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Real Options

In: Business and Management

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Running Head: MEMORANDUM

Real Option Analysis

Memorandum
To: CEO
From: ABC
Date: June 5, 2010
Sub.: Real Option Analysis
Introduction
In the current competitive and dynamic business environment, it is necessary for an organization to consider all the aspects before making an investment decision in a venture. It is also essential for the management of an organization to perform the analysis of operational facilities and financial facilities in a country. It helps the management to make an effective decision in invest in a venture to expand its business operation. The analysis also helps to reduce some risk that may affect the business operation.
Venture
The management of the organization is seeking towards facilitating its business in a new uncharted territory. The new venture may be the expansion of current product line or a new product or service. The management of the company is seeking to adjust with the growing demand in Brazil by building a new Caterpillar factory in it. The company doesn’t have information about the operational, financial and capital position in Brazil that may cause an increase in the uncertainties for the business. The organization has a leading position that will be effective tom provide unique advantages to it that is not available for the rivals maintaining purely domestic operations.
In the new venture, the management may shift its value chain activities across its operation networks to eliminate the impact of exchange rate fluctuations, or change in market or product factors. The building of a new caterpillar factory in Brazil would shift its operational and value chain activities. The company has different types of switching options to operate its business in the foreign countries (Tong & Reuer, 2007). The foreign direct investment is the technique that would be used to undertake the venture.
Techniques to Undertake Venture
An organization may expand its business operation in foreign countries through various ways. The global operation provides operational flexibility to an organization that causes an increase in the business effectiveness. The company can use the following technique to undertake the venture in Brazil –
Foreign direct investment:-
Foreign direct investment (FDI) can be described as the long term participation of an organization or a country in another country or the organization of another country. FDI generally involves the participation in management, technical know-how, expertise, etc. In other words, FDI can be described as any form of the investment that is made to earn interest from the enterprise which is operated outside the domestic territory of the investors (Patterson, 2004). To undertake the venture of caterpillar factory in Brazil the organization may use the FDI technique.
FDI technique could be used to establish a relationship between a parent company and its foreign subsidiaries. This business relationship would be effective to increase the effectiveness of business expansion. FDI is also used by the firms to develop new and emerging economies. In the current business environment, FDI is the most growing techniques to expand the business out of the domestic boundaries. FDI enables the management to exploit the technological advantages by establishing production subsidiaries or to improve the exports by increasing commercial presence in the foreign countries (Lee, 2002).
There are various benefits and disadvantages that are provided by FDI. Following are the benefits of undertaking the venture using FDI technique –
Flexibility – The benefit of the flexibility is directly associated with FDI. It is because; the FDI provides production flexibility that generates several incentives for a business that has geographically dispersed operations. The value of production also increases due to switching the production processes between locations of two different countries (Tong & Reuer, 2007). The flexibility in shifting locations provides advantage of lower input prices that protect the organization from adverse movements of exchange rates.
Reduction in downside risks – The advantage of flexibility also allows the global corporations to maintain flexibility in selecting input or output strategies that help to limit the downside risks.
Increase in opportunities – The FDI facilitate flexibility in the business operation that helps to access more opportunities to the firm in maximizing profits and minimizing losses. It also causes an increase in the firm’s value.
Existing strengths – The firms that undertake a venture through FDI also brings their strengths into the business operation and investment decision. The management of the organization may include its intangible assets and market power in the foreign business operation. At the same time, the management can also bring its particular administration heritage and control system that would be effective to increase the profitability and the value of the business (Tong & Reuer, 2007).
Unobserved capabilities – The FDI also helps a firm to bring its unobserved capabilities such as managerial experience, specialized market knowledge etc. in the operation of its subsidiaries that causes an increase in its business effectiveness over its competitors or domestic rivals.
Technological advancement – The venturing through FDI also facilitates technological advantages that cause an increase in its business effectiveness over its competitors.
The FDI provides different advantages to a firm that expands its business globally. The FDI may increase the downside risks for the investors. The downside risk depends on the following factors –
Degree of multi-nationality – The downside risk for an organization depends on the multi-nationality level of the organization. An increase in the number of currencies reduced the risks for the business. The FDI also causes an increase in the complexity and coordination costs for the business due to different locations of production facilities (Tong & Reuer, 2007).
Cultural differences – Undertaking the venture by using FDI technique poses the risk due to cultural differences. The cultural difference may cause the internal uncertainty in the business that may affect its profitability and business operations. The cultural differences reduce the benefits for the firm that it may attain from its latent operation. The cultural difference forces the organization to rely on local parties for the management system that reduces the effectiveness of standard control system of the parent organization. The management of the company also has to change its marketing strategy to adjust with the local market requirements.
Rules and regulations – Undertaking the venture through FDI also poses rules and regulations risks on the firm (Tong & Reuer, 2007). The firm currently entering in Brazil without its analysis that may affects its business effectiveness.
Multi-nationality:
The global business operation provides flexibility in shifting value chain activities along with distribution and manufacturing activities. The across country option provide the flexibility in shifting different business activities in other country. This technique provides the advantage of flexibility in shifting its distribution and marketing activities and also the value chain activities. The management of the company may change its business activities accordingly as the change in external conditions. Through this option, the management of the company may shift its activities by changing labor, costs, macroeconomic conditions and other inputs. The across country option provides a switching options to an organization that increases its effectiveness (Tong & Reuer, 2007).
But at the same time, each country has different rules and regulations that may create complexity for the management in operating their business or to implement a standardized process. The multi-nationality also causes an increase in the travel and communication expenses that reduce profitability and value of the business.
Real Option Analysis
The real option analysis helps to determine a range of possible options and to make the decision for investment. The real value option provides a better insight about the value of an asset that causes an increase in the cash flows of the business. It is because; by developing the understanding about the actual value of assets a firm can develop the technology within the business if the expected payoffs exceed its cost of development. It would be helpful to generate the more income for the physical assets. The real option analysis provides several options to a MNC to facilitate unique advantages (Mun, 2006). The analysis of all alternative is also performed in real option that reduces the probability to failure of the project. It causes an increase in the incentives for the business.
By using the real option analysis an organization may choose the best alternative to enter in the foreign market. It would reduce the cost for the business and would cause an increase in its profitability. The real option analysis also uses the option theory to evaluate the physical or real assets. It also helps to determine the operational flexibility within the business that also alters the present value of cash flows. The management of a firm may also determine the level of uncertainty that receives the management attention and helps to generate positive cash flows from real physical assets (Tong & Reuer, 2007).
Conclusion
With the above discussion, it can be concluded that before making an investment decision it is essential for an organization to perform an analysis for all alternatives. It would be effective to increase the firm’s value and profitability. At the same time it would also reduce downside risks for the business. There are various techniques from which an organization may undertake a new venture such as FDI and Multi-nationality. But before making a decision about the investing the organization should consider all pros and cons of these techniques. By using the real option analysis an organization may alter the present value of cash flows from real physical assets.

References
Lee, B.H. (2002). FDI from Developing Countries: A Vector for Trade and Development. OECD Publishing
Patterson, N.K. (2004). Foreign Direct Investment: Trends, Data Availability, Concepts, and Recording Practices. International Monetary Fund
Tong, T.W. & Reuer, J.J. (2007). Real options in multinational corporations: organizational challenges and risk implications. Journal of International Business Studies 38, 215-230.
Mun, J. (2006). Real Options Analysis: Tools And Techniques For Valuing Strategic Investments And Decisions (2nd ed.). John Wiley and Sons.

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