PREMATURE EXERCISE OF REAL OPTIONS
Abstract
This article endeavors to explore how endogenous and exogenous contingencies affect the
option exercise timing. While the exercise timing of real options is critical issue in real options
theory because real options, unlike financial options, do not have the predetermined timing of
option, the option exercising timing has not been sufficiently studied in the literature. Integrating
firm performance shortfall, the intensity of market competition, into this article’s theoretical
framework, we propose that these multilevel contingencies may increase the likelihood of
premature option exercising. we also propose that market importance that is function of
opportunities conferred by options can increase the likelihood of premature exercise of growth
option while reduce the likelihood of premature exercise of abandonment option.
Keywords: real options, premature exercising, firm performance shortfall, the intensity of
market competition, market importance.
1
INTRODUCTION
What factors affect the exercise timing of real options? Under the uncertainty over the
potential outcome of strategic investment decision, investments in real options usually initiated
by relatively small size toehold investment. This toehold investment then provides investors with
flexibility that enables them to wait and see until acquire new information about desirability of
the subsequent investment. On the one hand, if information implying high probability of the
realization of opportunities arrives, the investors will make subsequent investments. On the other
hand, the new information is negative, the investors may exercise an abandonment option
without bearing significant costs if market conditions turn out to be unfavorable (Smit &
Trigeorgis, 2006). Purchasing real options thus confers no obligation but right to make
subsequent decisions on investors. In other words, investors in real options can limit the
downside of the investments whereas preserve an access to upside potential of the investments
(Trigeorgis & Reuer, 2016)
Given this construct of real options, we propose that the potential value of option
investment is a function of the option exercising timing. In real options theory, firms have to
exercise their options (i.e. move on to the next step) only if uncertainty over strategic investment
has been sufficiently resolved (McGrath, 1997, 1999; Trigeorgis, 1996). From this perspective,
the option exercising timing can be categorized into three types: premature, mature, and belated
timing. The mature timing refers to the point that uncertainty has been sufficiently resolved. In
this sense, premature or late option exercising may give firms suboptimal returns.
Interestingly, while the belated exercise of real options has drawn attention from
escalation of commitment literature (Adner & Levinthal, 2004; Guler, 2007), the case of
premature option exercising has drawn little attention that it deserves from real options
2
researchers. Following Bowman and Hurry (1993) we define premature option exercising as the
exercise of real options before uncertainty over a certain investment has been sufficiently
resolved, and can create serious performance problems for firms investing in options (Bowman
& Hurry, 1993).
To explore the issue of premature option exercise, we focus on two different types of real
options that have been the center of real options research: growth option and abandonment
option. These two real options represent the opposite potential direction of the exercise a single
real option (Bowman & Hurry, 1993; Trigeorgis, 1996). Growth option refers to opportunity to
grow that is acquired by prior investment and can be captured by subsequent investment,
whereas abandonment option literally indicates forgoing permanently the toehold investment and
divesting current assets (Alessandri, Tong, & Reuer, 2012; Trigeorgis, 1996).
Thus, we define option exercising not just as the subsequent investment, but as the
transition to the next step. While the extant literature implicitly assumes that option exercising
necessarily means the subsequent investment, this assumption may be asymmetric in that real
options inherently provides investing firms with the option to abandon the toehold investment,
and this abandonment option lies at the heart of the flexibility offered by purchasing real options
(Adner & Levinthal, 2004; Kogut & Kulatilaka, 1994).
This paper investigates determinants of investors’ prematurely exercising growth option
or abandonment option. Specifically, we emphasize the need to examine more closely
organizational and environmental conditions simultaneously. Since the recent research has
shown that the value of option and the option exercising are significantly affected by firm level
as well as environmental contingencies (Adner & Levinthal, 2004; Bowman & Hurry, 1993;
Tong, Reuer, & Peng, 2008), exploring multilevel factors would be a reasonable approach.
3
To accomplish this research objective, we focus on firm performance shortfall and the
intensity of market competition as potential candidates that will likely affect the firm’s premature
option exercising, given that these two contingencies have long been considered as the critical
determinants of firm’s strategic decisions (Dixit & Pindyck, 1994; Ghemawat, 1991; Iyer &
Miller, 2008; Lambrecht & Perraudin, 2003; Miller & Leiblein, 1996; Porter, 1980). We also
explore the moderating impact of the importance of a certain market (i.e. market importance) to
firms holding real options on the focal market. Since the value of real options is the function of
strategic opportunities the options create for firms and of perception (Aguerrevere, 2009;
Alessandri et al., 2012; Barnett, 2008), we propose that the impact of firm performance shortfall
and market competition over the option exercising timing will be moderate by market
importance in two opposite ways. The likelihood of premature exercise of growth option may be
enhanced, whereas the likelihood of premature exercise of abandonment option may be
diminished.
In this paper, we endeavor to contribute to the real options literature in two ways. First,
we explicitly focus on the issue of premature option exercising. While the late option exercising
has been studies in real options literature and in escalation of commitment literature, the
premature option exercising has been rarely studied. Second, we discuss the critical
organizational and environmental contingencies in comprehensive way to develop meaningful
theoretical framework for better understanding of the factors that may engender premature option
exercising. While the previous research has examined the impact of each contingency on option
exercising timing, it has attended to only one contingency at a time, limiting our understanding
on option exercising timing (Belderbos and Zou, 2009; Dixit, 1992; Lee & Song, 2012; O’Brien
& Folta, 2009; Reuer & Leiblein, 2000; Smit & Ankum, 1993).
4
REAL OPTIONS AND PREMATURE EXERCISE
The strategic decisions that involve resource investment and allocation are usually made
and implemented under substantial uncertainty on potential outcomes of the decisions. Dixit and
Pindyck (1994) argue that the uncertainty prevents decision makers from making economically
rational resource investment decisions. Thus, decision-makers often, if not alwas, depend on
their own assessment of the probabilities of potential gain and loss for the investment (Dixit &
Pindyck, 1994). It is no wonder that the concept of real options focusing mainly on managing
investment decisions under uncertainty has engendered enthusiastic response in strategic
management literature
According to real options theory, acquiring real options through the initial toehold
investment allows firms to manage the uncertainty by limiting the downside risk of the
investment decision while gaining upside potential of it (Bowman & Hurry, 1993; Dixit &
Pindyck, 1994; McGrath, 1999). Firms can limit downside risk of their investments to the cost of
toehold investment which is the fraction of a firm value while they preserve preferential access
to future value of those investments (McGrath et al., 2004).
If uncertainty over the future value of a certain option is sufficiently resolved, the option
holding firm will exercise the option (i.e. step forward or abandon) (McGrath, 1999). However,
the firms holding real options are not obliged to make the next stage action which is irreversible,
but still have opportunities to defer it until a substantial portion of uncertainty about potential
outcomes has been resolved (Trigeorgis, 1996; Zardkoohi, 2004). This asymmetry having the
right but not the obligation to exercise options lies at the heart of the value of real options
(Trigeorgis, 1996).
5
Given that exercising options depends on the upside potential that will be conferred by
favorable exogenous conditions, it is reasonable to think that judging accurately whether or not
real options are in the money, and thereby, finding out the right time to exercise options are
arguably the most critical issue in real options reasoning (McGrath, 1999).
However, timing the option exercise are not only crucial but also significantly daunting
tasks in real options framework. Unlike financial options, real options do not have an explicit
expiration day (Adner & Levinthal, 2004). The absence of the fixed expiration day of real
options may give firms flexibility to wait and see the environmental change beyond the any
certain point if conditions are unfavorable. However, ironically, this absence also creates
significant problem in exercising options effectively because without explicit expiration day the
timing of option exercise can be conditioned by factors other than expected economic rent of the
exercise.
Previous research argues that during the course of the holding period, the value of the
option changes in response to environmental conditions as well as organizational context (Adner
& Levinthal, 2004; Barnett, 2008; Iyer & Miller, 2008; Ragozzino, Reuer, & Trigeorgis, 2016;
Tong et al., 2008). Some researchers have proposed that gathering more information during the
course of the option holding period can effectively solve the problem of the absence of prefixed
option exercising timing (Bowman & Hurry, 1993; Krychowski & Quélin, 2010). However,
organizational and environmental conditions may not allow firm to sufficiently gather relevant
information or to wait until uncertainty gets resolved, but rather force firms to prematurely
exercise options even under significant uncertainty. If firms prematurely exercise options, the
exercise will likely yield the suboptimal economic rent because firms made decisions under the
6
situation where exogenous conditions can turn into the least favorable direction in future
(Bowman & Hurry, 1993).
CONTINGENCIES AFFECTING PREMATURE OPTION EXERCISE
Given the negative consequence of the premature exercise of options, theoretical
framework exploring what conditions and how they force firms to prematurely exercise the
options are necessary to be developed for extending real options literature. Since timing of
option exercise is subject to exogenous as well as endogenous conditions (Adner & Levinthal,
2004; Barnett, 2008; Iyer & Miller, 2008; McGrath, 1997), we give attention to multilevel
determinants of option exercising timing.
Specifically, we mainly focus on three determinants selected from firm, industry and
social levels: 1) performance shortfall ; and 2) market competition. Since these conditions that a
firm encounters have long been considered by management literature as important determinants
of firms’ strategic decisions (Bowman, 1980; Bromiley, 1991; Porter, 1980), it may be
reasonable to assume that these conditions also play a pivotal role in the timing of option
exercise.
Therefore, we propose that performance shortfall, and market competition may increase
the likelihood of premature option exercise. That is, when a firm encounters significant
performance shortfall , and intense market competition, the firm that previously invested in real
options will likely be forced to exercise options (i.e. move on to next step) as its incentive to
keep options open diminishes. These arguments are illustrated in Figure 1.
[Insert Figure 1 about here]
Our main argument depends on two basic assumptions. First, we assume that the
incentive to keep options open will decrease as perceived uncertainty decreases in course of time
7
(Downey & Slocum, 1975; Fisch, 2008). This assumption is logical in that firms’ incentive to
hold options should be highest when firms first acquiring real options because uncertainty over
the future value of the investment in those real options will be the highest at this moment . As
firms spend more time in assessing real value of options, the firms’ incentives to keep options
open (i.e. wait and see) will likely decrease as the uncertainty decreases (Fisch, 2008).
Second, the value of exercising real options has an inverted u-shape relationship with
time. While the value of exercising real options may be at minimum at first because of
uncertainty, it will likely increase as uncertainty gets resolved and as information accumulation
helps firms to gain a better understanding of the value of the exercise (Bowman & Hurry, 1993).
The exercising value will be the greatest when firms encounter the most favorable conditions for
exercising options and uncertainty has been perfectly resolved. If the firms miss the best chance,
the value of exercising real options will likely decrease. For example, if market conditions
decline severely, a firm can withdraw from a certain market by exercising abandonment option
or switching option (Belderbos & Zou, 2009; Bowman & Hurry, 1993; Kogut & Kulatilaka,
1994; Trigeorgis, 1996). If the focal firm withdraws from that market at the optimal timing, the
value of exercising abandonment options will be the greatest. In other case, the abandonment
would be hasty decision (before the optimal timing) or escalation of commitment (after the
optimal timing).
As shown in graph (a) of Figure 1, the point that two curves intersect is the optimal point
that a firm can realize the greatest value of exercising options. However, firm performance
shortfall , market competition over the firm may push the firm’s incentive curve to the left
direction. As a result, the firm prematurely exercises real options and thereby gains less than the
greatest return. Since the exercise of option is ultimately subject to managerial choice and the
8
optimal timing of exercising options is independent from the behavior of firms (Adner &
Levinthal, 2004), it is reasonable to assume that multilevel contingencies affect the firm’s
incentive curve rather than the value of exercising option curve. This point is consistent with the
Bowman and Hurry’s (1993) argument about the negative consequence of premature options
exercising.
In addition, we also investigate how the magnitude of the importance of markets for firms
moderates the relationship between the three contingencies (i.e. firm performance shortfall and
market competition and the likelihood of premature option exercise. We propose that market
importance for firms may enhance the positive association between two conditions and the
likelihood of premature exercise of growth option while reduce the positive association between
the contingencies and the likelihood of premature exercise of abandonment option.
Given that toehold investment is the fraction of the value of the firm and can be given up
in the worst case, a firm investing in options on future opportunities in a relatively less important
market may be more prone to wait and see until uncertainty is resolved and conditions become
more favorable. This is because the firm can limit its loss to the toehold investment while keep
holding the opportunity to capitalize on upside potential in favorable conditions. In this case, the
focal firm can exercise abandonment option with less opportunity cost and afford to be
preempted market opportunities by competitors. On the other hand, if a certain market is
strategically important for firms that invested in real options in the market, the focal firms will
likely have high incentives to capitalize on opportunities in that market, and thereby, focus more
on that market.
In the next section, we explore the relationship between these two conditions (i.e. firm
performance shortfall, market competition, and government power over firms) and the likelihood
9
of premature option exercise as well as the moderating role of market importance in detail and
develop six propositions. These propositions are summarized in figure 2.
[Insert Figure 2 about here]
Performance shortfall
The performance shortfall that firms encounter has drawn significant attention from
strategic management researchers because managing or limiting organizational risk is closely
related to organizational return and performance (Bowman, 1980; Bromiley, 1991; Miller &
Leiblein, 1996). Focusing on the implication of risk for performance, researchers have
conceptualized firm performance shortfall as negative outcomes and shortfall in the firm’s actual
performance level against its aspiration level of performance (Miller & Leiblein, 1996; Miller &
Reuer, 1996; Reuer & Leiblein, 2000). Cyert and March (1963) note that the firm’s aspiration
level of performance is in turn a function of its past performance as well as of the performance of
comparable organizations.
Adopting the construct of performance shortfall, we can draw two corollaries. First, the
magnitude of performance shortfall that firms encounter is heterogeneous. That is, since firms’
aspiration level of performance is set based upon information of previous performance level of
firms as well as industry, it appears that firms experience different level of performance shortfall.
Second, performance shortfall is not static but continuously changes. Since aspiration level of
performance as well as firm performance continuously change time to time, the gap between
aspiration level and actual firm performance (i.e. firm performance shortfall) should change.
Given these corollaries and the previous research showing that performance shortfall has
a significant influence on firms’ behaviors (Cyert & March, 1963; Fombrun & Ginsberg, 1990;
Iyer & Miller, 2008), it can be argued that firms’ behaviors responding to downside risk will
10
likely be different in accordance with the magnitude of the risk they encountered and that a
single firm’s behaviors will likely change as the magnitude of its performance shortfall changes
(Barnett, 2008; Iyer & Miller, 2008; Staw, Sandelands, & Dutton, 1981).
According to real options reasoning, the increase of firm performance shortfall to a
certain level can become manifest in a firm’s failure—i.e. going out of business (McGrath, 1999;
Miller & Reuer, 1996). McGrath (1999) defines a failure as termination of a firm which is
resulted from actual performance that fall not only below aspiration level but below a critical
threshold referring the minimum level of performance enabling a firm to sustain its business.
Researchers have often adopted the firms’ proximity to bankruptcy to operationalize the firm’s
closeness to failure, and argue that firms may differently respond to downside risk in light of
how close they are to threats of bankruptcy (Barnett, 2008; Iyer & Miller, 2008; Staw et al.,
1981).
Given that the firms’ responses to performance shortfall depend on where they focus their
attention (Barnett, 2008), it can be argued that when the firm performance shortfall is so
significant that they are likely to go out of business, firms may shift their focus from achieving
aspiration level of performance to sustain their business (March & Shapira, 1987; Miller & Chen,
2004; Iyer & Miller, 2008). Since firms’ attention will likely facilitate action towards those
issues and activities being focused on (Ocasio, 1997), firms mainly focusing on organizational
survival will likely choose to avoid activities that entail high potential return as well as high risk
such as explorative search and making new toehold investment for capitalizing uncertain
opportunities in future (D’Aveni, 1989; Iyer & Miller, 2008; March & Shapira, 1987).
In contrast, firms not significantly threatened by risk of going out of business but
encounter less severe downside risk will likely engage in explorative search in order to increase
11
their performance to the aspiration level because survival is not their main focus (Fombrun &
Ginsberg, 1990; Miller & Chen, 2004). Therefore, we argue that firms encountering greater
performance shortfall will be more likely to prematurely exercise their options before
opportunities leading firms to investing in real options have been fully developed or before
uncertainty related to potential opportunities gets sufficiently resolved.
On the one hand, when firms have not acquired sufficient economic return since the
initial toehold investment and opportunities have not been fully developed, they may consider
two choices: wait and see longer, or abandon a real option. However, since firms threatened by
significant performance shortfall cannot afford to wait and see until conditions turn into
favorable to exercise options, they will try to realize the resale value of their option investment
(Trigeorgis, 1996). This argument is consistent with the Weeds’ (1999) finding that the firm
tends to abandon research rapidly as profitability declines, at times despite the existence of
positive expected profits.
On the other hand, if a firm holding real options has yielded not trivial economic return
since the prior toehold investment in a certain market, it would focus more on that market. If this
firm confronts a significant performance shortfall and thereby cannot afford to wait and see until
uncertainty over the real potential of opportunities gets sufficiently resolved, the firm may more
depend on the focal market that has provided it with secure economic return. Therefore, the focal
firm would likely attempt to acquire more growth opportunities by making subsequent
investment, even if the current return might stem from a passing whim and the uncertainty over
the expected opportunities has not been resolved sufficiently.
However, firms confronting insignificant performance shortfall and thereby having an
incentive to increase its performance will be more prone to keep options open to increase their
12
performance, because premature option exercise would yield the lowest performance (Bowman
& Hurry, 1993; Cyert & March, 1963). From this perspective, we propose that the increase of
performance shortfall will likely force the focal firms to make decision and behave faster than
they would have done with less serious downside risk because the substantial downside risk
decreases the value of waiting to firms.
Proposition 1: Firm performance shortfall is positively associated with the likelihood of
the premature exercise of a growth option and an abandonment option.
Market competition
Market competition has long been considered as the crucial topic in strategic
management field and the most influential determinants of the behavior of firms. From this
perspective, it can be reasoned that market competition has a significant influence on the timing
of option exercise. Lambrecht and Perraudin (2003) argue that managerial decisions of options
exercise timing are often affected by a firm’s competitive environment. In some situations, a firm
may need to be worried that competitors preempt strategic opportunities in a certain market by
acting first, and thereby, literally enjoy first mover advantage. In this case, competitive forces
may provide the focal firm with an incentive to exercise option early to prevent competitors from
preempting opportunities in the market (Dixit & Pindyck, 1994; Jackson & Dutton, 1988;
Kulatilaka & Perotti, 1998). However, in other situations, firms need to defer option exercising
until their competitors have acted first because uncertainty over the second stage investment is
substantial (Lambrecht & Perraudin, 2003).
Therefore, competitive real options analysis requires researchers to take the ways in
which the firm’s actions affect rival’s responses into account, because the timing and value of
exercising real options depend critically on competitive interaction between firms and their
13
competitors (Ghemawat, 1991; Smit & Trigeorgis, 2006). That is, the benefits of the wait and see
must be weighed against the potential benefit offered by commitment and preemption (Adner &
Levinthal, 2004; Ghemawat, 1991).
In general, intense competitive interactions between the focal firm and competitors
promote the focal firm’s premature options exercising in two ways. First, researchers have
argued that competition diminishes the value of the waiting, because the threat of preemption by
competitors give the focal firm substantial incentive to invest earlier than it would have done
under the less competitive market conditions (Grenadier, 2002; Trigeorgis, 1996).
In other case, if a firm had not found strategic opportunities in a certain market or lagged
far behind of its competitors, the focal firm would consider the abandonment option. For the
focal firm, the increase of intensity of competition will likely offer greater incentive than before
to exercise either abandonment option or option to growth. Under the intense competition, firms
may have less incentive to wait and see until uncertainty about potential investment outcomes
gets sufficiently resolved than it would have under less competitive market conditions. The
empirical results show that flexible ownership strategies with the toehold investment in response
to market uncertainty is less valuable under intense competition (Li & Li, 2010)
Second, the intense competition provides a firm with substantial incentive to preempt
valuable resources and capabilities which in turn will later create important strategic
opportunities (Kim & Kogut, 1996). Smit and Trigeorgis (2006) argue that R&D competition
erodes the option value to wait and thereby encourages firms to accelerate completion of the
project. Therefore, I suggest that intensive competition increases not only the threat of being
preempted by competitors, but also the incentive of firms to preempt market opportunities even
if conditions are not favorable or uncertainty over additional investment has not been sufficiently
14
resolved. In addition, if a firm can acquire certain real options before competitors recognize the
real value of the options, the firm can get the competitive advantage. However, due to the
information asymmetry, the firm may not easily and quickly figure out the real value of the
options (Ackerlof, 1970). Therefore, preemptive options exercising under intense competition
may likely be a premature one. From this perspective, I propose that intense market competition
makes firms holding real options less capable of deferring the option exercise and increases the
pressure on firms to move faster than they would under the less competitive environment.
Proposition 2: The intensity of market competition is positively associated with the
likelihood of the premature exercise of a growth option and an abandonment option.
Moderating role of market importance
Previously we proposed that firm performance shortfall and the intensity of market
competition over a firm may increase the likelihood of premature options exercising. Here we
assert that the relationship will be moderated by the market importance for a firm. The market
importance is a function of strategic opportunities that a firm perceives a certain market may
offer. Therefore, the importance of markets for firms may vary with environmental conditions as
well as with organizational context. Aguerrevere (2009) finds that the relationship between
intensity of competition and the expected value of option exercising varies with strategic
opportunities engendered by market demand for firms’ products in a certain market.
In addition, given that economic conditions of each market are substantially different
from one another (Porter, 1980), firms may emphasize more on their activities in the more
important market for them than in less important markets. For example, Kumar (2005) notes that
firms acquire or divest joint ventures with the objective to refocus on a target market and to
capitalize on growth opportunities in a target market.
15
Therefore, market importance may exert its moderating impact in two ways. That is, if a
certain market is important for firms, the likelihood of premature exercise of abandonment
option may decrease while the likelihood of premature exercise of growth option may increase.
First, since a firm perceives that the important market will later provide it with valuable strategic
opportunities such as for significant growth or profit generation, firms encountering substantial
downside risk, market competition and the power imbalance will likely have higher incentives to
exercise growth options even faster than it would have done without the moderating impact.
Firms encountering serious downside risk may not afford to wait and see until opportunities
emerge and uncertainty gets resolved. Therefore, these firms will likely to focus more on
important market and thereby to exercise growth option faster in the important market than in
less important markets. Under the intense market competition, firms attending to beat the
competition by preempting valuable resources and capabilities will likely exercise growth option
faster when the market is very important to them. Furthermore, if a certain market is very
important for firms, the incentive of firms having intention to comply to governmental pressure
for exercising growth option will even increase larger than without the moderating impact.
Second, the market importance will likely reduce the incentive of firms intending to
prematurely exercise abandonment option. Even if toehold investment enables firms to limit the
downside risk of investment, since the firms perceive the high potential opportunities in the
important market, the firms’ opportunity cost of exercising abandonment option may increase
and thereby their incentive to prematurely exercise abandonment option will diminish. Li and Li
(2010) find that using real options approach (e.g. flexible ownership strategies) in response to
uncertainty becomes less valuable for MNEs when the industry they entered show strong sales
growth potential (Li & Li, 2010). Berry (2013) reports that the divestment decisions of firms are
16
closely related to growth opportunities of countries. She finds that when foreign subsidiaries are
located in countries offering high growth opportunities and are operating in related product
markets to the firm’s core business lines, those subsidiaries are less likely divested (Berry, 2013).
Therefore, we propose that the market importance moderate the positive relationship
between two contingencies (i.e. firm performance shortfall, and the intensity of market
competition) and the likelihood of premature option exercising in ways such that the market
importance enhances the positive relationship between two contingencies and the likelihood of
premature growth option exercising while reduces the positive relationship between two
contingencies and the likelihood of premature abandonment option exercising.
Proposition 3: The magnitude of market importance enhances the positive association
between performance shortfall and the likelihood of the premature exercise of growth
option while reduces the positive association between performance shortfall and the
likelihood of the premature exercise of abandonment option
Proposition 4: The magnitude of market importance enhances the positive association
between the intensity of market competition and the likelihood of the premature exercise
of growth option while reduces the positive association between the intensity of market
competition and the likelihood of the premature exercise of abandonment option
DISCUSSION AND CONCLUSION
In the present research, we mainly attend to the issue of the option exercising timing and,
especially, premature option exercising. While finding out the right time to exercise options is
critical to maximize option exercising value in real options reasoning, the extant literature has
not given enough attention to this issue. In particular, the issue of premature option exercising
has been investigated few times. A prevailing view informed by the extant research is that firms
may exercise their options only if conditions are favorable and uncertainty over strategic
investment has been resolved. This standard real options perspective assumes that firms may
behave in economically rational way to maximize the value of options when they exercise the
17
options. In this study we depart from this perspective by arguing that the option exercising
timing can be deviated from the theoretical optimal timing by endogenous or exogenous forces.
Specifically, we propose that firm performance shortfall, the intensity of market
competition, and the magnitude of the governmental power over firms (i.e. the power imbalance
between two parties) may increase the likelihood of premature option exercising by reducing
firms’ incentive to wait and see and increasing their incentives to move on to the next step early.
We also propose that if a certain market is more important for firms than other markets, the
firms’ incentives to prematurely exercise growth option may increase while the others’
incentives to prematurely exercise abandonment option may reduce.
In this aspect, this paper contributes to the literature in two ways. First, we explicitly
focus on the issue of premature option exercising which has rarely been tried in the real options
literature. Second, we suggest the comprehensive theoretical framework that may promote better
understanding of the conditions causing premature option exercising by integrating firm
performance shortfall, market competition and the governmental power over firms into the
framework.
We note two areas for future research, which can help to address some of the paper’s
limitations. First, while the present study endeavors to explore the relationship between
multilevel contingencies (i.e. firm performance shortfall, and the intensity of market
competition) and the likelihood of premature option exercising, we investigate each relationship
independently from the others. However, as we noted in foregone section, since these
contingencies are critical determinants of strategic behaviors of firms, it is hard to believe that
the impact of these contingencies on the likelihood of premature option exercising is independent
from each other. Therefore, future research might find it valuable to investigate the moderating
18
role of upper level contingencies in the relationship between lower level contingencies and the
likelihood of premature option exercising.
Second, we rely on the Bowman and Hurry’s (1993) theoretical proposition that
premature option exercising yields low level performance and return. Researchers may be
interested in investigating whether and how premature option exercising damage the option
exercising value and return through an empirical research.
Despite the limitations, the present study endeavors to join the expanding the real options
literature. In contrast with a prevailing view that firms may exercise options when option
exercising create the maximum value, we argue that option exercising timing is subject to
endogenous as well as exogenous contingencies. To better understand the mechanism, we
propose a framework associated with these contingencies and develop propositions investigating
how those contingencies may affect the option exercising timing. Consequently, it can be argued
that firm performance shortfall, the intensity of market competition, and the governmental power
over firms may likely increase the likelihood of premature option exercising. Moreover, these
relationships change depending on whether a certain market is important for firms or not. In
closing, we hope the arguments presented here could stimulate more research exploring the
option exercising timing.
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Figure 1. Premature option exercise and suboptimal return
23
value
value


Firm performance shortfall
Market competition
Firms’
incentive to
wait and see
Optimal
Timing
time of
Value
Option
Exercising
Premature
Timing
Optimal
Timing
time
b)
a)
Figure 2. Theoretical model
The magnitude of
market importance
for firms
24
(Enhance)
gfdgfdsgfdsgd


The likelihood
of premature
exercise of
growth option
(+)
Firm
performance
shortfall
The intensity of
market competition
(Reduce)
The likelihood
of premature
exercise of
abandonment option
(+)
25