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Part 2 : Valuation Recent Trends www.clairfield.com 2010
Part 2 : Valuation Recent Trends www.clairfield.com 2010

Part 2 : Valuation Recent Trends

www.clairfield.com

2010

M&A activity is driven by multiple macro-economic and industry forces and opportunities … CHANGE IN

M&A activity is driven by multiple macro-economic and industry forces and opportunities …

macro-economic and industry forces and opportunities … CHANGE IN INDUSTRY STRUCTURE Consolidation Pre-emptive

CHANGE IN INDUSTRY STRUCTURE

Consolidation

Pre-emptive M&A by competitors

Technology advances

Pre-emptive M&A by competitors Technology advances CHANGE IN CAPITAL MARKET OPPORTUNITIES Availability of

CHANGE IN CAPITAL MARKET OPPORTUNITIES

Availability of funding

Investor expectations and sentiment

Performance of stock market

expectations and sentiment Performance of stock market REGULATORY AND POLITICAL PRESSURE Europe as a trading block

REGULATORY AND POLITICAL PRESSURE

Europe as a trading block post EMU

Deregulation of global trade

Interest in emerging markets: China etc

Relative values of stock prices versus hard assets World M&A UK M&A 1,400 300 1,000
Relative values of stock prices versus hard
assets
World M&A
UK M&A
1,400
300
1,000
200
RISK OF
UNDERPERFORMANCE
600
100
200
Need to reduce debt
(whilst preserving the
core)
0
0
H1 H2 H1 H2 H1 H2 H1 H2 H1
H2
H1 H2 H1 H2 H1 H2 H1 H2 H1
H2
2004
2005
2006
2007
2008
2004
2005
2006
2007
2008
World Half-Year Total
Telecoms specific
UK Cross Border
UK Domestic
Change in
performance of
different elements of
the portfolio
Note: Includes all cross border and domestic deals completed 1st
Jan 2004 - December 2007. Excludes MBOs &
Privatisations.
Source: Datalogic, Thomsom Financial, KPMG analysis
£
billion
£
billion
Thomsom Financial, KPMG analysis £ billion £ billion DESIRE FOR FOCUS AND SIMPLICITY SEARCH FOR GROWTH

DESIRE FOR FOCUS AND SIMPLICITY

SEARCH FOR GROWTH OPPORTUNITIES

Complexity of business unit

Extend geographic coverage

Overload of business unit priorities

Acquire complementing assets

Identification of synergies across the portfolio

Extend within or across industries

 

Do we value them correctly?

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Buy-side deals are becoming more successful…

Buy-side deals are becoming more successful…

BUY-SIDE EXPERIENCE

SELL-SIDE EXPERIENCE

Value creation

100%

80%

60%

40%

20%

0%

53%

   

31%

 

32%

 

38%

34%

30%

   

17%

 

31%

34%

1999

 

2004

 

2007

Enhance value Neutral Reduce value

Enhance value

Enhance value Neutral Reduce value

Neutral

Enhance value Neutral Reduce value

Reduce value

 

35% of vendors completed their most recent disposal at a price significantly below their own valuation

Deals that do not add value

 
 
 

Of these, an average 20% price reduction from valuation to selling price was experienced

Deals

 

adding

 
 

value

 

60% of all vendors suffer post deal issues

Source:

KPMG survey ‘Beating the Bears’ - 2008

Source:

KPMG survey ‘Increasing value from disposals – A case study for professionalising the sell side’ - 2009

3

… but that sell-side activities are becoming more challenging

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Almost 70% of deals add no value

Almost 70% of deals add no value

UK-WIDE M&A VALUE CREATION

100% 31 80% 53 Deals that do not add value 60% 39 40% 30 20%
100%
31
80%
53
Deals that do not
add value
60%
39
40%
30
20%
Deals that do
30
add value
17
0%
2001
2008
Deals destroyed value
Deals produced no discernible difference
Deals added value
% of deals

Source: KPMG surveys

WHY MERGERS FAIL

Resistance to Change 60% Limitations of Existing Infrastructure 43% Lack of Executive Alignment 38% Lack
Resistance to Change
60%
Limitations of Existing Infrastructure
43%
Lack of Executive Alignment
38%
Lack of Executive Champion
36%
Unrealistic Expectations
33%
Lack of Cross-Functional Teams
30%
Inadequate Team and User Skills
28%
Key Stakeholders Not Involved
18%
Project Charter Too Narrow
14%
0
10
20
30
40
50
60
70
Contribution to Merger Failure (%)

Source:

Financial News, Briefing Note 19, 17 Sept 2001, Offer Information Week

Underestimating the management effort required to realise benefits is the primary reason for failure to deliver value from mergers

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Almost 70% of deals add no value, why?

Almost 70% of deals add no value, why?

Operational performance improvement is recognised as being key to realising value from transactions

RATIONALE FOR DEAL

Operational improvements: e.g, improved back office processes, expanded customer service functionality, etc. –
Operational improvements:
e.g, improved back office
processes, expanded customer
service functionality, etc.
– “1992 was the last time the most
common form of exit was
receivership, as it is now.” (1)
Consideration
Value Creation
Rationalisation of
manufacturing
Create
Shareholder
Deal
Price
Operational
factors
Value
Costs
Paid
– “The ability to supplement deal
skills with appropriate management
expertise will allow proactive
assistance to be given to portfolio
companies to add to product
value.” (2)
Premium
Product
development
Destroy
Sales
Shareholder
growth
Value
– “I wonder if people are coveting
operational skills simply because
they are more operationally
involved in the businesses at the
moment than they want to be
[because of under-performance].” (3)
Standalone
New
Synergies
Value
Strategies
Source:
(1) Jon Moulton, Managing Partner, Alchemy
Partners, Super Return 2002 Conference
(2) KPMG/Manchester Business School Survey
(3) Simon Turner, joint Chief Executive
Inflexion, FT February 28
Value £m

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Choosing Valuation Methods

Choosing Valuation Methods

There are basically three valuation methods (market,

contain

many models.

For example, under economic methods, there are three main models - DCF, Economic Profit (EVA, ROIC and CFROI) and option pricing models.

Within DCF models there are further sub-models depending on whether you are discounting dividends, FCFE or FCFF.

Even within each sub-model, further choices can be made as to whether 2-stage, 3-stage or multi-stage explicit growth periods are used.

asset-based

and

economic

methods)

which

Dividend Discount
Dividend
Discount
asset-based and economic methods) which Dividend Discount DCF Models Economic Economic Methods Profit Option
DCF Models Economic Economic Methods Profit
DCF Models
Economic
Economic
Methods
Profit
Discount DCF Models Economic Economic Methods Profit Option Pricing FCFE APV Model FCFF Market Market Methods
Discount DCF Models Economic Economic Methods Profit Option Pricing FCFE APV Model FCFF Market Market Methods
Discount DCF Models Economic Economic Methods Profit Option Pricing FCFE APV Model FCFF Market Market Methods
Discount DCF Models Economic Economic Methods Profit Option Pricing FCFE APV Model FCFF Market Market Methods
Option Pricing
Option Pricing

FCFEModels Economic Economic Methods Profit Option Pricing APV Model FCFF Market Market Methods Methods Asset-Based

APV Model

FCFF

Market Market Methods Methods Asset-Based Asset-Based Methods Methods
Market Market Methods Methods
Asset-Based Asset-Based Methods Methods

6

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Prior Theories of valuation

Prior Theories of valuation

• Miller and Modigliani – the “primitive firm” (1963)

– Expected free cash flows from operations

– Discounted at a constant weighted average cost of capital

– Assumes that operating cash flows are unaffected by capital structure

– Optimal capital structure a tradeoff between the benefit of a debt tax shield and the present value of business disruption costs

• Leland – Four terms in the valuation equation (1998)

– Value of the unlevered firm

– PV of the tax shield on debt

– Minus the PV of tax shield lost if debt becomes extreme

– Minus the PV of business disruption costs (as a function of debt)

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Prior Theories of valuation

Prior Theories of valuation

• Schwartz and Moon (1999)

– The value of the primitive firm is enhanced by real options

– They model the value of an abandonment option

– Other real options are also important:

• Growth options (Myers 1977)

• Options to exit and re-enter

• Options to abandon (liquidate)

• Options to enter and exit Chapter 11

8

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But are we happy with those theories?

But are we happy with those theories?

• None of the prior theories does a very good job of explaining the significant and persistent differences in capital structure across industries

Market Debt-to-Equity (2002)

A-rated Companies

Confidential

ZKN-MFB-Stoll_Charts-5-18-05-TC

Pharmaceutical

Retail

Media (Print)

Food and Beverages

Chemical

Energy

Commercial Banking

Median = 0.07 Median = 0.13 Median = 0.13 Median = 0.20 Median = 0.34
Median = 0.07
Median = 0.13
Median = 0.13
Median = 0.20
Median = 0.34

Median = 0.87

Median = 1.21

0.0

0.5

1.0

1.5

2.0

2.5

Market Debt-to-Equity Ratio

13

Copyright © 2005 Monitor Company Group, L.P. — Confidential — CAM

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The Reality – a new theory of the firm

The Reality – a new theory of the firm

• A firm is like a three-layer cake:

– The cost of debt is suboptimal exercise of the firm’s real options and the benefit is its tax shield

– Greater operating flexibility allows for greater debt capacity

operating flexibility allows for greater debt capacity Financial Options Real Options The Primitive Firm
Financial Options Real Options The Primitive Firm
Financial Options
Real Options
The Primitive Firm

Financial Options — Debt and

Equity are options on the firm’s portfolio of assets (with flexibility) Real Options — Payouts
Equity are options on the firm’s portfolio of assets (with flexibility) Real Options — Payouts
Equity are options on the firm’s portfolio of assets (with flexibility) Real Options — Payouts

Equity are options on the firm’s portfolio of assets (with flexibility)

Real Options — Payouts on the portfolio of assets are modified by real options (e.g., capacity caps, expansion, and bankruptcy)

The primitive firm is modeled without flexibility (DCF)

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New trends in Valuation Methodologies

New trends in Valuation Methodologies

Comparable Multiples Discounted Cash Flow (the primitive firm) New trends such as APV, EVA and Monte Carlo Option Pricing: real options Option Pricing: financial options The future of valuation: the firm as a 3-layer cake

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Comparable Multiples:

Comparable Multiples:

Valuation based on actual transactions

• First, we should acknowledge that

– There are rarely any close comparables

– Often neither the assets nor the liabilities have liquid markets for trading

• All comparables are going concerns

• Recommended approach is a multiple regression V (houses) = a + b (number of square feet)

+ c (number of rooms)

+ d (age of house)

+ e (acreage)

+ f (number of fireplaces)

+ g (taxes)

+ h (swimming

pool)

Entity multiple = a + b (earnings before interest and taxes)

+ c (growth in earnings)

+ d (capital turnover)

+ e (return on invested capital)

12

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Traditional DCFlow Valuation – the primitive firm

Traditional DCFlow Valuation – the primitive firm

Most valuations of non-financial companies start with estimated free-cash flows to the entity, discount them at the weighted average cost of capital, then subtract out the value of debt

PV of (Expected Free Cash Flows + Continuing Value) = Entity Value

(Expected Free Cash Flows + Continuing Value) = Entity Value +CV=Entity Value Discounted at the weighted

+CV=Entity Value

Discounted at the weighted average cost of capital
Discounted at the weighted
average cost of capital

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DCF - Predicted FCF follow an irregular pattern

DCF - Predicted FCF follow an irregular pattern

70

60

50

40

30

20

10

0

-10

Free Cash Flows of company X could be

($ millions, 2004-2014)

1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
6
7
8
9
10

Revenue growth:

-- one year 31.6% -- 3-5 years 17.5% -- long-term 10.2%

14

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DCF Valuation

DCF Valuation

The continuing value (CV) assumptions are also crucial

– Will the company’s ROIC fall to equal its WACC or remain at current levels?

– What is the cost of capital given the two alternatives?

– How will its cost of capital change, and what will its value drivers be? E.g., revenue growth, operating margin, capital turns?

– Which Continuing Value formula should one use?

– Are the ROIC and growth assumptions consistent with the assumed amount of earnings retention?

Entry multiple

=

Entity Market val ue/EBITDA

CV =

WACC g

=

multiple x NOPLAT

=

10.1x(243)

Exit multiple

= 3.1 x

=

26.6

NOPLAT

11 (1

/

g r

)

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DCF Valuation (Cont.)

DCF Valuation (Cont.)

A model in evolution

– From fixed discount rate to iteration process

– From fixed WACC to changing wacc per year

– From mono input to Monte Carlo Analysis

31/12/2005 31/12/2006 31/12/2007 31/12/2008 31/12/2009 31/12/2010 Equity 1.184.838 2.963.995 3.092.459 3.277.123
31/12/2005
31/12/2006
31/12/2007
31/12/2008
31/12/2009
31/12/2010
Equity
1.184.838
2.963.995
3.092.459
3.277.123
3.497.139
3.752.617
Debt
1.066.826
803.598
2.643.064
2.727.972
2.637.111
2.497.997
Total
2.251.664
3.767.593
5.735.523
6.005.095
6.134.250
6.250.614
Ratio equity
52,6%
78,7%
53,9%
XYZ NV
Ratio debt
47,4%
21,3%
46,1%
Cash flows in EUR per :
31/12/2006
31/12/2007
31/12/2008
31/12/2009
31/12/2010
31/12/2011
31/12/2012
31/12/2013
31/12/2014
31/12/2015
RV
Levered beta
0,71
0,52
0,69
0,69
0,66
0,64
EBIT
457.502
365.590
510.021
703.419
723.840
921.384
827.735
831.074
834.476
837.939
837.939
Depreciation
87.879
247.410
249.279
243.119
258.344
225.011
228.692
245.853
263.351
281.192
281.192
WACC
7,71%
9,14%
7,78%
7,82%
7,95%
8,12%
Taxes on
EBIT (-)
(142.614)
(114.860)
(161.168)
(225.918)
(230.519)
(295.161)
(259.580)
(254.865)
(250.320)
(245.335)
(245.335)
Net operating cash flow
402.768
498.140
598.133
720.620
751.665
851.234
796.847
822.062
847.506
873.796
873.796
Investment Formation Expenses
0
0
0
0
0
0
0
0
0
0
Forecast: Expected Annual Return
Frequency Chart
Investments Intangible Assets
0
0
0
0
0
0
0
0
0
0
1,000 Trials
Investments Tangible Assets
4 Outliers
0
1.680.000
119.740
138.465
152.250
164.426
168.311
171.612
174.978
178.410
281.192
Investments Leasing
0
0
0
0
0
0
0
0
0
0
.035
35
Divestment leasing
0
0
0
0
0
0
0
0
0
0
Investments Net Working Capital Long Term
(695)
(709)
(723)
(738)
(752)
(767)
(783)
(798)
(814)
(831)
Investments Net Working Capital Short Term
(185.007)
440.979
287.081
213.634
186.047
31.372
62.900
49.063
49.839
51.939
0
.026
26.25
Free Cash Flow
588.470
(1.622.130)
192.035
369.259
414.120
656.203
566.418
602.186
623.503
644.277
592.605
WACC
9,14%
7,78%
7,82%
7,95%
8,12%
8,45%
8,96%
9,53%
9,72%
9,69%
9,69%
.018
17.5
Present Value of annual future FCF
539.176
(1.396.308)
153.179
271.829
280.230
403.134
310.570
290.537
270.385
255.354
2.423.625
.009
8.75
Present Value of future FCFs
Present Value of Residual Value
1.378.085
2.423.625
Excess marketable securities as per
31-dec-05
0
.000
0
Financial
Assets
(+) / Hidden liabilities (-)
0
-75%
-31%
13%
56%
100%
Value of Company as per
Debt as at (-)
31-dec-05
3.801.710
EQUITY VALUE AS OF
30/06/2006
2.763.708 EUR
31-dec-05
(1.066.826)
Value of Equity as at
31-dec-05
2.734.884
in Euro
2.763.708 000 €
Equity value as of
31-dec-05
2.734.880
16
Equity value as of
30-jun-06
2.763.708
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But DCF tends to undervaluate

But DCF tends to undervaluate

-.75<x<-.67

-.8<x<-.75

-.67<x<-.5

-.5<x<0

0<x<.5

1<x<2 2<x<3 3<x<4 4<x<5 x>5

x<-.8

.5<x<1

• The histogram below shows the DCF value of a company minus its market value as a percentage of its market value for 27,123 valuations between January 31, 2000 and July 31, 2004.

 

9000

8000

7000

6000

Number of

5000

Companies

4000

3000

2000

1000

0

Lognormal

distribution

68.1% 56.3%>0 3.2%
68.1%
56.3%>0
3.2%

(DCF-Market)/Market

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Bias in the DCF model?

Bias in the DCF model?

• We hypothesize that DCF works well for large, diversified companies that have low volatility and low growth, but undervalues companies that have high volatility and high growth. Cells Contain median difference between DCF and market value at the end of a month scaled by market value.

Analyst projection of 3-5 year revenue growth

Volatility one

Year forward as a % of SPX volatility

 

Lowest

     

Highest

g<5.3%

g<7.9%

g<10.9

g<16.3%

g<113.4%

Lowest

5.4%

1.1%

8.7%

7.7%

40.4%

v<1.50x

1,463

1,518

1,344

861

239

 

12.9%

10.6%

13.6%

18.4%

3.0%

v<1.82x

1,218

1,384

1,281

1,044

497

 

27.6%

19.9%

20.2%

15.8%

9.4%

v<2.22x

1,091

1.197

1,130

1,150

857

 

50.7%

34.7%

16.7%

2.7%

-3.1%

v<2.91x

994

798

1,031

1,326

1,275

Highest

51.4%

21.8%

2.9%

-7.3%

-21.7%

v<660.5x

659

527

639

1,043

2,555

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Criticism on DCF

Criticism on DCF

False mutually exclusive scenarios

Volatility ignored A key driver of value given option-pricing methodology Difficult to incorporate in a DCF approach

Does not capture value of flexibility (real options) Abandonment (divestiture, close-down) Expansion/growth (greenfield, M&A)

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Evolution from DCF to APV

Evolution from DCF to APV

AdjustedAdjusted PresentPresent ValueValue

BaseBase--casecase valuevalue

Value of the project as if financed only with Equity

+/-

Value of the project as if financed only with Equity +/- Value Value of of all

ValueValue ofof allall financingfinancing sideside effectseffects

InterestInterest taxtax shieldsshields

FinancialFinancial distressdistress costscosts

SubsidiesSubsidies andand guaranteesguarantees

HedgesHedges

IssueIssue costscosts

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How Does the APV Model Work?

How Does the APV Model Work?

1. Value the firm as if it were financed entirely with equity

2. Evaluate the financing side effects of the interest tax shield

3. Assess the costs of financial distress

4. Estimate the other financing side effects

5. Aggregate the components to arrive at an enterprise APV value

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Specific Applications for the APV Model

Specific Applications for the APV Model

1. Changing debt structures (eg. LBOs and MBOs)

2. Multi-business valuations (especially HQ functions)

3. Tax loss carry forward situations

4. Project finance

5. Optimizing debt levels

6. Presenting synergies

7. As a quick sanity check

APVAPV tendstends toto infinityinfinity

APVAPV tendstends toto infinityinfinity

WACCWACC WACCWACC
WACCWACC
WACCWACC

GearingGearing

GearingGearing

TheThe GapGap betweenbetween APVAPV

TheThe GapGap betweenbetween APVAPV

andand WACCWACC isis thethe costcost

andand WACCWACC isis thethe costcost

EnterpriseEnterprise

EnterpriseEnterprise

ofof bankruptcybankruptcy

ofof bankruptcybankruptcy

valuevalue

valuevalue

levelslevels

levelslevels

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New trends in valuation …

New trends in valuation …

What is EVA™

1. Registered trademark of Stern, Stewart & Co

2. Performance measure

3. Re-arrangement of DCF

4. Positive EVA implies shareholder value creation

5. McKinsey’s EVA is called ROIC

Economic Profit Models Residual Income Models CFROI ROIC EVA
Economic Profit
Models
Residual
Income Models
CFROI
ROIC
EVA

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Economic Value Added defined

Economic Value Added defined

• EVA is the profit (or loss) remaining after deducting the cost of capital from the operating profit after taxes.

• EVA measures the shareholder value created (or destroyed) over a certain period. EVA shows that a company creates value only if operating earnings are sufficient to earn back its cost of capital

EVA = NOPAT – ((Cost of Capital) x (Capital)) EVA = Net assets x (RONA
EVA = NOPAT – ((Cost of Capital) x (Capital))
EVA = Net assets x (RONA – WACC)
 

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Real Options (the second layer) -- Value trees

Real Options (the second layer) -- Value trees

Positive cash flows are dividends while negative cash flows are investments. All cash flows are proportional to the value in each state of nature so that expected cash flows are preserved

Value at year t

1320

FCF -9 4 22
FCF
-9
4
22
cash flows are preserved Value at year t 1320 FCF -9 4 22 54 Company X

54

Company X

Volatility = 97%

U= 2.65 = e σT

D = .38 = 1/u

P=.32

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The firm’s real options…

The firm’s real options…

1. Real options is the term used to denote the explicit valuation of the opportunities associated with changing decisions in response to the resolution of relevant uncertainty.

2. A real option is the right, but not the obligation, to take an action (eg deferring, expanding, contracting or abandoning) at a predetermined cost (exercise price), for a predetermined period

(Stewart Myers, MIT)

This is not an option This is an option Good news Cash flow Cash flow
This is not an option
This is an option
Good news
Cash flow
Cash flow
Invest
Don’t
Cash flow
Cash flow
Bad news
Good news
Invest
Invest
Don’t
Good news
Cash flow
Cash flow
Bad news
Invest
Invest
Don’t
Bad news
Cash flow
Invest
Cash flow

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What is a Real Option?

What is a Real Option?

A real option is the right, but not the obligation, to take an action in the future upon the receipt of information. A call is the right to buy (or invest) at a fixed price, and a put is the right to sell.

Examples:

Defer

Expand

Extend

Shrink

Abandon

right to sell. Examples: Defer Expand Extend Shrink Abandon Simple Options Five factors affect the value

Simple Options

Five factors affect the value of an option

Value of an underlying asset (+)Simple Options Five factors affect the value of an option Exercise price (-) Volatility (+) Time

Exercise price (-)the value of an option Value of an underlying asset (+) Volatility (+) Time to expiration

Volatility (+)option Value of an underlying asset (+) Exercise price (-) Time to expiration (+) Risk-free rate

Time to expiration (+)of an underlying asset (+) Exercise price (-) Volatility (+) Risk-free rate (+) P r o

Risk-free rate (+)(+) Exercise price (-) Volatility (+) Time to expiration (+) P r o b a b

Probability

of V

Higher volatility increases the probability of finishing in-the- money where V > D D V
Higher volatility
increases the
probability of
finishing in-the-
money where V > D
D
V

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A Few War Stories That Introduce More Real Options

A Few War Stories That Introduce More Real Options

Compound Options are options on options

– Phased construction

– Research and development

– New product development

– Exploration and production

– Equity in a levered firm

– Call option on equity

Sequential

Simultaneous

Examples $650 million chemical plant $7,000 million high- tech clean room

Switching Options

– Shutting down and reopening

• Mines

• Automobile assembly plants

– Exit and reentry

– Turning off then on

• Peak load power plants

– Switching between modes of operation

• Dual fuel power plants

between modes of operation • Dual fuel power plants Depends on Switching cost Volatility of underlying

Depends on Switching cost Volatility of underlying Non-recombining binomial tree

Examples Valuation of peak-load power Exit from PC assembly Exit from aerospace division Mine operation

•Rainbow options (multiple sources of uncertainty)

– Price and quantity uncertainty

– Quadranomial

Example $1,000 million oil field development

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Switching Option – An Example of an Exit and Reentry Decision

Switching Option – An Example of an Exit and Reentry Decision

Despite the strong growth, consumer PC assembly players have found their market participation to be mostly dissatisfying as they are not earning their cost of capital

Consumer PC Assembly (Mid-1990s)

Gateway 29.7% Acer -2.0% Compaq -4.1% Apple -7.0% Packard Bell -11.0% -20% 0% 20% 40%
Gateway
29.7%
Acer
-2.0%
Compaq
-4.1%
Apple
-7.0%
Packard Bell
-11.0%
-20%
0%
20%
40%

Spread: ROIC — WACC

Source: Analyst Reports; Annual Statements

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Real Options — A Four Step Process

Real Options — A Four Step Process

Steps

Compute Present Value of PrimativeFirm Using DCF Model the Uncertainty Using Event Trees Identify and
Compute Present Value
of PrimativeFirm
Using DCF
Model the
Uncertainty
Using Event Trees
Identify and Incorporate
Managerial
Flexibilities Creating a
Value Tree
Calculate Real
Option Value (ROA)

Objectives

Compute base case present value without flexibility at t = 0

Identify major uncertainties in each stage Understand how those uncertainties affect the PV

Analyze the event tree to identify and incorporate managerial flexibility to respond to new information

Value the total project using a simple algebraic methodology

Comments

Still no flexibility; this value should equal the value from Step 1 Explicitly estimate uncertainty Monte Carlo analysis Management estimates

Incorporating flexibility transforms event trees, which transforms them into decision trees The flexibility continuously alters the risk characteristics of the project, and hence the cost of capital

ROA includes the base

case present value without flexibility plus the option (flexibility) value

Under high

uncertainty and managerial flexibility option value will be

 

substantial

Output

Project’s PV without flexibility

Detailed event tree capturing the possible present values of the project

A detailed scenario tree combining possible events and management responses

ROA of the project and optimal contingent plan for the available real options

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Financial Options -- the third layer

Financial Options -- the third layer

• The cumulative cash flow along each possible path determines the cash available for payment of zero-coupon debt.

• The equity is an option on the second layer of the cake

• And the real options on the second layer are options on the primitive firm.

• Assumptions:

1. Cumulative cash flows calculated along each path

2. Zero coupon debt

• Due if liquidation occurs

• Otherwise due in year 10

• At face value

3. Liquidation value

4. Growth (Expansion) option

• Expansion factor = X%

• Execution cost = $xxx million

5. Equity is an option on the firm with real options – residual CF is valued

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With and Without Debt – Interactive boundary conditions

With and Without Debt – Interactive boundary conditions
2500 2000 1500 1000 500 0 0 1 2 3 4 5 6 7 8
2500
2000
1500
1000
500
0
0
1
2
3
4
5
6
7
8
9
10
Entity Value w/o Debt
Entity Value w/ Debt
900
800
700
600
500
400
300
200
100
0
0
1
2
3
4
5
6
7
8
9
10
-100
Cumulative Cash w/o Debt
Cumulative Cash w/ Debt

This panel shows that the entity value (layer 2) is affected as one adds debt in layer 3 – the abandonment decision without debt is altered when the firm takes on (zero coupon) debt because abandonment (liquidation) amounts to early payment, therefore abandonment occurs later with debt.

Here abandonment takes place in year 7 when there is no debt. But if there is debt, abandonment is deferred because the entity value is greater than the residual after liquidation and debt payment.

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Optimal Capital Structure

Optimal Capital Structure

$ Value

500

400

300

200

100

0

494 Parameters 411 Tax rate = 20% Abandonment price = $1,100 329 322 247 Tax
494
Parameters
411
Tax rate = 20%
Abandonment price =
$1,100
329
322
247
Tax Benefit of Debt
217
Net Benefit of Debt
169
169
145
194
172
160
102
84
52
102
67
Cost of Debt –
suboptimal exercise of abandonment
32
Debt
0
500
1,000
1,500
2,000
2,500
3,000

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Next Steps

Next Steps

• Extension from value branch to value tree

– Need to study ways of estimating volatility

– Model growth as a series of one-period European call options

– Capture inter-dependency between financial and real options

– Optimal capital structure is tradeoff between

• Cost of debt as suboptimal exercise of abandonment and growth options

• Benefit of debt as tax shelter

– Explains why

• DCF undervalues high growth and high volatility situations

• There are cross-sectional regularities in debt-to-equity ratios

• CFOs say that flexibility is the single most important variable when considering capital structure

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Syncap Management gmbh, member of Clairfield Partners Hans Buysse, Partner +32 475 44 46 32
Syncap Management gmbh, member of Clairfield Partners Hans Buysse, Partner +32 475 44 46 32
Syncap Management gmbh, member of Clairfield Partners Hans Buysse, Partner +32 475 44 46 32

Syncap Management gmbh, member of Clairfield Partners

Hans Buysse, Partner

+32 475 44 46 32 www.clairfield.com

2010

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