The effect of uncertainty correlation and resource fungibility on the valuation of a portfolio of external exploration activities

The real options theory and the diversification approach to strategic investments represent two important ways of thinking about how firms cope with uncertainty. Yet, these two lines of reasoning have developed independently of each other and the literature has missed interesting opportunities for cross-fertilization between them. This dissertation incorporates the diversification view into the real options approach in order to assess the value of a portfolio of related strategic investments. The study is built upon the observation that firms often simultaneously invest in multiple options, and develops a model of the interaction among such multiple investments within a single firm. In particular, this dissertation seeks to understand how the presence of uncertainty correlation between these investments and fungible resources between the investing firm and its investments affect the value of a portfolio of strategic options. By introducing these two effects the study shows the conditions under which the value of the portfolio can be lower or higher than the value that results from the linear combination of each individual option. The portfolio of real options approach is tested on a sample of 549 equity agreements, acquisitions, divestitures, and buyouts between pharmaceutical companies and biotechnology labs from 1989 to 1999. A binary logit model was specified for analyzing the entry mode decisions; a negative binomial regression model was specified for analyzing size decisions; and a hazard rate model was specified for analyzing termination decisions. The results strongly support the advantage of using a portfolio of real options model over the single option models previously proposed in the literature and provide support for the two different effects that mediate uncertainty--uncertainty correlation and resource fungibility. Consequently, this study extends the conceptual base of real option analysis within strategic management by carefully specifying and empirically testing a more complete option model. In doing so, it improves upon previous real options valuation models and enhances the possibilities for understanding how firms diversify in highly uncertain environment.