competition and Monopoly 408
9.3. Strategic Investment Timing under Uncertainty 408
9.3.1. Strategic Interactions and the Timing of Investment 408
9.3.2. Innovation with Uncertainty over Completion and Time Delays 411
9.4. Exercise Strategies under Incomplete Information with
Applications 414
9.4.1. Entry and Preemption under Incomplete Information 414
9.4.2. Applications 416
9.5. General Equilibrium Investment Strategies under Imperfect
Competition and Asymmetric Information 419
9.5.1.
Equilibrium Investment Strategies under Imperfect
Competition
419
9.5.2. Investment Strategies under Asymmetric Information 421
9.6. Conclusions 423
Appendix 9.1. Derivation of Option-Pricing Differential
Equation 425
Appendix 9.2. Discounted Profit Flow and Value Function 427
Contents ix
Appendix 9.3. Sequential Stackelberg Leader–Follower
Entry 428
Chapter 10

Overview and Implications 429
10.1.
Introduction 429
10.1.1. Linking Corporate Finance and Strategic Planning 429
10.1.2. An Expanded Valuation Framework to Capture Flexibility and
Strategic Value
431
10.2.
Implications of the Strategic Options and Games
Framework 439
10.2.1. Timing Games for Simple Commercial Options 440
10.2.2. Investment Games Involving Strategic Options 442
10.3.
Empirical Implications 445
References 447
Index 461
xContents
Figures
Figure I.1 Impact of Corporate Strategic Planning on the Market
Value of the Firm xxx
Figure 1.1 Impact of Corporate Strategic Planning on the Market
Value of the Firm 4
Figure 1.2 Competitive Strategies and Relative Market (Price) Perfor-
mance of Firms in Three High-Tech Industries 8
Figure 1.3 Analogy of a Call Option with the Flexibility to
Wait 12
Figure 1.4 Resources as a Basis for Profitability 20
Figure 1.5 A Classification for Real-Growth Options 23
Figure 1.6 A Classification of Strategic Moves 29
Figure 2.1 Porter’s “Five Forces” Industry and Competitive

Analysis 41
Figure 2.2 The Boston Consulting Group’s (BCG) Growth-Profitability
Matrix 71
Figure 2.3 Exercising Options in Option-Value Space 75
Figure 2.4 The Real-Options Growth (ROG) Matrix 77
Figure 2.5 The Growth Matrix 82
Figure 2.6 R & D Investment in the Real-Options Growth (ROG)
Matrix 84
Figure 2.7 A Shared Option in the Real-Options Growth (ROG)
Matrix 88
Figure 2.8 Polaroid versus Kodak’s Shared Options in Real-Options
Growth Matrix 89
Figure 3.1 Corporate Securities as Options on the Firm’s Value 101
Figure 3.2 Static NPV: Invest Now 107
Figure 3.3 Proprietary Opportunity (License): Wait to Invest under
Uncertainty 107
xii Figures
Figure 3.4 The (Simple) Option to Defer 111
Figure 3.5 Shared Opportunity: Invest Now if Early Commitment
Can Preempt Competition 113
Figure 3.6 Value of a Project That Has Options to Expand or Con-
tract Production Capacity 114
Figure 3.7 The Option to Abandon Production Capacity 117
Figure 3.8 Fluctuations of Salvage Value Underlying Option to Switch
Use 118
Figure 3.9 Option to Temporarily Shut Down the Production
Process 120
Figure 3.10 Option to Temporarily Shut Down and Reopen a
Mine 121
Figure 3.11 Option to Switch Inputs with Changing Gas Prices 123

Figure 3.12 Capital Outlays for R & D Project to Develop a New
Technology, and Expected Cash Inflows from the Potential
Follow-on Commercial Project 125
Figure 3.13 Dynamics in the Value of the Commercial Project 126
Figure 3.14 Net Value of the Option to Invest in the Commercial
Project 127
Figure 3.15 Asymmetry in the Distribution of Project Value Due to
Flexibility 131
Figure 3.16 Decision Tree for the Offshore Oil Development
Project 137
Figure 3.17 The Convenience Yield of Three-Month Brent Crude
Futures from January 1991 to December 1993 139
Figure 3.18 Brent Crude Oil Price 141
Figure 3.19 Decision Tree for a “Sure Small Quantity” Type
Block 146
Figure 3.20 Cumulative Distribution of Oil Reserves by Block Type 148
Figure 4.1 Innovation Race 185
Figure 4.2 Simultaneous Innovation Race with High versus Low
R & D Investment Cost 187
Figure 4.3 Sequential Investment Game with High versus Low R & D
Investment Cost 189
Figure 4.4 Simultaneous Innovation Game with High versus Low
R & D Investment Cost under Incomplete Information 190
Figure 4.5 Downward-Sloping Reaction Curves under Cournot
Quantity Competition 194
Figures xiii
Figure 4.6 Cournot-Nash and Stackelberg Equilibriums under
Quantity Competition 195
Figure 4.7 Bertrand-Nash and Stackelberg Equilibriums under Price
Competition 199

Figure 4.8 Contrarian versus Reciprocating Competitive Reactions
(Strategic Substitutes versus Complements) 201
Figure 5.1 Proprietary Opportunity (License): Wait to Invest under
Uncertainty 223
Figure 5.2 Simultaneous Investment Timing Game: Compete and
Invest Prematurely 224
Figure 5.3 Two-Stage Investment 227
Figure 5.4 Competitive Strategies Depending on Type of Investment
and Nature of Competitive Reaction 232
Figure 5.5 Proprietary Strategic Benefits When Competitor Reactions
are Contrarian or Reciprocating 234
Figure 5.6 Shared Benefits of Strategic Investment When Competitor
Actions Are Reciprocating or Contrarian 239
Figure 5.7 Both Firms Can Make Strategic Investment in the First
Stage Enhancing Market Value 244
Figure 5.8 Cooperate in Technology Investment (Innovation) 248
Figure 6.1 Sign of the Strategic Effect and Competitive Strategies
Following a Tough or Accommodating Position under
Contrarian or Reciprocating Competition 256
Figure 6.2 The Two-Stage Game in Extensive Form under Different
Market Structures 259
Figure 6.3 The Base Case (No strategic R & D investment) 266
Figure 6.4 Competitive Investment Strategies in the R & D
Example 270
Figure 6.5 Reaction Functions and Equilibrium Cournot, Stackelberg,
and Monopoly Outcomes 273
Figure 6.6 Equilibrium Nash, Stackelberg, and Monopoly
Outcomes 279
Figure 6.7 Competitive Investment Strategies in the Goodwill/
Advertising Example 281

Figure 7.1 The Basic Two-stage Investment Game Involving R & D
and Commercialization Phase under Different Market
Structures 301
Figure 7.2 Firm A’s Expanded NPV in the Commercialization Stage
versus Market Demand 304
xiv Figures
Figure 7.3 Sensitivity of Firm A’s Total Project Value to the Degree of
Shared Cost Benefits to Competitor B 307
Figure 7.4 Sensitivity of Firm A’s Proprietary R & D Investment Value
to Market Demand Uncertainty and to the Time Interval
(separation) between Strategic R & D Investment and
Follow-on Commercialization Investment 308
Figure 7.5 Sensitivity of Net Project Value of Firm A’s Investment to
Technical R & D Uncertainty 310
Figure 7.6 Value of Firm A’s Proprietary Certain R & D and Uncer-
tain R & D versus the Base Case of No R & D with Learn-
ing Experience Cost Effects by Both Firms 316
Figure 7.7 Demand Zones for First-Stage R & D Competition and
Cooperation via a Joint R & D Venture 320
Figure 8.1 Timing Product Launch under Competition 348
Figure 8.2 War of Attrition Game 349
Figure 8.3 The Two-by-Two Competition versus Coordination Game
(Prisoners’ Dilemma) 351
Figure 8.4 The Real-Options Approach to Classifying Acquisitions 355
Figure 8.5 Staged Decisions for a Buy-and-Build Strategy 359
Figure 8.6 Timing Strategies of Follow-on Investments under
Asymmetric Competition 362
Figure 8.7 Different Competitive Strategies Following “Buy” or
“Build” Expansion in a Value-Enhancement or a
Value-Preemption Game 364

Figure 8.8 Two-Period Example of the Expansion Game (in Extensive
Form) 374
Figure 8.9 Numerical Example of the Two-Period Expansion
Game 376
Figure 8.10 The Two-by-Two Simultaneous Subgame in Each State
and the Nash Equilibriums for Different Demand
Regions 380
Figure 8.11 Nonlinear Payoff of Expansion Option Compared to
Exogenous Demand 382
Figure 8.12 Hypothetical “States of the World” as Number of Flights
from 2000 to 2020 for Schiphol Airport and Rollback
Procedure for a Flexible Expansion Strategy 384
Figure 8.13 Development of Market Share over Time Illustrating the
Growth of the Larger Airports in Flight Movements,
Passengers, and Freight in the Period 1991–2000 390
Figures xv
Figure 9.1 Values of Leader and Follower and Critical Demand Entry
Thresholds in Duopoly 407
Figure 10.1 Impact of Corporate Strategic Planning on the Market
Value of the Firm 430
Figure 10.2 Classification for Corporate Real (Growth) Options 435
Figure 10.3 Timing Strategies of Follow-on Investments under
Competition 441
Figure 10.4 Sign of the Strategic Effect and Competitive Strategies
Following a Tough or Accommodating Position under
Contrarian or Reciprocating Competition 443
Tables
Table 1.1 Industry (average) Volatility (market and firm-specific
uncertainty) and Proportion of PVGO to Price for a Number

of Representative Industries, as of June 30, 1998 6
Table 1.2 Value Determinants, Strategies, and Real Options 30
Table 2.1 External and Internal Views of the Firm and Approaches to
Strategy 39
Table 3.1 Common Corporate Real Options 108
Table 3.2 Quantities, Prices, and Operating Cash Inflows of a Mine in
Various States 129
Table 3.3 Replication of Mine Project Value (license) with a Gold
Position 133
Table 3.4 Yearly Standard Deviation of Oil Returns 141
Table 3.5 Reserve Valuation (NPV*) at Different Quantities of Proven
Reserves 145
Table 3.6 Valuation Results for Oil Field on Dutch Continental
Shelf 150
Table 4.1 Taxonomy of Game-Theory Metaphors and Investment
Applications 182
Table 4.2 Profits for Firm A and Firm B under Cournot Quantity
Competition 193
Table 4.3 Output Decisions and Profits in Duopoly under Cournot
Competition 197
Table 5.1 Successive Stages of Analysis: Option Games, Related
Literature, Problem Description, Implications, and Practical
Examples/Applications 220
Table 6.1 Equilibrium Quantities, Profits, and State Project Values for
Various Market Structures under Contrarian Quantity
Competition in the Second Stage 263
Table 6.2 Equilibrium Prices for Different Market Structures under
Reciprocating Price Competition in the Second Stage 265
Table 6.3 The Strategic Reaction Effect (when Demand Develops
Favorably) under Contrarian Quantity Competition 274

Table 6.4 Second-Stage Equilibrium State Project Values and
Strategic Effects for Different Market Structures and States
of Demand for the Base Case and Proprietary R & D
Investment Case 275
Table 6.5 Breakdown of Value Components for the Strategic R & D
Investment versus the Base Case When the Investment Is
Proprietary or Shared 277
Table 6.6 The Strategic Reaction Effect (when Demand Develops
Favorably) under Reciprocating Price Competition 285
Table 6.7 Unconditional Value Components of the Strategic
Investment under Reciprocating Competition When the
Investment Is Proprietary or Shared 286
Table 7.1 Summary (Overview) of the Breakdown of Value
Components for the Strategic R & D Investment of
Firm A in Different Cases 302
Table 8.1 Stock Prices, Earnings, and Values of Current Operations
versus Growth Opportunities for the Airports of British
Airports Authority, Frankfurt, Copenhagen, Zurich, and
Vienna 388
xviii Tables
Boxes
Box I.1 Behind the Nobel Prize Awards xxv
Box I.2 Reciprocity: Bill Gates Could Gain a Lot from a Little Game
Theory xxix
Box 1.1 Real Options, Growth Opportunities, and Market
Valuation 7
Box 1.2 Innovation Race: Example of an Option Game 15
Box 1.3 Observed Firm Behavior: Amazon.com versus
Barnes & Noble 26
Box 2.1 The Evolution of Strategy 37

Box 2.2 Modularity, Real Options, and Computer Industry
Evolution 61
Box 2.3 Strategy in a Changing Competitive Landscape 65
Box 2.4 A Gardening Metaphor: Options as Tomatoes 73
Box 2.5 Option Valuation: An Example 85
Box 3.1 Thoughts on Decision-Making by Important People 95
Box 3.2 Optional Investing and Market Performance 98
Box 3.3 Numerical Valuation Example: A License by a High-
Tech Firm 103
Box 4.1 It’s Only a Game—but a Very Useful One 164
Box 4.2 Benefits of Game Theory: Anticipating Your Rival 165
Box 4.3 Game Theory: Overview and Its Impact on Daily
Situations 166
Box 4.4 E-commerce Auctions and the Winner’s Curse 174
Box 4.5 Nash Equilibrium, (Ir)rationality, and Auction
Overbidding 176
Box 4.6 Mixed Strategies: Game Theory and Sports 179
Box 5.1 Tit for Tat: Cooperation Based on Reciprocity 241
xx Boxes
Box 5.2 How Can Companies Collude? 250
Box 6.1 Contrarian (Cournot Quantity) Competition and Timing of
Investments in the Production of Memory Chips 269
Box 6.2 Observed Firm Behavior: Reciprocating (Price) Competition
and Advertising Retaliation in the Cigarette Industry 283
Box 7.1 In R & D, the Next Best Thing to a Gut Feeling 324
Box 8.1 Exploiting Uncertainty: Real Options in Practice 332
Box 8.2 Options and Games at Merck 337
Box 8.3 Case Application of Competition between AMD and Intel in
Microchips 341
Box 8.4 California’s Electricity Crisis as a Game of Chicken 344

Box 8.5 Game Theory and German Telecoms: Predicting Rival’s
Behavior, or Who Will Blink First? 345
Acknowledgments
We are indebted to Carliss Baldwin,
Karel Cool, Marco Dias, Avinash
Dixit, W. Carl Kester, Scott P. Mason,
and Stewart C. Myers for useful
comments on earlier work that
provided the basis for this book.
Introduction:
Strategic Investment as
Real Options and Games
I used to think I was indecisive
—
but now
I’m not so sure.
—
Anonymous
I.1. About This Book
In this book we present a new perspective on strategic investment, draw-
ing on and synthesizing new valuation methods from finance, such as real
options, and basic concepts from industrial organization and game the-
ory. This book on new approaches to strategic valuation aims at both a
professional and an academic audience. We synthesize cutting-edge ideas
on strategic valuation, which are communicated in accessible language
and illustrated with examples and applications. Our approach will be
helpful to professional managers and students of strategy in developing a
conceptual framework and choosing the tools for strategic investment
decisions. Such an applied orientation provides critical insight into both

the opportunities and the potential pitfalls of strategy implementation.
The gap between finance and corporate strategy remains embarrass-
ingly large, as academics and practitioners alike have recognized for some
time now. The most important managerial decisions
—
in terms of both
the size of expenditures and their impact on the future of the firm
—
are
strategic decisions, yet they are the least well understood and often are
made without the discipline of rigorous analysis. For such strategic deci-
sions, the traditional discounted-cash-flow (DCF) approach is often short-
sighted. Strategic thinking and capital budgeting should be combined
explicitly when firms make capital investments to gain strategic advan-
tage. Traditional methods of appraising projects do well when valuing
bonds, deciding on maintenance or replacement, or determining other
passive investments in a stable environment where a stream of cash flows
can be well specified. These methods, however, have serious shortcom-
ings in valuing investments when management has the ability to control
future cash flows and revise future decisions, particularly when current
investment may interact with future investments (growth options), may
Special thanks to Mikhael Shor of Vanderbilt University for identifying some of the quota-
tions appearing in the chapter headings in this book.
xxiv Introduction
confer future strategic advantages, or may affect (and be affected by) ac-
tions and reactions of other parties external to the firm (such as competi-
tors and suppliers).
In this book we synthesize the newest developments in corporate fi-
nance and related fields, in particular real options and game theory, to
help bridge the gap between traditional corporate finance and strategic

planning. We use practical examples and references from company expe-
riences to demonstrate the relevance of this approach. The book discusses
strategic valuation examples from various industries, such as R & D in-
vestment in high-tech industries, joint research ventures, product intro-
ductions in consumer electronics, infrastructure and public investment
(e.g., airport expansion), and examples from oil exploration investment.
Our treatment of “strategic investment” goes far beyond use of standard
real-options analysis; we extend the potential of real options by combin-
ing it with principles from industrial organization and game theory to
capture the competitive dimensions and endogenous interactions of strate-
gic decisions between the firm and its competitors.
We believe that now is the right time to bring these new ideas on strate-
gic valuation to a broader audience. Strategy has been a stagnant field (in
terms of concrete quantitative valuation tools) for some time, and the gap
between finance and strategy has been apparent. The relatively new fields
of game theory and real options have now gained academic credibility
and recognition. In 1994 the Central Bank of Sweden awarded the Nobel
Prize in economic science to John Nash, John C. Harsanyi, and Reinhard
Selten for their contributions to game theory. Box I.1 reveals what’s be-
hind the Nash Prize. In 1997 the Nobel Prize was awarded to Myron
Scholes and Robert Merton for developing options pricing. In the last
several years, all the major consulting firms have attempted to apply these
ideas in their practice.
We hope that our book appeals to academics in finance and strategy as
well as to high-ranking professionals and a general audience. We are
pleased to bring material developed in our work and the work of others
to a broader audience and integrate it with other fascinating concepts
and approaches from strategy, corporate finance, and related fields. Every
attempt was made to make the book accessible to a wide audience, yet at
the same time it should be challenging, engaging, and, though not math-

ematical, compelling to an intellectually rigorous reader.
I.2. Real Options and Games: Linking Corporate Finance
and Strategy
In an increasingly uncertain and dynamic global marketplace, strategic
adaptability has become essential if firms are to take advantage of favor-