THE VALUE OF SWITCHING AND GROWTH OPTIONS IN FOREIGN DIRECT INVESTMENT DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in the Graduate School of The Ohio State University By Sangcheol Song, M.S. ***** The Ohio State University 2008 Dissertation Committee: Approved by Professor Mona Makhija, Advisor _______________________ Professor Jay Barney Advisor Professor Benjamin Campbell Business Administration Graduate Program II ABSTRACT According to real options theory, foreign direct investments can be structured in ways that allow firms flexibility under environmental uncertainty. Through the options built into these investments, multinational companies can capture upside opportunities and contain downside risks stemming from the environment. Prior empirical studies on real options investments, however, have shown mixed or inconclusive results about the real options value of foreign direct investment. In this dissertation we argue that this may be due to the fact that these studies do not fully take into account the different types of environmental uncertainty faced by firms, the potentially contradictory interplay among different types of options embedded in an investment, and/or managerial costs of creating and managing real options. The purpose of this dissertation is to address these problems in the multinational flexibility literature. In the main essay, ‘Growth and Switching Options in Foreign Direct Investments,’ we examine in greater depth the two important perspectives of real options associated with foreign direct investments, growth and switching. We show that the ability to derive growth and switching options depends on the way in which foreign direct investments are configured across countries. Furthermore, these configurations of foreign direct investments are argued to have different theoretical implications for firm value under different types of host country uncertainty. Using panel data of Korean foreign direct III investment during the period 1991-2004, a period encompassing varying conditions of uncertainty in host countries, we find that, consistent with our expectations, firms with switching options (gained through highly dispersed operations and higher levels of ownership across countries) were associated with higher value in periods of higher exchange rate uncertainty than those without such options. As predicted, we also find that firms with growth options (gained through concentrated presence of subsidiaries in specific countries and lower levels of ownership) were associated with higher value in conditions of host market uncertainty than firms without such option. Additionally, we found that greater cultural distance between host and home countries within the international network reduces the value of switching options, most likely due to the additional transactions costs associated with it. On the other hand, higher ownership levels lessen this negative impact of cultural distance. The findings associated with ownership and cultural distance within the firm’s international network point to the relevance of managerial control and coordination within the realm of real options. Finally, we found evidence supporting the notion that firms make future investment choices based on their expected needs for real options. When firms desire switching options, we find that they add to their breadth by establishing a new subsidiary in new countries. When the need for growth options is greater, they add a new subsidiary in countries in which they already have investments. IV Dedicated to my parents, my sister and two brothers, and nieces and nephews V ACKNOWLEDGMENTS My special thanks are reserved for Professor Mona Makhija. Her kind endurance and warm-hearted encouragement have enabled me to run to the finish line of my doctoral program. Professors Jay Barney, Jay Anand, Seung-hyun Lee, and Banjamin Campbell, Mikelle Calhoun have guided me through my coursework and dissertation work. Their ardent love for teaching and research has stimulated my academic journey to more interesting and new questions in my field. Having arrived at this juncture in my life, I would also like to share my delight and thanks with my lovely parents, sister, two brothers, four nieces and two nephews at Korea. Their inherent love for me and unhesitant support of my academic pursuits in the United States empowered me in every moment I experienced of disappointment and depression. The support and prayers of Pastor Sung-jin Hong and the Handul church family will be forever cherished in my mind. God and Jesus Christ raised me up more than I could do myself in every step of the Ph.D. program. Financial and administrative support from The Ohio State University and the Fisher College of Business is also greatly appreciated. VI VITA February 6, 1972 Born- Buan, Korea 1992 – 1996 B.A., Yonsei University, Seoul, Korea 1996 – 1998 MBA, Yonsei University, Seoul, Korea 1998 – 2001 Teaching officer, Korean Third Military Academy, Korea 2001 – 2004 Korea Development Bank, Seoul, Korea 2004 – 2008 Graduate Research/Teaching Assistant, The Ohio State University PUBLICATIONS 1. Song, S., Makhija, M., and Lee, S., 2008. Growth and Switching Options in Foreign Direct Investments, Academy of Management 2008 Annual Conference Best Paper Proceedings, Anneheim, USA (Also nominated as one of four finalists for the Samsung Distinguished Paper). 2. Song, S. 2007. Two Contradictory Effects of Prior Experience on Early Exits of Partially-owned Firms,” Hayes Research Forum Proceedings, The Ohio State University, 2007. Volume 7. 3. Song. S. 1999. The Effect of Resource Types and Ownership Share Levels on Ownership Change: The Bargaining Power Perspective (in Korean), Korean Academy of International Business, Korea (Awarded as Best Master’s Thesis) FIELDS OF STUDY Major Field: Business Administration (International Business) VII TABLE OF CONTENTS Page Abstract……….…………………………………………………………………… … ⅱ Dedication…… …………………………………………………………………… … ⅳ Acknowledgments…….…………………………………………………….……………ⅴ Vita………………………………………………………….……………………………ⅵ Table of Contents……….……………… ……………………………………………ⅶ List of Tables …………… …………………………………………………………… ⅸ List of Figures………………………………………………………………………… ⅹ Chapters: 1. Purpose of this Dissertation…………………………………………………………….1 2. Review of the Literature on Real Options and Foreign Direct Investments ………… 6 2.1 Introduction…………………………………………………………………………6 2.2 Key Components of Real Options Theory………………………………………….8 2.3 Management and Implementation of Real Options………………………….……27 3. Need for Future Research…………………………………………………………… 43 3.1 Motive for the Research 43 3.2 Theoretical Underpinnings 48 VIII 4. Conceptual Model and Hypotheses 56 4.1 Conceptual Model 56 4.2 Hypotheses 57 5. Research Methodology 69 5.1 Data 69 5.2 Dependent variables 70 5.3 Independent variables 71 5.4 Control variables 76 5.5 Analytical procedures 80 6. Research Findings and Discussion 83 6.1 Research Findings 83 6.2 Discussion of Findings 93 7. Conclusions and Implications 105 7.1 Conclusions 105 7.2 Implications 108 References IX LIST OF TABLES Table Page 2.1 Uncertainty Types in Real Option Literature………………… …… …… ……36 2.2 Investment Types in Real Options Literature……… ……………………… …….38 2.3 Delayability and the Boundary of Real Options Theory……… …………… ……39 2.4 Timing and value of Exercising Real Options……………………………… …40 2.5 Options Types in Real Option Literature………………………………………… 41 2.6 Performance Measures in Real Options Literature…………….………… …… …42 3.1 Two Option Relating to FDI…… …… ……………………………………… …55 6.1 Descriptive Statistics and Correlation Matrix.………….………………… ….… 98 6.2 Selection Model 1…………………………………………………………… 99 6.3 Selection Model 2……………………………………………………………….….100 6.4 Results for Hypothesis Tests…………………………………… …………… …101 6.5 Effects of Cultural Distance…………… …………….……………………….….103 6.6 Firm’s Behavioral Choice: Increase in Breadth and Depth…….…………… 104 X LIST OF FIGURES 4.1 Conceptual Model………………………………………………………… … 68 [...]... options theory contributes significantly to our understanding of how firms can invest in specific ways in order to address the uncertainty they face, and the particular role of foreign direct investments in this regard In this respect, we conduct a thorough examination of the theoretical and empirical literature in relation to foreign direct investment In doing so, we identify areas for future research in. .. multinationality and downside risk reduction The diversity of these findings points to the need for a more fine-grained investigation of the real options perspective in relation to foreign direct investments In uncovering the reason for these divergent findings, we find that several assumptions made in the current literature are problematic First, some researchers (E.g Allen and Pantzalis, 1996; Tang and Tikoo,... Issue of Flexibility In addition to the options to defer, which help to understand the timing and abandonment decisions, there are other types of options of importance to the firm, including the option to grow or increase investment In order to accomplish this, firms make foothold investments in a new market for the possibility of expansion in the future (Chang, 1995; Kogut, 1983) After the initial... of underlying assets, uncertainty types, and organizational constraints (Vassalo, Anand, and Folta, 2004; Anand, Oriani, and Vassola, 2007) Based on the interactions among different types of options within a portfolio of investments, Folta and O’Brien (2004) compared the relative magnitude of growth and deferral options They found that entry into a new industry is influenced by the relative value of. .. literature in greater depth and to examine the need for future work in this regard 5 CHAPTER 2 A REVIEW OF THE LITERATURE ON REAL OPTIONS AND FOREIGN DIRECT INVESTMENTS 2.1 Introduction Real options theory has become an important theoretical tool in understanding the strategies of a firm facing high uncertainty This theory suggests that under conditions of high uncertainty, firms can use various types of strategic... measure the value of multinational flexibility, Allen and Pantzalis (1996) and Thomas and Eden (2004) assessed the firm’s excess market value (EMV), the ratio of market value plus the book value of debt minus total assets, all divided by total net sales They extracted the EMV of each individual firm from the 24 averaged EMV of all the domestic firms in the same industry This measure is used to reflect the. .. endogenous uncertainty is resolved (at least in part) by the actions of the firm (e.g by engaging in more learning) over time (Chi and Seth, 2001; Cuypers and Martin, 2006; Folta, 1998; Roberts and Weitzman, 1981) In making the point that real options logic does not hold for endogenous uncertainty, Cuypers and Martin (2006) noted since only investing will reveal the relevant information under uncertainty so... variety of variables in this regard, including technological uncertainty, initial investment levels, number of partners, and the number of options, as well as preemption by competitors (Folta and Miller, 2002; Miller and Folta, 2002; Kumar, 2005; Trigeorgis, 2002) Table 2.4 shows the extant literature dealing with the conditions and value of acquiring and/ or divesting real options investment 19 2.2.4 The. .. circumstances? What if the costs of creating and managing real options are positively correlated with the values of the investments? How would this affect managerial decision making? The problem is that little effort has been devoted thus far in the literature to examining the relationship between costs of real options investments and the value generated from them We argue that these managerial costs... been applied to foreign direct investment in several areas of research, including timing of foreign entry (Campa, 1994; Rivoli and Salario, 1996), mode of foreign entry (Cupyers and Martin, 2006; Folta, 1998; Tong, Reuer, and Peng, 2007), value of multinationality or international joint ventures (Chi, 2000; Chi and McGuire, 2000; Reuer and Leiblein, 2000; Tong, Reuer, and Tong, 2007; Tong and Reuer, 2007), . In the main essay, Growth and Switching Options in Foreign Direct Investments,’ we examine in greater depth the two important perspectives of real options associated with foreign direct investments,. reduction. The diversity of these findings points to the need for a more fine-grained investigation of the real options perspective in relation to foreign direct investments. In uncovering the reason. THE VALUE OF SWITCHING AND GROWTH OPTIONS IN FOREIGN DIRECT INVESTMENT DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in