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...alternative perspective on strategic capital investments, called "real options." Proponents of real options argue that this is superior way of approaching decision making and capital budgeting, compared with other approaches, as it allows for greater strategic flexibility and encourages exploration, experimentation, and innovation. Within the healthcare literature, articles on real options have focused on pricing these options.
This article is unique to the healthcare literature as it emphasizes the cognitive or strategic aspects of real options. Additionally, this article integrates two techniques for applying the real options approach for interested practitioners using a hospital's imaging department as an example, while providing scholars with additional applications and questions for future research. For practitioners, the implications are that thinking of and planning for capital investments as real options may create greater strategic and operating flexibility than other, more traditional approaches.
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As the old adage says, "Patience is a virtue." Within the past 30 years or so, strategic and financial management scholars have been formulating a complementary set of theories that incorporates this adage as one of its core characteristics--the option to delay or wait. Intuitively, practitioners have known for some time that delaying a project may clarify uncertainty, thus reducing the potential for a negative occurrence. Take, for example, the situation where a physician group asks a hospital to acquire a new piece of technology and expand its facilities at the same time. The hospital administrator may wish to maintain the right to delay the more expensive project--expanding its facility--until he knows that the requesting physician group has first used the piece of equipment to a satisfactory level. This right or option to delay has value. Thus, patience may not only be a virtue, but it may also have positive economic consequences as well.
Traditional capital budgeting methods, such as the net present value (NPV) approach, do not capture this value to delay, however. Nor do they capture other issues related to operating flexibility and strategic interactions (Dixit 1989). In response to this deficiency in strategic thinking and capital budgeting techniques, a growing body of literature has emerged to help practitioners and researchers deal with corporate decision making.
Scholars working in this field call this body of literature "real options." Real options are investment opportunities that are characterized by "a limited commitment that creates future decision rights" (McGrath, Ferrier, and Mendelow 2004, 86). Thinking of capital budgeting decisions as real options means thinking of strategic and capital investments as similar to financial stock options. Proponents of real options suggest that this form of strategic thinking and investment is inherently more beneficial than the NPV approach. As Kognt and Kulatilaka (2001, 744)
observe, a "real options approach marries the theory of financial options to foundational ideas in strategy, organizational theory, and complex systems."
As illustrated, healthcare practitioners have likely been using this type of logic for decades. Jensen and Warren (2001) note that the pharmaceutical and biomedical industries are the most frequently used examples in the literature. However, our review of the healthcare literature uncovered few articles on real options. Literature on real options can be divided into its financial or pricing aspects and its cognitive or strategic aspects. The healthcare journal articles all deal with the financial or pricing aspects. Thus, after briefly describing the origins of the concept of real options, we focus on the cognitive or strategic aspects and provide examples of strategic applications within the healthcare setting for both practitioners and researchers.
ORIGINS
Literature on real options emerged from work by financial economists who were developing an option pricing theory (e.g., Black and Scholes 1972, 1973; Merton 1973). These scholars were seeking to create theories to value financial option contracts. Before this research on options, Miller and Modigliani (MM) (1961) had shown that a firm's market value represented two parts: the present value of its assets and the present value in its growth opportunities in real assets. Myers (1977) proposed thinking of investment opportunities associated with capital budgeting projects (i.e., the growth opportunities in real assets as described in the MM model) as growth options (Trigeorgis 1993). As the literature developed, growth options related to capital budgeting decisions became known as options in real assets or real options. Thus, the literature related to option pricing theory was expanded and applied to capital budgeting issues.
An option is "a security giving the right to buy or sell an asset, subject to certain conditions, within a specified period of time" (Black and Scholes 1972, 637). There are two main types of option contracts: a call option and a put option. A call option allows the holder of the option the right to purchase the underlying asset within a given time and at a specified price (known as the strike or exercise price). A put option allows the holder of the option to sell the underlying asset at the strike price within the given period of the contract. Combinations of put and call options exist as well.
For example, when the hospital mentioned previously purchases the piece of equipment, it also acquires a call option to expand its facilities, and the option's exercise price is the cost of expansion. In addition, the firm's ability to sell that piece of equipment (even at a loss) can be thought of as a put option. The ability to delay a project is not the only area of flexibility addressed within the literature on real options. The major categories related to real options include the option to initiate, abandon, expand, contract, wait, slow down, speed up, switch, sell, or sequence a project (Bowman and Hurry 1993; Merton 1998; Trigeorgis 1993). From the perspective of real options, an explicit economic value is associated with all of these areas of flexibility.
Several different methods are used to price real options. However, a review of these methods is beyond the scope of this article and is not necessary to understand the logic and applications of real options, which is the focus of this article. (1)
REAL OPTIONS REASONING
The cognitive aspects of the real options literature are called "real options reasoning" (e.g.,...
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