Investment-Timing and the Threat of Disruption

Abstract

An incumbent firm needs to determine how to best manage the risk of the arrival of a disruptive technology. The numerous actions available to the incumbent firm indicates a complex real-options model of investment is required. This thesis investigates the behaviour of an incumbent firm, with assets-in-place, when they have access to an investment opportunity. The incumbent must not only choose when to invest in the opportunity, but also the optimal structure with which to compete against a new entrant who also has this investment opportunity.

In order to delay competition in the market the incumbent can elect to permanently abandon the innovative option rather than seek to compete with the new entrant. The assets-in-place contributes significant value to the incumbent and by delaying the competition effect, the incumbent can reduce the cannibalization of assets-in-place. This is despite the fact that the incumbent can attempt to profitably invest in the innovation before the entrant. Clearly the assets-in-place provide a benefit to firm value for the incumbent, but act as a burden for the growth option’s development. Should consumer preferences begin to favour the innovation, then the decision to abandon the growth option loses its value. The incumbent in this instance does not care that they may accelerate the entrant’s investment as they can still profitably preempt the entrant.

In a competitive market, when the incumbent efficiently produces the innovation at no extra cost compared to an independent firm, the incumbent will elect to internalise, rather than spin off, the growth option. When the incumbent produces the innovation at a higher cost, than other market participants, they will spin off the growth option instead of internalising. When consumers favour the innovation, the incumbent becomes indifferent between spinning off and internalising the growth option as the objective functions in both cases converge to maximising the value of the growth option.