REAL OPTIONS: FACT AND FANTASY - New York...
Transcript of REAL OPTIONS: FACT AND FANTASY - New York...
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REALOPTIONS:FACTANDFANTASY
AswathDamodaran
Aswath Damodaran 2
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UnderlyingTheme:SearchingforanElusivePremium
Aswath Damodaran
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¨ Traditionaldiscountedcashflow modelsunderestimatethevalueofinvestments,wherethereareoptionsembeddedintheinvestmentsto¤ Delayordefermakingtheinvestment(delay)¤ Adjustoralterproductionschedulesaspricechanges(flexibility)¤ Expandintonewmarketsorproductsatlaterstagesintheprocess,baseduponobservingfavorableoutcomesattheearlystages(expansion)
¤ Stopproductionorabandoninvestmentsiftheoutcomesareunfavorableatearlystages(abandonment)
¨ Putanotherway,realoptionadvocatesbelievethatyoushouldbepayingapremiumondiscountedcashflowvalueestimates.
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Abadinvestment…
Aswath Damodaran
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+100
-120
1/2
1/2
Today
Success
Failure
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Becomesagoodone…
Aswath Damodaran
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3/4
1/4
+20
-20
+80
-100
2/3
1/3
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ThreeBasicQuestions
Aswath Damodaran
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¨ Whenistherearealoptionembeddedinadecisionoranasset?
¨ Whendoesthatrealoptionhavesignificanteconomicvalue?
¨ Canthatvaluebeestimatedusinganoptionpricingmodel?
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Whenisthereanoptionembeddedinanaction?
Aswath Damodaran
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¨ Anoptionprovidestheholderwiththerighttobuyorsellaspecifiedquantityofanunderlyingassetatafixedprice(calledastrikepriceoranexerciseprice)atorbeforetheexpirationdateoftheoption.
¨ Therehastobeaclearlydefinedunderlyingassetwhosevaluechangesovertimeinunpredictableways.
¨ Thepayoffsonthisasset(realoption)havetobecontingentonanspecifiedeventoccurringwithinafiniteperiod.
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PayoffDiagramonaCall
Aswath Damodaran
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Price of underlying asset
StrikePrice
Net Payoff on Call
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PayoffDiagramonPutOption
Aswath Damodaran
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Price of underlying asset
StrikePrice
Net PayoffOn Put
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Whendoestheoptionhavesignificanteconomicvalue?
Aswath Damodaran
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¨ Foranoptiontohavesignificanteconomicvalue,therehastobearestrictiononcompetitionintheeventofthecontingency.Inaperfectlycompetitiveproductmarket,nocontingency,nomatterhowpositive,willgeneratepositivenetpresentvalue.
¨ Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivity- youandonlyyoucantakeadvantageofthecontingency.Theybecomelessvaluableasthebarrierstocompetitionbecomelesssteep.
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Determinantsofoptionvalue
Aswath Damodaran
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¨ VariablesRelatingtoUnderlyingAsset¤ ValueofUnderlyingAsset;asthisvalueincreases,therighttobuyatafixedprice
(calls)willbecomemorevaluableandtherighttosellatafixedprice(puts)willbecomelessvaluable.
¤ Varianceinthatvalue;asthevarianceincreases,bothcallsandputswillbecomemorevaluablebecausealloptionshavelimiteddownsideanddependuponpricevolatilityforupside.
¤ Expecteddividendsontheasset,whicharelikelytoreducethepriceappreciationcomponentoftheasset,reducingthevalueofcallsandincreasingthevalueofputs.
¨ VariablesRelatingtoOption¤ StrikePriceofOptions;therighttobuy(sell)atafixedpricebecomesmore(less)
valuableatalowerprice.¤ LifeoftheOption;bothcallsandputsbenefitfromalongerlife.
¨ LevelofInterestRates;asratesincrease,therighttobuy(sell)atafixedpriceinthefuturebecomesmore(less)valuable.
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Whencanyouuseoptionpricingmodelstovaluerealoptions?
Aswath Damodaran
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¨ Thenotionofareplicatingportfoliothatdrivesoptionpricingmodelsmakesthemmostsuitedforvaluingrealoptionswhere¤ Theunderlyingassetistraded- thisyieldnotonlyobservableprices
andvolatilityasinputstooptionpricingmodelsbutallowsforthepossibilityofcreatingreplicatingportfolios
¤ Anactivemarketplaceexistsfortheoptionitself.¤ Thecostofexercisingtheoptionisknownwithsomedegreeof
certainty.¨ Whenoptionpricingmodelsareusedtovaluerealassets,we
havetoacceptthefactthat¤ Thevalueestimatesthatemergewillbefarmoreimprecise.¤ Thevaluecandeviatemuchmoredramaticallyfrommarketprice
becauseofthedifficultyofarbitrage.
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Creatingareplicatingportfolio
Aswath Damodaran
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¨ Theobjectiveincreatingareplicatingportfolioistouseacombinationofriskfreeborrowing/lendingandtheunderlyingassettocreatethesamecashflowsastheoptionbeingvalued.¤ Call=Borrowing+BuyingDoftheUnderlyingStock¤ Put=SellingShortDonUnderlyingAsset+Lending¤ Thenumberofsharesboughtorsoldiscalledtheoptiondelta.
¨ Theprinciplesofarbitragethenapply,andthevalueoftheoptionhastobeequaltothevalueofthereplicatingportfolio.
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TheBinomialOptionPricingModel
Aswath Damodaran
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50
70
35
100
50
25
K = $ 40t = 2r = 11%
Option Details
StockPrice Call
60
10
0
50 D - 1.11 B = 1025 D - 1.11 B = 0D = 0.4, B = 9.01Call = 0.4 * 35 - 9.01 = 4.99
Call = 4.99
100 D - 1.11 B = 6050 D - 1.11 B = 10D = 1, B = 36.04Call = 1 * 70 - 36.04 = 33.96
Call = 33.9670 D - 1.11 B = 33.9635 D - 1.11 B = 4.99D = 0.8278, B = 21.61Call = 0.8278 * 50 - 21.61 = 19.42
Call = 19.42
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TheLimitingDistributions….
Aswath Damodaran
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¨ Asthetimeintervalisshortened,thelimitingdistribution,ast->0,cantakeoneoftwoforms.¤ Ifast->0,pricechangesbecomesmaller,thelimitingdistributionisthenormaldistributionandthepriceprocessisacontinuousone.
¤ Ifast->0,pricechangesremainlarge,thelimitingdistributionisthepoisson distribution,i.e.,adistributionthatallowsforpricejumps.
¨ TheBlack-Scholesmodelapplieswhenthelimitingdistributionisthenormaldistribution,andexplicitlyassumesthatthepriceprocessiscontinuousandthattherearenojumpsinassetprices.
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BlackandScholes…
Aswath Damodaran
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¨ TheversionofthemodelpresentedbyBlackandScholeswasdesignedtovalueEuropeanoptions,whichweredividend-protected.
¨ ThevalueofacalloptionintheBlack-Scholesmodelcanbewrittenasafunctionofthefollowingvariables:¤ S=Currentvalueoftheunderlyingasset¤ K=Strikepriceoftheoption¤ t=Lifetoexpirationoftheoption¤ r=Risklessinterestratecorrespondingtothelifeoftheoption¤ s2 =Varianceintheln(value)oftheunderlyingasset
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TheBlackScholesModel
Aswath Damodaran
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Valueofcall=SN(d1)- Ke-rt N(d2)where
d2=d1-s √t
¨ ThereplicatingportfolioisembeddedintheBlack-Scholesmodel.Toreplicatethiscall,youwouldneedto¤ BuyN(d1)sharesofstock;N(d1)iscalledtheoptiondelta¤ BorrowKe-rt N(d2)
d1 = ln S
K! "
# $ + (r + σ
2
2) t
σ t
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TheNormalDistribution
Aswath Damodaran
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d N(d) d N(d) d N(d)-3.00 0.0013 -1.00 0.1587 1.05 0.8531 -2.95 0.0016 -0.95 0.1711 1.10 0.8643 -2.90 0.0019 -0.90 0.1841 1.15 0.8749 -2.85 0.0022 -0.85 0.1977 1.20 0.8849 -2.80 0.0026 -0.80 0.2119 1.25 0.8944 -2.75 0.0030 -0.75 0.2266 1.30 0.9032 -2.70 0.0035 -0.70 0.2420 1.35 0.9115 -2.65 0.0040 -0.65 0.2578 1.40 0.9192 -2.60 0.0047 -0.60 0.2743 1.45 0.9265 -2.55 0.0054 -0.55 0.2912 1.50 0.9332 -2.50 0.0062 -0.50 0.3085 1.55 0.9394 -2.45 0.0071 -0.45 0.3264 1.60 0.9452 -2.40 0.0082 -0.40 0.3446 1.65 0.9505 -2.35 0.0094 -0.35 0.3632 1.70 0.9554 -2.30 0.0107 -0.30 0.3821 1.75 0.9599 -2.25 0.0122 -0.25 0.4013 1.80 0.9641 -2.20 0.0139 -0.20 0.4207 1.85 0.9678 -2.15 0.0158 -0.15 0.4404 1.90 0.9713 -2.10 0.0179 -0.10 0.4602 1.95 0.9744 -2.05 0.0202 -0.05 0.4801 2.00 0.9772 -2.00 0.0228 0.00 0.5000 2.05 0.9798 -1.95 0.0256 0.05 0.5199 2.10 0.9821 -1.90 0.0287 0.10 0.5398 2.15 0.9842 -1.85 0.0322 0.15 0.5596 2.20 0.9861 -1.80 0.0359 0.20 0.5793 2.25 0.9878 -1.75 0.0401 0.25 0.5987 2.30 0.9893 -1.70 0.0446 0.30 0.6179 2.35 0.9906 -1.65 0.0495 0.35 0.6368 2.40 0.9918 -1.60 0.0548 0.40 0.6554 2.45 0.9929 -1.55 0.0606 0.45 0.6736 2.50 0.9938 -1.50 0.0668 0.50 0.6915 2.55 0.9946 -1.45 0.0735 0.55 0.7088 2.60 0.9953 -1.40 0.0808 0.60 0.7257 2.65 0.9960 -1.35 0.0885 0.65 0.7422 2.70 0.9965 -1.30 0.0968 0.70 0.7580 2.75 0.9970 -1.25 0.1056 0.75 0.7734 2.80 0.9974 -1.20 0.1151 0.80 0.7881 2.85 0.9978 -1.15 0.1251 0.85 0.8023 2.90 0.9981 -1.10 0.1357 0.90 0.8159 2.95 0.9984 -1.05 0.1469 0.95 0.8289 3.00 0.9987 -1.00 0.1587 1.00 0.8413
d1
N(d1)
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AdjustingforDividends
Aswath Damodaran
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¨ Ifthedividendyield(y=dividends/Currentvalueoftheasset)oftheunderlyingassetisexpectedtoremainunchangedduringthelifeoftheoption,theBlack-Scholesmodelcanbemodifiedtotakedividendsintoaccount.
¨ C=Se-yt N(d1)- Ke-rt N(d2)where,
d2=d1-s √t
¨ Thevalueofaputcanalsobederived:¨ P=Ke-rt (1-N(d2))- Se-yt (1-N(d1))
d1 = ln S
K! "
# $ + (r - y + σ
2
2) t
σ t
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ChoiceofOptionPricingModels
Aswath Damodaran
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¨ MostpractitionerswhouseoptionpricingmodelstovaluerealoptionsargueforthebinomialmodelovertheBlack-Scholesandjustifythischoicebynotingthat¤ Earlyexerciseistheruleratherthantheexceptionwithrealoptions
¤ Underlyingassetvaluesaregenerallydiscontinous.¨ Ifyoucandevelopabinomialtreewithoutcomesateachnode,itlooksagreatdeallikeadecisiontreefromcapitalbudgeting.Thequestionthenbecomeswhenandwhythetwoapproachesyielddifferentestimatesofvalue.
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TheDecisionTreeAlternative
Aswath Damodaran
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¨ Traditionaldecisiontreeanalysistendstouse¤ Onecostofcapitaltodiscountcashflows ineachbranchtothepresent¤ Probabilitiestocomputeanexpectedvalue¤ Thesevalueswillgenerallybedifferentfromoptionpricingmodel
values
¨ Ifyoumodifieddecisiontreeanalysisto¤ Usedifferentdiscountratesateachnodetoreflectwhereyouarein
thedecisiontree(ThisistheCopelandsolution) (or)¤ Usetheriskfree ratetodiscountcashflows ineachbranch,estimate
theprobabilitiestoestimateanexpectedvalueandadjusttheexpectedvalueforthemarketriskintheinvestment
¨ DecisionTreescouldyieldthesamevaluesasoptionpricingmodels
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AdecisiontreevaluationofapharmaceuticalcompanywithonedrugintheFDApipeline…
Aswath Damodaran
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Test
Abandon
Succeed
70%
Fail
30%-$50
-$140.91
Types 1 & 2
Type 2
Type 1
Fail
10%
10%
30%
Develop
Abandon
Develop
Abandon
Develop
Abandon
Succeed
Succeed
Succeed
Fail
Fail
Fail
75%
25%
80%
20%
80%
20%-$328.74
-$328.74
-$328.74
$585.62
-$328.74
-$97.43-$366.30
-$366.30
$887.05
50%
$50.36
$93.37
$573.71
-$143.69
$402.75
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KeyTestsforRealOptions
Aswath Damodaran
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¨ Isthereanoptionembeddedinthisasset/decision?¤ Canyouidentifytheunderlyingasset?¤ Canyouspecifythecontingencyunderwhichyouwillgetpayoff?
¨ Isthereexclusivity?¤ Ifyes,thereisoptionvalue.¤ Ifno,thereisnone.¤ Ifinbetween,youhavetoscalevalue.
¨ Canyouuseanoptionpricingmodeltovaluetherealoption?¤ Istheunderlyingassettraded?¤ Cantheoptionbeboughtandsold?¤ Isthecostofexercisingtheoptionknownandclear?
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I.OptionsinProjects/Investments/Acquisitions
Aswath Damodaran
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¨ Oneofthelimitationsoftraditionalinvestmentanalysisisthatitisstaticanddoesnotdoagoodjobofcapturingtheoptionsembeddedininvestment.¤ Thefirstoftheseoptionsistheoptiontodelaytakingainvestment,whenafirmhasexclusiverightstoit,untilalaterdate.
¤ Thesecondoftheseoptionsistakingoneinvestmentmayallowustotakeadvantageofotheropportunities(investments)inthefuture
¤ Thelastoptionthatisembeddedinprojectsistheoptiontoabandonainvestment,ifthecashflowsdonotmeasureup.
¨ Theseoptionsalladdvaluetoprojectsandmaymakea“bad” investment(fromtraditionalanalysis)intoagoodone.
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A.TheOptiontoDelay
Aswath Damodaran
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¨ Whenafirmhasexclusiverightstoaprojectorproductforaspecificperiod,itcandelaytakingthisprojectorproductuntilalaterdate.
¨ Atraditionalinvestmentanalysisjustanswersthequestionofwhethertheprojectisa“good” oneiftakentoday.
¨ Thus,thefactthataprojectdoesnotpassmustertoday(becauseitsNPVisnegative,oritsIRRislessthanitshurdlerate)doesnotmeanthattherightstothisprojectarenotvaluable.
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ValuingtheOptiontoDelayaProject
Aswath Damodaran
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Present Value of Expected Cash Flows on Product
PV of Cash Flows from Project
Initial Investment in Project
Project has negativeNPV in this section
Project's NPV turns positive in this section
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Example1:Valuingproductpatentsasoptions
Aswath Damodaran
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¨ Aproductpatentprovidesthefirmwiththerighttodeveloptheproductandmarketit.
¨ Itwilldosoonlyifthepresentvalueoftheexpectedcashflowsfromtheproductsalesexceedthecostofdevelopment.
¨ Ifthisdoesnotoccur,thefirmcanshelvethepatentandnotincuranyfurthercosts.
¨ IfIisthepresentvalueofthecostsofdevelopingtheproduct,andVisthepresentvalueoftheexpectedcashflowsfromdevelopment,thepayoffsfromowningaproductpatentcanbewrittenas:
Payofffromowningaproductpatent =V- I ifV>I=0 ifV≤I
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PayoffonProductOption
Aswath Damodaran
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Present Value ofcashflows on product
Net Payoff tointroduction
Cost of product introduction
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ObtainingInputsforPatentValuation
Input Estimation Process
1. Value of the Underlying Asset • Present Value of Cash Inflows from taking projectnow
• This will be noisy, but that adds value.2. Variance in value of underlying asset • Variance in cash flows of similar assets or firms
• Variance in present value from capital budgetingsimulation.
3. Exercise Price on Option • Option is exercised when investment is made.• Cost of making investment on the project ; assumed
to be constant in present value dollars.4. Expiration of the Option • Life of the patent
5. Dividend Yield • Cost of delay• Each year of delay translates into one less year of
value-creating cashflowsAnnual cost of delay = 1
n
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ValuingaProductPatent:Avonex
Aswath Damodaran
30
¨ Biogen,abio-technologyfirm,hasapatentonAvonex,adrugtotreatmultiplesclerosis,forthenext17years,anditplanstoproduceandsellthedrugbyitself.
¨ Thekeyinputsonthedrugareasfollows:¤ PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion¤ PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion¤ PatentLife=t=17yearsRisklessRate=r=6.7%(17-yearT.Bond rate)¤ VarianceinExpectedPresentValues=s2 =0.224(Industryaveragefirmvariancefor
bio-techfirms)¤ ExpectedCostofDelay=y=1/17=5.89%
¨ Theoutputfromtheoptionpricingmodel¤ d1=1.1362 N(d1)=0.8720¤ d2=-0.8512 N(d2)=0.2076CallValue=3,422exp(-0.0589)(17)(0.8720)- 2,875exp(-0.067)(17) (0.2076)=$907million
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31
TheOptimalTimetoExercise
Aswath Damodaran
31 Patent value versus Net Present value
0
100
200
300
400
500
600
700
800
900
1000
17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1Number of years left on patent
Val
ue
Value of patent as option Net present value of patent
Exercise the option here: Convert patent to commercial product
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32
Valuingafirmwithpatents
Aswath Damodaran
32
¨ Thevalueofafirmwithasubstantialnumberofpatentscanbederivedusingtheoptionpricingmodel.
ValueofFirm=Valueofcommercialproducts(usingDCFvalue+Valueofexistingpatents(usingoptionpricing)+(ValueofNewpatentsthatwillbeobtainedinthe
future– Costofobtainingthesepatents)¨ Thelastinputmeasurestheefficiencyofthefirmin
convertingitsR&Dintocommercialproducts.Ifweassumethatafirmearnsitscostofcapitalfromresearch,thistermwillbecomezero.
¨ Ifweusethisapproach,weshouldbecarefulnottodoublecountandallowforahighgrowthrateincashflows(intheDCFvaluation).
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33
ValueofBiogen’sexistingproducts
Aswath Damodaran
33
¨ Biogenhadtwocommercialproducts(adrugtotreatHepatitisBandIntron)atthetimeofthisvaluationthatithadlicensedtootherpharmaceuticalfirms.
¨ Thelicensefeesontheseproductswereexpectedtogenerate$50millioninafter-taxcashflowseachyearforthenext12years.
¨ Tovaluethesecashflows,whichwereguaranteedcontractually,the pre-taxcostofdebtoftheguarantorswasused:PresentValueofLicenseFees=$50million(1– (1.07)-12)/.07
=$397.13million
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34
ValueofBiogen’sFutureR&D
Aswath Damodaran
34
¨ Biogencontinuedtofundresearchintonewproducts,spendingabout$100milliononR&Dinthemostrecentyear.TheseR&Dexpenseswereexpectedtogrow20%ayearforthenext10years,and5%thereafter.
¨ Itwasassumedthateverydollarinvestedinresearchwouldcreate$1.25invalueinpatents(valuedusingtheoptionpricingmodeldescribedabove)forthenext10years,andbreakevenafterthat(i.e.,generate$1inpatentvalueforevery$1investedinR&D).
¨ Therewasasignificantamountofriskassociatedwiththiscomponentandthecostofcapitalwasestimatedtobe15%.
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35
ValueofFutureR&D
Aswath Damodaran
35
Yr ValueofPatents R&DCost ExcessValue PV(at15%)
1 $150.00 $120.00 $30.00 $26.09
2 $180.00 $144.00 $36.00 $27.22
3 $216.00 $172.80 $43.20 $28.40
4 $259.20 $207.36 $51.84 $29.64
5 $311.04 $248.83 $62.21 $30.93
6 $373.25 $298.60 $74.65 $32.27
7 $447.90 $358.32 $89.58 $33.68
8 $537.48 $429.98 $107.50 $35.14
9 $644.97 $515.98 $128.99 $36.67
10 $773.97 $619.17 $154.79 $38.26
$318.30
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36
ValueofBiogen
Aswath Damodaran
36
¨ ThevalueofBiogenasafirmisthesumofallthreecomponents– thepresentvalueofcashflowsfromexistingproducts,thevalueofAvonex(asanoption)andthevaluecreatedbynewresearch:Value=Existingproducts+ExistingPatents+Value:FutureR&D
=$397.13million+$907million+$318.30million=$1622.43million
¨ SinceBiogenhadnodebtoutstanding,thisvaluewasdividedbythenumberofsharesoutstanding(35.50million)toarriveatavaluepershare:¤Valuepershare=$1,622.43million/35.5=$45.70
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37
TheRealOptionsTest:PatentsandTechnology
Aswath Damodaran
37
¨ TheOptionTest:¤ UnderlyingAsset:Productthatwouldbegeneratedbythepatent¤ Contingency:
n IfPVofCFsfromdevelopment>Costofdevelopment:PV- Costn IfPVofCFsfromdevelopment<Costofdevelopment:0
¨ TheExclusivityTest:¤ Patentsrestrictcompetitorsfromdevelopingsimilarproducts¤ Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreatthesamedisease.
¨ ThePricingTest¤ UnderlyingAsset:Patentsarenottraded.Notonlydoyouthereforehavetoestimatethepresentvaluesand
volatilitiesyourself,youcannotconstructreplicatingpositionsordoarbitrage.¤ Option:Patentsareboughtandsold,thoughnotasfrequentlyasoilreservesormines.¤ CostofExercisingtheOption:Thisisthecostofconvertingthepatentforcommercialproduction.Here,
experiencedoeshelpanddrugfirmscanmakefairlypreciseestimatesofthecost.
¨ Conclusion:Youcanestimatethevalueoftherealoptionbutthequalityofyourestimatewillbeadirectfunctionofthequalityofyourcapitalbudgeting.Itworksbestifyouarevaluingapubliclytradedfirmthatgeneratesmostofitsvaluefromoneorafewpatents- youcanusethemarketvalueofthefirmandthevarianceinthatvaluetheninyouroptionpricingmodel.
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38
Example2:ValuingNaturalResourceOptions
Aswath Damodaran
38
¨ Inanaturalresourceinvestment,theunderlyingassetistheresourceandthevalueoftheassetisbasedupontwovariables- thequantityoftheresourcethatisavailableintheinvestmentandthepriceoftheresource.
¨ Inmostsuchinvestments,thereisacostassociatedwithdevelopingtheresource,andthedifferencebetweenthevalueoftheassetextractedandthecostofthedevelopmentistheprofittotheowneroftheresource.
¨ DefiningthecostofdevelopmentasX,andtheestimatedvalueoftheresourceasV,thepotentialpayoffsonanaturalresourceoptioncanbewrittenasfollows:
Payoffonnaturalresourceinvestment =V- X ifV>X=0 ifV≤X
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39
PayoffDiagramonNaturalResourceFirms
Aswath Damodaran
39
Value of estimated reserve of natural resource
Net Payoff onExtraction
Cost of Developing Reserve
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EstimatingInputsforNaturalResourceOptions
Input Estimation Process
1. Value of Available Reserves of the Resource • Expert estimates (Geologists for oil..); Thepresent value of the after-tax cash flows fromthe resource are then estimated.
2. Cost of Developing Reserve (Str ike Price) • Past costs and the specifics of the investment
3. Time to Expiration • Relinqushment Period: if asset has to berelinquished at a point in time.
• Time to exhaust inventory - based uponinventory and capacity output.
4. Variance in value of underlying asset • based upon variability of the price of theresources and variability of available reserves.
5. Net Production Revenue (Dividend Yield) • Net production revenue every year as percentof market value.
6. Development Lag • Calculate present value of reserve based uponthe lag.
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41
ValuingGulfOil
Aswath Damodaran
41
¨ GulfOilwasthetargetofatakeoverinearly1984at$70pershare(Ithad165.30millionsharesoutstanding,andtotaldebtof$9.9billion).¤ Ithadestimatedreservesof3038millionbarrelsofoilandtheaveragecostofdevelopingthesereserveswasestimatedtobe$10abarrelinpresentvaluedollars(Thedevelopmentlagisapproximatelytwoyears).
¤ Theaveragerelinquishmentlifeofthereservesis12years.¤ Thepriceofoilwas$22.38perbarrel,andtheproductioncost,taxesandroyaltieswereestimatedat$7perbarrel.
¤ Thebondrateatthetimeoftheanalysiswas9.00%.¤ Gulfwasexpectedtohavenetproductionrevenueseachyearofapproximately5%ofthevalueofthedevelopedreserves.Thevarianceinoilpricesis0.03.
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42
ValuingUndevelopedReserves
Aswath Damodaran
42
¨ Inputsforvaluingundevelopedreserves¤ Valueofunderlyingasset=Valueofestimatedreservesdiscountedbackforperiod
ofdevelopmentlag=3038*($22.38- $7)/1.052 =$42,380.44¤ Exerciseprice=Estimateddevelopmentcostofreserves=3038*$10=$30,380
million¤ Timetoexpiration=Averagelengthofrelinquishmentoption=12years¤ Varianceinvalueofasset=Varianceinoilprices=0.03¤ Risklessinterestrate=9%¤ Dividendyield=Netproductionrevenue/Valueofdevelopedreserves=5%
¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.6548 N(d1)=0.9510d2=1.0548 N(d2)=0.8542CallValue=42,380.44exp(-0.05)(12)(0.9510)-30,380(exp(-0.09)(12) (0.8542)
=$13,306million
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43
ValuingGulfOil
Aswath Damodaran
43
¨ Inaddition,GulfOilhadfreecashflows tothefirmfromitsoilandgasproductionof$915millionfromalreadydevelopedreservesandthesecashflows arelikelytocontinuefortenyears(theremaininglifetimeofdevelopedreserves).
¨ Thepresentvalueofthesedevelopedreserves,discountedattheweightedaveragecostofcapitalof12.5%,yields:¤ Valueofalreadydevelopedreserves=915(1- 1.125-10)/.125=$5065.83
¨ AddingthevalueofthedevelopedandundevelopedreservesValueofundevelopedreserves =$13,306millionValueofproductioninplace =$5,066millionTotalvalueoffirm =$18,372millionLessOutstandingDebt =$9,900millionValueofEquity =$8,472millionValuepershare =$8,472/165.3 =$51.25
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44
TheOptiontoExpand/TakeOtherProjects
Aswath Damodaran
44
¨ Takingaprojecttodaymayallowafirmtoconsiderandtakeothervaluableprojectsinthefuture.
¨ Thus,eventhoughaprojectmayhaveanegativeNPV,itmaybeaprojectworthtakingiftheoptionitprovidesthefirm(totakeotherprojectsinthefuture)providesamore-than-compensatingvalue.
¨ Thesearetheoptionsthatfirmsoftencall“strategicoptions” anduseasarationalefortakingon“negativeNPV” oreven“negativereturn” projects.
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45
B.TheOptiontoExpand
Aswath Damodaran
45
Present Value of Expected Cash Flows on Expansion
PV of Cash Flows from Expansion
Additional Investment to Expand
Firm will not expand inthis section
Expansion becomes attractive in this section
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46
Theoptiontoexpand:Valuingayoung,start-upcompany
Aswath Damodaran
46
¨ YouhavecompleteaDCFvaluationofasmallanti-virussoftwarecompany,SecureMail,andestimatedavalueof$115million.
¨ Assumethatthereisthepossibilitythatthecompanycouldusethecustomerbasethatitdevelopsfortheanti-virussoftwareandthetechnologyonwhichthesoftwareisbasedtocreateadatabasesoftwareprogramsometimeinthenext5years.¤ ItwillcostSecureMailabout$500milliontodevelopanewdatabase
program,iftheydecidedtodoittoday.¤ Basedupontheinformationyouhavenowonthepotentialforadatabase
program,thecompanycanexpecttogenerateabout$40millionayearinafter-taxcashflowsfortenyears.Thecostofcapitalforprivatecompaniesthatprovidedatabasesoftwareis12%.
¤ Theannualizedstandarddeviationinfirmvalueatpubliclytradeddatabasecompaniesis50%.
¤ Thefive-yeartreasurybondrateis3%.
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47
ValuingtheExpansionOption
Aswath Damodaran
47
S =Valueofenteringthedatabasesoftwaremarket=PVof$40millionfor10years@12% =$226million
K =Exerciseprice=Costofenteringthedatabasesoftwaremarket=$500million
t =Periodoverwhichyouhavetherighttoenterthemarket=5years
s =Standarddeviationofstockpricesofdatabasefirms=50%r =Risklessrate=3%¨ CallValue=$56MillionDCFvaluationofthefirm =$115millionValueofOptiontoExpandtoDatabasemarket =$56millionValueofthecompanywithoptiontoexpand =$171million
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48
Anoteofcaution:Opportunitiesarenotoptions…
Aswath Damodaran
48
An Exclusive Right toSecond Investment
A Zero competitiveadvantage on Second Investment
100% of option valueNo option value
Increasing competitive advantage/ barriers to entry
Pharmaceuticalpatents
TelecomLicenses
Brand Name
TechnologicalEdge
First-Mover
Second Investment has zero excess returns
Second investmenthas large sustainableexcess return
Option has no value Option has high value
Is the first investment necessary for the second investment?
Pre-RequisitNot necessary
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49
TheRealOptionsTestforExpansionOptions
Aswath Damodaran
49
¨ TheOptionsTest¤ UnderlyingAsset:ExpansionProject¤ Contingency¤ IfPVofCFfromexpansion>ExpansionCost:PV- ExpansionCost¤ IfPVofCFfromexpansion<ExpansionCost:0
¨ TheExclusivityTest¤ Barriersmayrangefromstrong(exclusivelicensesgrantedbythegovernment)toweaker
(brandname,knowledgeofthemarket)toweakest(firstmover).¨ ThePricingTest
¤ UnderlyingAsset:Aswithpatents,thereisnotradingintheunderlyingassetandyouhavetoestimatevalueandvolatility.
¤ Option:Licensesaresometimesboughtandsold,butmorediffuseexpansionoptionsarenot.¤ CostofExercisingtheOption:Notknownwithanyprecisionandmayitselfevolveovertimeas
themarketevolves.¨ Usingoptionpricingmodelstovalueexpansionoptionswillnotonlyyield
extremelynoisyestimates,butmayattachinappropriatepremiumstodiscountedcashflow estimates.
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50
C.TheOptiontoAbandon
Aswath Damodaran
50
¨ Afirmmaysometimeshavetheoptiontoabandonaproject,ifthecashflowsdonotmeasureuptoexpectations.
¨ Ifabandoningtheprojectallowsthefirmtosaveitselffromfurtherlosses,thisoptioncanmakeaprojectmorevaluable.
Present Value of Expected Cash Flows on Project
PV of Cash Flows from Project
Cost of Abandonment
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51
ValuingtheOptiontoAbandon
Aswath Damodaran
51
¨ AirbusisconsideringajointventurewithLearAircrafttoproduceasmallcommercialairplane(capableofcarrying40-50passengersonshorthaulflights)¤ Airbuswillhavetoinvest$500millionfora50%shareoftheventure¤ Itsshareofthepresentvalueofexpectedcashflowsis480million.
¨ LearAircraft,whichiseagertoenterintothedeal,offerstobuyAirbus’s50%shareoftheinvestmentanytimeoverthenextfiveyearsfor$400million,ifAirbusdecidestogetoutoftheventure.
¨ Asimulationofthecashflowsonthistimeshareinvestmentyieldsavarianceinthepresentvalueofthecashflowsfrombeinginthepartnershipis0.16.
¨ Theprojecthasalifeof30years.
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52
ProjectwithOptiontoAbandon
Aswath Damodaran
52
¨ ValueoftheUnderlyingAsset(S)=PVofCashFlowsfromProject =$480million
¨ StrikePrice(K)=SalvageValuefromAbandonment=$400million
¨ VarianceinUnderlyingAsset’sValue=0.16¨ Timetoexpiration=LifeoftheProject=5years¨ DividendYield=1/LifeoftheProject=1/30=0.033(Weareassumingthattheproject’spresentvaluewilldropbyroughly1/neachyearintotheproject)
¨ Assumethatthefive-yearrisklessrateis6%.Thevalueoftheputoptioncanbeestimated.
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53
ShouldAirbusenterintothejointventure?
Aswath Damodaran
53
ValueofPut=Ke-rt (1-N(d2))- Se-yt (1-N(d1))=400exp(-0.06)(5)(1-0.4624)- 480exp(-0.033)(5)(1-0.7882)=$73.23million
¨ Thevalueofthisabandonmentoptionhastobeaddedontothenetpresentvalueoftheprojectof-$20million,yieldingatotalnetpresentvaluewiththeabandonmentoptionof$53.23million.
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54
ImplicationsforInvestmentAnalysis/Valuation
Aswath Damodaran
54
¨ Havingaoptiontoabandonaprojectcanmakeotherwiseunacceptableprojectsacceptable.
¨ Otherthingsremainingequal,youwouldattachmorevaluetocompanieswith¤ Morecostflexibility,thatis,makingmoreofthecostsoftheprojectsintovariablecostsasopposedtofixedcosts.
¤ Fewerlong-termcontracts/obligationswithemployeesandcustomers,sincetheseaddtothecostofabandoningaproject.
¨ Theseactionswillundoubtedlycostthefirmsomevalue,butthishastobeweighedoffagainsttheincreaseinthevalueoftheabandonmentoption.
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55
D.OptionsinCapitalStructure
Aswath Damodaran
55
¨ Themostdirectapplicationsofoptionpricingincapitalstructuredecisionsisinthedesignofsecurities.Infact,mostcomplexfinancialinstrumentscanbebrokendownintosomecombinationofasimplebond/commonstockandavarietyofoptions.¤ Ifthesesecuritiesaretobeissuedtothepublic,andtraded,the
optionshavetobepriced.¤ Ifthesearenon-tradedinstruments(bankloans,forinstance),they
stillhavetobepricedintotheinterestrateontheinstrument.
¨ Theotherapplicationofoptionpricingisinvaluingflexibility.Often,firmspreservedebtcapacityorholdbackonissuingdebtbecausetheywanttomaintainflexibility.
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56
TheValueofFlexibility
Aswath Damodaran
56
¨ Firmsmaintainexcessdebtcapacityorlargercashbalancesthanarewarrantedbycurrentneeds,tomeetunexpectedfuturerequirements.
¨ Whilemaintainingthisfinancingflexibilityhasvaluetofirms,italsohasacost;theexcessdebtcapacityimpliesthatthefirmisgivingupsomevalueandhasahighercostofcapital.
¨ Thevalueofflexibilitycanbeanalyzedusingtheoptionpricingframework;afirmmaintainslargecashbalancesandexcessdebtcapacityinordertohavetheoptiontotakeprojectsthatmightariseinthefuture.
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57
TheValueofFlexibility
Aswath Damodaran
57
Actual ReinvestmentNeeds
Expected (Normal) Reinvestment Needs that can be financed without flexibility
Cost of Maintaining Financing Flexibility
Use financing flexibilityto take unanticipatedinvestments (acquisitions)
Payoff: (S-K)*Excess Return/WACC
Excess Return/WACC = PV of excess returns in perpetutity
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Disney’sOptimalDebtRatio
Aswath Damodaran
58
DebtRatio CostofEquity CostofDebt CostofCapital0.00% 13.00% 4.61% 13.00%10.00% 13.43% 4.61% 12.55%Current:18% 13.85% 4.80% 12.22%20.00% 13.96% 4.99% 12.17%30.00% 14.65% 5.28% 11.84%40.00% 15.56% 5.76% 11.64%50.00% 16.85% 6.56% 11.70%60.00% 18.77% 7.68% 12.11%70.00% 21.97% 7.68% 11.97%80.00% 28.95% 7.97% 12.17%90.00% 52.14% 9.42% 13.69%
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59
InputstoOptionValuationModel- Disney
Aswath Damodaran
59
Model input
Estimated as In general… For Disney
S Expected annual reinvestment needs (as % of firm value)
Measures magnitude of reinvestment needs
Average of Reinvestment/ Value over last 5 years = 5.3%
s2 Variance in annual reinvestment needs
Measures how much volatility there is in investment needs.
Variance over last 5 years in ln(Reinvestment/Value) =0.375
K (Internal + Normal access to external funds)/ Value
Measures the capital constraint
Average over last 5 years = 4.8%
T 1 year Measures an annual value for flexibility
T =1
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60
ValuingFlexibilityatDisney
Aswath Damodaran
60
¨ Thevalueofanoptionwiththesecharacteristicsis1.6092%.Youcanconsiderthisthevalueoftheoptiontotakeaproject,buttheoverallvalueofflexibilitywillstilldependuponthequalityoftheprojectstaken.Inotherwords,thevalueoftheoptiontotakeaprojectiszeroiftheprojecthaszeronetpresentvalue.
¨ Disneyearns18.69%onitsprojectshasacostofcapitalof12.22%.Theexcessreturn(annually)is6.47%.Assumingthattheycancontinuetogeneratetheseexcessreturnsinperpetuity:ValueofFlexibility(annual)=1.6092%(.0647/.1222)=0.85%ofvalue
¨ Disney’scostofcapitalatitsoptimaldebtratiois11.64%.Thecostitincurstomaintainflexibilityistherefore0.58%annually(12.22%-11.64%).Itthereforepaystomaintainflexibility.
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61
DeterminantsoftheValueofFlexibility
Aswath Damodaran
61
¨ CapitalConstraints(ExternalandInternal):Thegreaterthecapacitytoraisefunds,eitherinternallyorexternally,thelessthevalueofflexibility.¤ 1.1:Firmswithsignificantinternaloperatingcashflowsshouldvalue
flexibilitylessthanfirmswithsmallornegativeoperatingcashflows.¤ 1.2:Firmswitheasyaccesstofinancialmarketsshouldhavealower
valueforflexibilitythanfirmswithoutthataccess.¨ Unpredictabilityofreinvestmentneeds:Themore
unpredictablethereinvestmentneedsofafirm,thegreaterthevalueofflexibility.
¨ Capacitytoearnexcessreturns:Thegreaterthecapacitytoearnexcessreturns,thegreaterthevalueofflexibility.¤ 1.3:Firmsthatdonothavethecapacitytoearnorsustainexcess
returnsgetnovaluefromflexibility.
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62
E.ValuingEquityasanoption
Aswath Damodaran
62
¨ Theequityinafirmisaresidualclaim,i.e.,equityholderslayclaimtoallcashflowsleftoverafterotherfinancialclaim-holders(debt,preferredstocketc.)havebeensatisfied.
¨ Ifafirmisliquidated,thesameprincipleapplies,withequityinvestorsreceivingwhateverisleftoverinthefirmafteralloutstandingdebtsandotherfinancialclaimsarepaidoff.
¨ Theprincipleoflimitedliability,however,protectsequityinvestorsinpubliclytradedfirmsifthevalueofthefirmislessthanthevalueoftheoutstandingdebt,andtheycannotlosemorethantheirinvestmentinthefirm.
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63
PayoffDiagramforLiquidationOption
Aswath Damodaran
63
Value of firm
Net Payoffon Equity
Face Valueof Debt
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64
Applicationtovaluation:Asimpleexample
Aswath Damodaran
64
¨ Assumethatyouhaveafirmwhoseassetsarecurrentlyvaluedat$100millionandthatthestandarddeviationinthisassetvalueis40%.
¨ Further,assumethatthefacevalueofdebtis$80million(Itiszerocoupondebtwith10yearslefttomaturity).
¨ Iftheten-yeartreasurybondrateis10%,¤ howmuchistheequityworth?¤ Whatshouldtheinterestrateondebtbe?
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65
ModelParameters
Aswath Damodaran
65
¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$100million
¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million
¨ Lifeoftheoption=t¤ Lifeofzero-coupondebt=10years
¨ Varianceinthevalueoftheunderlyingasset=s2
¤ Varianceinfirmvalue=0.16¨ Risklessrate=r
¤ Treasurybondratecorrespondingtooptionlife=10%
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66
ValuingEquityasaCallOption
Aswath Damodaran
66
¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.5994 N(d1)=0.9451d2=0.3345 N(d2)=0.6310
¨ Valueofthecall=100(0.9451)- 80exp(-0.10)(10)(0.6310)=$75.94million
¨ Valueoftheoutstandingdebt=$100- $75.94=$24.06million
¨ Interestrateondebt=($80/$24.06)1/10-1=12.77%
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67
I.TheEffectofCatastrophicDropsinValue
Aswath Damodaran
67
¨ Assumenowthatacatastrophewipesouthalfthevalueofthisfirm(thevaluedropsto$50million),whilethefacevalueofthedebtremainsat$80million.Whatwillhappentotheequityvalueofthisfirm?a. Itwilldropinvalueto$25.94million[$50million-
marketvalueofdebtfrompreviouspage]b. Itwillbeworthnothingsincedebtoutstanding>Firm
Valuec. Itwillbeworthmorethan$25.94million
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68
ValuingEquityintheTroubledFirm
Aswath Damodaran
68
¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$50million
¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million
¨ Lifeoftheoption=t¤ Lifeofzero-coupondebt=10years
¨ Varianceinthevalueoftheunderlyingasset=s2
¤ Varianceinfirmvalue=0.16¨ Risklessrate=r
¤ Treasurybondratecorrespondingtooptionlife=10%
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69
TheValueofEquityasanOption
Aswath Damodaran
69
¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.0515 N(d1)=0.8534d2=-0.2135 N(d2)=0.4155
¨ Valueofthecall=50(0.8534)- 80exp(-0.10)(10) (0.4155)=$30.44million
¨ Valueofthebond=$50- $30.44=$19.56million¨ Theequityinthisfirmdropsby$45.50million,lessthantheoveralldropinvalueof$50million,becauseoftheoptioncharacteristicsofequity.
¨ Thismightexplainwhystockinfirms,whichareinChapter11andessentiallybankrupt,stillhasvalue.
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70
Equityvaluepersists..
Aswath Damodaran
70
Value of Equity as Firm Value Changes
0
10
20
30
40
50
60
70
80
100 90 80 70 60 50 40 30 20 10Value of Firm ($ 80 Face Value of Debt)
Val
ue
of
Equi
ty
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71
II.Theconflictbetweenstockholdersandbondholders
Aswath Damodaran
71
¨ Consideragainthefirmdescribedintheearlierexample,withavalueofassetsof$100million,afacevalueofzero-couponten-yeardebtof$80million,astandarddeviationinthevalueofthefirmof40%.Theequityanddebtinthisfirmwerevaluedasfollows:¤ ValueofEquity=$75.94million¤ ValueofDebt=$24.06million¤ ValueofFirm==$100million
¨ Nowassumethatthestockholdershavetheopportunitytotakeaprojectwithanegativenetpresentvalueof-$2million,butassumethatthisprojectisaveryriskyprojectthatwillpushupthestandarddeviationinfirmvalueto50%.Wouldyouinvestinthisproject?a. Yesb. No
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72
ValuingEquityaftertheProject
Aswath Damodaran
72
¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$100million- $2million=$98million(Thevalueofthefirmisloweredbecauseofthenegativenetpresentvalueproject)
¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million
¨ Lifeoftheoption=t¨ Lifeofzero-coupondebt=10years¨ Varianceinthevalueoftheunderlyingasset=s2
¤ Varianceinfirmvalue=0.25¨ Risklessrate=r
¤ Treasurybondratecorrespondingtooptionlife=10%
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73
OptionValuation
Aswath Damodaran
73
¨ OptionPricingResultsforEquityandDebtValue¤ ValueofEquity=$77.71¤ ValueofDebt=$20.29¤ ValueofFirm=$98.00
¨ Thevalueofequityrisesfrom$75.94millionto$77.71million,eventhoughthefirmvaluedeclinesby$2million.Theincreaseinequityvaluecomesattheexpenseofbondholders,whofindtheirwealthdeclinefrom$24.06millionto$20.19million.
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74
EffectsofanAcquisition
Aswath Damodaran
74
¨ Assumethatyouarethemanagerofafirmandthatyoubuyanotherfirm,withafairmarketvalueof$150million,forexactly$150million.Inanefficientmarket,thestockpriceofyourfirmwilla. Increaseb. Decreasec. RemainUnchanged
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75
Effectsonequityofaconglomeratemerger
Aswath Damodaran
75
¨ Youareprovidedinformationontwofirms,whichoperateinunrelatedbusinessesandhopetomerge.
FirmA FirmBValueofthefirm $100million $150millionFaceValueofDebt(10yr zeros) $80million $50millionMaturityofdebt 10years 10yearsStd.Dev.invalue 40% 50%Correlationbetweencashflows 0.4¤ Theten-yearbondrateis10%.
¨ Thevarianceinthevalueofthefirmaftertheacquisitioncanbecalculatedasfollows:Varianceincombinedfirmvalue =w1
2 s12 +w2
2 s22 +2w1 w2 r12s1s2
=(0.4)2 (0.16)+(0.6)2 (0.25)+2(0.4)(0.6)(0.4)(0.4)(0.5)=0.154
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76
ValuingtheCombinedFirm
Aswath Damodaran
76
¨ Thevaluesofequityanddebtintheindividualfirmsandthecombinedfirmcanthenbeestimatedusingtheoptionpricingmodel:
FirmA FirmB CombinedfirmValueofequityinthefirm $75.94 $134.47 $207.43Valueofdebtinthefirm $24.06 $15.53 $42.57Valueofthefirm $100.00 $150.00 $250.00¨ Thecombinedvalueoftheequitypriortothemergeris$210.41million
anditdeclinesto$207.43millionafter.¨ Thewealthofthebondholdersincreasesbyanequalamount.¨ Thereisatransferofwealthfromstockholderstobondholders,asa
consequenceofthemerger.Thus,conglomeratemergersthatarenotfollowedbyincreasesinleveragearelikelytoseethisredistributionofwealthoccuracrossclaimholdersinthefirm.
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77
Obtainingoptionpricinginputs- Somerealworldproblems
Aswath Damodaran
77
¨ Theexamplesthathavebeenusedtoillustratetheuseofoptionpricingtheorytovalueequityhavemadesomesimplifyingassumptions.Amongthemarethefollowing:(1)Therewereonlytwoclaimholdersinthefirm- debtandequity.(2)Thereisonlyoneissueofdebtoutstandinganditcanberetiredatfacevalue.(3)Thedebthasazerocouponandnospecialfeatures(convertibility,putclausesetc.)(4)Thevalueofthefirmandthevarianceinthatvaluecanbeestimated.
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RealWorldApproachestoValuingEquityinTroubledFirms:GettingInputs
Input Estimation Process
Value of the Firm • Cumulate market values of equity and debt (or)
• Value the assets in place using FCFF and WACC (or)
• Use cumulated market value of assets, if traded.
Variance in Firm Value • If stocks and bonds are traded,
σ2firm = we2 σe2 + wd2 σd2 + 2 we wd ρed σe σd
where σe2 = variance in the stock price
we = MV weight of Equity
σd2 = the variance in the bond price wd = MV weight of
debt
• If not traded, use variances of similarly rated bonds.
• Use average firm value variance from the industry in
which company operates.
Value of the Debt • If the debt is short term, you can use only the face or book
value of the debt.
• If the debt is long term and coupon bearing, add the
cumulated nominal value of these coupons to the face
value of the debt.
Maturity of the Debt • Face value weighted duration of bonds outstanding (or)
• If not available, use weighted maturity
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79
ValuingEquityasanoption- Eurotunnelinearly1998
Aswath Damodaran
79
¨ Eurotunnelhasbeenafinancialdisastersinceitsopening¤ In1997,Eurotunnelhadearningsbeforeinterestandtaxesof-£56millionandnetincomeof-£685million
¤ Attheendof1997,itsbookvalueofequitywas-£117million¨ Ithad£8,865millioninfacevalueofdebtoutstanding
¤ Theweightedaveragedurationofthisdebtwas10.93yearsDebtType FaceValue DurationShortterm 935 0.5010year 2435 6.720year 3555 12.6Longer 1940 18.2Total £8,865mil 10.93years
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80
TheBasicDCFValuation
Aswath Damodaran
80
¨ Thevalueofthefirmestimatedusingprojectedcashflowstothefirm,discountedattheweightedaveragecostofcapitalwas£2,312million.
¨ Thiswasbaseduponthefollowingassumptions–¤ Revenueswillgrow5%ayearinperpetuity.¤ TheCOGSwhichiscurrently85%ofrevenueswilldropto65%of
revenuesinyr5andstayatthatlevel.¤ Capitalspendinganddepreciationwillgrow5%ayearinperpetuity.¤ Therearenoworkingcapitalrequirements.¤ Thedebtratio,whichiscurrently95.35%,willdropto70%afteryear5.
Thecostofdebtis10%inhighgrowthperiodand8%afterthat.¤ Thebetaforthestockwillbe1.10forthenextfiveyears,anddropto
0.8afterthenext5years.¤ Thelongtermbondrateis6%.
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81
OtherInputs
Aswath Damodaran
81
¨ ThestockhasbeentradedontheLondonExchange,andtheannualizedstd deviationbaseduponln (prices)is41%.
¨ ThereareEurotunnelbonds,thathavebeentraded;theannualizedstd deviationinln(price)forthebondsis17%.¤ Thecorrelationbetweenstockpriceandbondpricechangeshasbeen
0.5.Theproportionofdebtinthecapitalstructureduringtheperiod(1992-1996)was85%.
¤ Annualizedvarianceinfirmvalue=(0.15)2 (0.41)2 +(0.85)2 (0.17)2 +2(0.15)(0.85)(0.5)(0.41)(0.17)=0.0335
¨ The15-yearbondrateis6%.(Iusedabondwithadurationofroughly11yearstomatchthelifeofmyoption)
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82
ValuingEurotunnelEquityandDebt
Aswath Damodaran
82
¨ InputstoModel¤ Valueoftheunderlyingasset=S=Valueofthefirm=£2,312million¤ Exerciseprice=K=FaceValueofoutstandingdebt=£8,865million¤ Lifeoftheoption=t=Weightedaveragedurationofdebt=10.93years¤ Varianceinthevalueoftheunderlyingasset=s2 =Varianceinfirmvalue=
0.0335¤ Risklessrate=r=Treasurybondratecorrespondingtooptionlife=6%
¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:¤ d1=-0.8337 N(d1)=0.2023¤ d2=-1.4392 N(d2)=0.0751
¨ Valueofthecall=2312(0.2023)- 8,865exp(-0.06)(10.93) (0.0751)=£122million
¨ Appropriateinterestrateondebt=(8865/2190)(1/10.93)-1=13.65%
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83
InClosing…
Aswath Damodaran
83
¨ Therearerealoptionseverywhere.¨ Mostofthemhavenosignificanteconomicvaluebecause
thereisnoexclusivityassociatedwithusingthem.¨ Whenoptionshavesignificanteconomicvalue,theinputs
neededtovaluetheminabinomialmodelcanbeusedinmoretraditionalapproaches(decisiontrees)toyieldequivalentvalue.
¨ Therealvaluefromrealoptionsliesin¤ Recognizingthatbuildinginflexibilityandescapehatchesintolarge
decisionshasvalue¤ Insightswegetonunderstandinghowandwhycompaniesbehavethe
waytheydoininvestmentanalysisandcapitalstructurechoices.