Business Case Studies & Business Publications

Dumbarton Bearing Supply, LLC: Recognizi...

Lipson, Marc L.

Case

Dumbarton Bearing Supply, LLC: Recognizing Real Options

Lipson, Marc L.

F-1990 | Published August 25, 2021 | 7 pages Case

Collection: Darden School of Business

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Angus MacIntyre, CEO of Dumbarton Bearing Supply, LLC (Dumbarton), is deciding whether to introduce a new ceramic ball-bearing product line and whether to produce those bearings by refitting an existing production line or by building a new production line. The initial analysis favors a refit—despite a much higher variable cost, the investment is relatively small, and as a result this approach poses little risk. However, this analysis does not recognize the possibility that Dumbarton could abandon the new product line and recoup much of its investment in scenarios where demand for the new bearings is low. The ability to abandon the product line at a later date is a classic “real option.” When properly recognized, this real option flips the conclusion on the production choice—it allows Dumbarton to capture the benefits of a newly built line’s very low marginal cost while mitigating the risk created by a larger investment. The case provides insights into option-like features of decisions without any use of option-pricing tools. This case has been used successfully to introduce real options in Darden’s core finance curriculum, a specialty master’s degree program in data analytics, and an Executive Education program. It would be appropriate either in a sequence of cases covering optionality or as a later case in a sequence of cases on net present value (NPV) analyses. Any student with an understanding of basic NPV analysis can execute the required work, so the case can be used in a wide variety of settings. The emphasis can be easily shifted from technical modeling (advanced techniques in valuation) to intuition (strategic choices) as needed.

The case can be used to pursue the following objectives: (1) Introduce students to risks associated with operating leverage while building familiarity with modeling fixed- and variable-cost structures and then executing meaningful scenario analyses. (2) Highlight the importance of contingent decision-making (learning over time). (3) Illustrate how payoff diagrams can reflect both risk (slope) and optionality (nonlinearity) of choices. (4) Introduce the modeling of real options in a simple and intuitive manner: the calculation of an expected net present value (NPV) rather than simply the NPV of expected values. This draws attention to the economic consequences of real options without the need for advanced option-valuation techniques or terminology.