VALUATION: PACKET 3 REAL OPTIONS, ACQUISITION...
Transcript of VALUATION: PACKET 3 REAL OPTIONS, ACQUISITION...
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VALUATION:PACKET3REALOPTIONS,ACQUISITIONVALUATIONANDVALUEENHANCEMENTAswathDamodaranUpdated:September2016
Aswath Damodaran 1
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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
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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
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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
SK! "
# $ + (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
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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
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¨ Traditionaldecisiontreeanalysistendstouse¤ Onecostofcapitaltodiscountcashflows ineachbranchtothepresent¤ Probabilitiestocomputeanexpectedvalue¤ Thesevalueswillgenerallybedifferentfromoptionpricingmodel
values¨ Ifyoumodifieddecisiontreeanalysisto
¤ Usedifferentdiscountratesateachnodetoreflectwhereyouareinthedecisiontree(ThisistheCopelandsolution) (or)
¤ Usetheriskfree ratetodiscountcashflows ineachbranch,estimatetheprobabilitiestoestimateanexpectedvalueandadjusttheexpectedvalueforthemarketriskintheinvestment
¨ 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
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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
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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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30
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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58
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.
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AcquirersAnonymous:SevenStepsbacktoSobriety…
AswathDamodaran
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Acquisitionsaregreatfortargetcompaniesbutnotalwaysforacquiringcompanystockholders…
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Andthelong-termfollowupisnotpositiveeither..
Aswath Damodaran
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¨ Managersoftenarguethatthemarketisunabletoseethelongtermbenefitsofmergersthattheycanseeatthetimeofthedeal.Iftheyareright,mergersshouldcreatelongtermbenefitstoacquiringfirms.
¨ Theevidencedoesnotsupportthishypothesis:¤ McKinseyandCo.hasexaminedacquisitionprogramsatcompanieson
n Didthereturnoncapitalinvestedinacquisitionsexceedthecostofcapital?n Didtheacquisitionshelptheparentcompaniesoutperformthecompetition?n Halfofallprogramsfailedonetest,andaquarterfailedboth.
¤ Synergyiselusive.KPMGinamorerecentstudyofglobalacquisitionsconcludesthatmostmergers(>80%)fail- themergedcompaniesdoworsethantheirpeergroup.
¤ Alargenumberofacquisitionsthatarereversedwithinfairlyshorttimeperiods.About20%oftheacquisitionsmadebetween1982and1986weredivestedby1988.Instudiesthathavetrackedacquisitionsforlongertimeperiods(tenyearsormore)thedivestiturerateofacquisitionsrisestoalmost50%.
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Ascarythought…Thediseaseisspreading…IndianfirmsacquiringUStargets– 1999- 2005
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Months around takeover
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Growingthroughacquisitionsseemstobea“loser’sgame”
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¨ Firmsthatgrowthroughacquisitionshavegenerallyhadfarmoretroublecreatingvaluethanfirmsthatgrowthroughinternalinvestments.
¨ Ingeneral,acquiringfirmstendto¤ Paytoomuchfortargetfirms¤ Overestimatethevalueof“synergy” and“control”¤ Haveadifficulttimedeliveringthepromisedbenefits
¨ Worsestill,thereseemstobeverylittlelearningbuiltintotheprocess.Thesamemistakesaremadeoverandoveragain,oftenbythesamefirmswiththesameadvisors.
¨ Conclusion:Thereissomethingstructurallywrongwiththeprocessforacquisitionswhichisfeedingintothemistakes.
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Thesevensinsinacquisitions…
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1. RiskTransference:Attributingacquiringcompanyriskcharacteristicstothetargetfirm.
2. Debtsubsidies:Subsidingtargetfirmstockholdersforthestrengthsoftheacquiringfirm.
3. Auto-pilotControl:The“20%controlpremium” andothermyth…
4. ElusiveSynergy:Misidentifyingandmis-valuingsynergy.5. Itsallrelative:Transactionmultiples,exitmultiples…6. Verdictfirst,trialafterwards:Pricefirst,valuationtofollow7. It’snotmyfault:Holdingnooneresponsiblefordelivering
results.
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Testingsheet
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Test Passed/Failed Rationalization
Risk transference
Debt subsidies
Control premium
The value of synergy
Comparables and Exit MultiplesBias
A successful acquisition strategy
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Letsstartwithatargetfirm
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¨ Thetargetfirmhasthefollowingincomestatement:Revenues 100OperatingExpenses 80= OperatingIncome 20Taxes 8=After-taxOI 12
¨ Assumethatthisfirmwillgeneratethisoperatingincomeforever(withnogrowth)andthatthecostofequityforthisfirmis20%.Thefirmhasnodebtoutstanding.Whatisthevalueofthisfirm?
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Test1:RiskTransference…
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¨ Assumethatasanacquiringfirm,youareinamuchsaferbusinessandhaveacostofequityof10%.Whatisthevalueofthetargetfirmtoyou?
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Lesson1:Don’ttransferyourriskcharacteristicstothetargetfirm
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¨ Thecostofequityusedforaninvestmentshouldreflecttheriskoftheinvestmentandnottheriskcharacteristicsoftheinvestorwhoraisedthefunds.
¨ Riskybusinessescannotbecomesafejustbecausethebuyerofthesebusinessesisinasafebusiness.
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Test2:Cheapdebt?
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¨ Assumeasanacquirerthatyouhaveaccesstocheapdebt(at4%)andthatyouplantofundhalftheacquisitionwithdebt.Howmuchwouldyoubewillingtopayforthetargetfirm?
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Lesson2:Renderuntothetargetfirmthatwhichisthetargetfirm’sbutnotapennymore..
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¨ Asanacquiringfirm,itisentirelypossiblethatyoucanborrowmuchmorethanthetargetfirmcanonitsownandatamuchlowerrate.Ifyoubuildthesecharacteristicsintothevaluationofthetargetfirm,youareessentiallytransferringwealthfromyourfirm’sstockholdertothetargetfirm’sstockholders.
¨ Whenvaluingatargetfirm,useacostofcapitalthatreflectsthedebtcapacityandthecostofdebtthatwouldapplytothefirm.
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Test3:ControlPremiums
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¨ Assumethatyouarenowtoldthatitisconventionaltopaya20%premiumforcontrolinacquisitions(backedupbyMergerstat).Howmuchwouldyoubewillingtopayforthetargetfirm?
¨ WouldyouranswerchangeifItoldyouthatyoucanrunthetargetfirmbetterandthatifyoudo,youwillbeabletogeneratea30%pre-taxoperatingmargin(ratherthanthe20%marginthatiscurrentlybeingearned).
¨ Whatifthetargetfirmwereperfectlyrun?
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Lesson3:Bewareofrulesofthumb…
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¨ Valuationisclutteredwithrulesofthumb.Afterpainstakinglyvaluingatargetfirm,usingyourbestestimates,youwillbeoftenbetoldthat¤ Itiscommonpracticetoaddarbitrarypremiumsforbrandname,qualityofmanagement,controletc…
¤ Thesepremiumswillbeoftenbebackedupbydata,studiesandservices.Whattheywillnotrevealistheenormoussamplingbiasinthestudiesandthestandarderrorsintheestimates.
¤ Ifyouhavedoneyourvaluationright,thosepremiumsshouldalreadybeincorporatedinyourestimatedvalue.Payingapremiumwillbedoublecounting.
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Test4:Synergy….
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¨ Assumethatyouaretoldthatthecombinedfirmwillbelessriskythanthetwoindividualfirmsandthatitshouldhavealowercostofcapital(andahighervalue).Isthislikely?
¨ Assumenowthatyouaretoldthattherearepotentialgrowthandcostsavingssynergiesintheacquisition.Wouldthatincreasethevalueofthetargetfirm?
¨ Shouldyoupaythisasapremium?
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TheValueofSynergy
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Synergy is created when two firms are combined and can be either financial or operating
Operating Synergy accrues to the combined firm as Financial Synergy
Higher returns on new investments
More newInvestments
Cost Savings in current operations
Tax BenefitsAdded Debt Capacity Diversification?
Higher ROC
Higher Growth Rate
Higher Reinvestment
Higher Growth RateHigher Margin
Higher Base-year EBIT
Strategic Advantages Economies of Scale
Longer GrowthPeriod
More sustainableexcess returns
Lower taxes on earnings due to - higher depreciaiton- operating loss carryforwards
Higher debt raito and lower cost of capital
May reducecost of equity for private or closely heldfirm
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ValuingSynergy
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(1)thefirmsinvolvedinthemergerarevaluedindependently,bydiscountingexpectedcashflowstoeachfirmattheweightedaveragecostofcapitalforthatfirm.(2)thevalueofthecombinedfirm,withnosynergy,isobtainedbyaddingthevaluesobtainedforeachfirminthefirststep.(3)Theeffectsofsynergyarebuiltintoexpectedgrowthratesandcashflows,andthecombinedfirmisre-valuedwithsynergy.
ValueofSynergy=Valueofthecombinedfirm,withsynergy-Valueofthecombinedfirm,withoutsynergy
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Synergy- Example1Highergrowthandcostsavings
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P&G Gillette Piglet: No Synergy Piglet: SynergyFree Cashflow to Equity $5,864.74 $1,547.50 $7,412.24 $7,569.73 Annual operating expenses reduced by $250 millionGrowth rate for first 5 years 12% 10% 11.58% 12.50% Slighly higher growth rateGrowth rate after five years 4% 4% 4.00% 4.00%Beta 0.90 0.80 0.88 0.88Cost of Equity 7.90% 7.50% 7.81% 7.81% Value of synergyValue of Equity $221,292 $59,878 $281,170 $298,355 $17,185
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Synergy:Example3TaxBenefits?
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¨ AssumethatyouareBestBuy,theelectronicsretailer,andthatyouwouldliketoenterthehardwarecomponentofthemarket.YouhavebeenapproachedbyinvestmentbankersforZenith,whichwhilestillarecognizedbrandname,isonitslastlegsfinancially.Thefirmhasnetoperatinglossesof$2billion.Ifyourtaxrateis36%,estimatethetaxbenefitsfromthisacquisition.
¨ IfBestBuyhadonly$500millionintaxableincome,howwouldyoucomputethetaxbenefits?
¨ IfthemarketvalueofZenithis$800million,wouldyoupaythistaxbenefitasapremiumonthemarketvalue?
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Lesson4:Don’tpayforbuzzwords
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¨ Throughtime,acquirershavealwaysfoundwaysofjustifyingpayingforpremiumsoverestimatedvaluebyusingbuzzwords- synergyinthe1980s,strategicconsiderationsinthe1990sandrealoptionsinthisdecade.
¨ Whileallofthesecanhavevalue,theonusshouldbeonthosepushingfortheacquisitionstoshowthattheydoandnotonthosepushingagainstthemtoshowthattheydonot.
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Test5:ComparablesandExitMultiples
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¨ Nowassumethatyouaretoldthatananalysisofotheracquisitionsrevealsthatacquirershavebeenwillingtopay5timesEBIT..GiventhatyourtargetfirmhasEBITof$20million,wouldyoubewillingtopay$100millionfortheacquisition?
¨ WhatifIestimatetheterminalvalueusinganexitmultipleof5timesEBIT?
¨ Asanadditionalinput,yourinvestmentbankertellsyouthattheacquisitionisaccretive.(YourPEratiois20whereasthePEratioofthetargetisonly10…Therefore,youwillgetajumpinearningspershareaftertheacquisition…)
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Biasedsamples=Poorresults
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¨ Biasedsamplesyieldbiasedresults.Basingwhatyoupayonwhatotheracquirershavepaidisarecipefordisaster.Afterall,weknowthatacquirer,onaverage,paytoomuchforacquisitions.Bymatchingtheirprices,weriskreplicatingtheirmistakes.
¨ Evenwhenweusethepricingmetricsofotherfirmsinthesector,wemaybebasingthepriceswepayonfirmsthatarenottrulycomparable.
¨ Whenweuseexitmultiples,weareassumingthatwhatthemarketispayingforcomparablecompaniestodayiswhatitwillcontinuetopayinthefuture.
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Lesson5:Don’tbealemming…
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¨ Alltoooften,acquisitionsarejustifiedbyusingoneofthefollowingtwoarguments:¤ Everyoneelseinyoursectorisdoingacquisitions.Youhavetodothesametosurvive.
¤ Thevalueofatargetfirmisbaseduponwhatothershavepaidonacquisitions,whichmaybemuchhigherthanwhatyourestimateofvalueforthefirmis.
¨ Withtherightsetofcomparablefirms,youcanjustifyalmostanyprice.
¨ EPSaccretionisameaninglessmeasure.Afterall,buyingancompanywithaPElowerthanyourswillleadmathematicallytoEPSaccretion.
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Test6:TheCEOreallywantstodothis…ortherearecompetitivepressures…
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¨ NowassumethatyouknowthattheCEOoftheacquiringfirmreally,reallywantstodothisacquisitionandthattheinvestmentbankersonbothsideshaveproducedfairnessopinionsthatindicatethatthefirmisworth$100million.Wouldyoubewillingtogoalong?
¨ Nowassumethatyouaretoldthatyourcompetitorsarealldoingacquisitionsandthatifyoudon’tdothem,youwillbeatadisadvantage?Wouldyoubewillingtogoalong?
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Lesson6:Don’tletegosorinvestmentbankersgetthebetterofcommonsense…
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¨ Ifyoudefineyourobjectiveinabiddingwaraswinningtheauctionatanycost,youwillwin.Butbewarethewinner’scurse!
¨ Thepremiumspaidonacquisitionsoftenhavenothingtodowithsynergy,controlorstrategicconsiderations(thoughtheymaybeprovidedasthereasons).TheymayjustreflecttheegosoftheCEOsoftheacquiringfirms.Thereisevidencethat“overconfident”CEOsaremorelikelytomakeacquisitionsandthattheyleaveatrailacrossthefirmsthattheyrun.
¨ Pre-emptiveordefensiveacquisitions,whereyouoverpay,eitherbecauseeveryoneelseisoverpayingorbecauseyouareafraidthatyouwillbeleftbehindifyoudon’tacquirearedangerous.Iftheonlywayyoucanstaycompetitiveinabusinessisbymakingbadinvestments,itmaybebesttothinkaboutgettingoutofthebusiness.
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Toillustrate:Abaddealismade,andjustifiedbyaccountants&bankers
Aswath Damodaran
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TheCEOstepsin…anddigsahole…
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¨ LeoApothekerwastheCEOofHPatthetimeofthedeal,broughtintoreplaceMarkHurd,thepreviousCEOwhowasforcedtoresignbecauseofa“sex”scandal.
¨ InthefaceofalmostuniversalfeelingthatHPhadpaidtoomuchforAutonomy,Mr. Apotheker addressing a conference at the time of the deal: “We have a pretty rigorous process inside H.P. that we follow for all our acquisitions, which is a D.C.F.-based model,”he said, in a reference to discounted cash flow, a standard valuation methodology. “And we try to take a very conservative view.”
¨ Apotheker added, “Just to make sure everybody understands, Autonomy will be, on Day 1, accretive to H.P….. “Just take it from us. We did that analysis at great length, in great detail, and we feel that we paid a very fair price for Autonomy. And it will give a great return to our shareholders.
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Ayearlater…HPadmitsamistake…andexplainsit…
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Test7:Isithopeless?
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¨ Theoddsseemtobeclearlyweightedagainstsuccessinacquisitions.Ifyouweretocreateastrategytogrow,baseduponacquisitions,whichofthefollowingoffersyourbestchanceofsuccess?
This OrthisSoleBidder BiddingWarPublictarget PrivatetargetPaywithcash PaywithstockSmalltarget LargetargetCostsynergies Growthsynergies
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Bettertoloseabiddingwarthantowinone…
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Returns in the 40 months before & after bidding warSource: Malmendier, Moretti & Peters (2011)
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Youarebetteroffbuyingsmallratherthanlargetargets…withcashratherthanstock
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Andfocusingonprivatefirmsandsubsidiaries,ratherthanpublicfirms…
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GrowthvsCostSynergies
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Synergy:Oddsofsuccess
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¨ Studiesthathavefocusedonsynergieshaveconcludedthatyouarefarmorelikelytodelivercostsynergiesthangrowthsynergies.
¨ Synergiesthatareconcreteandplannedforatthetimeofthemergeraremorelikelytobedeliveredthanfuzzysynergies.
¨ Synergyismuchmorelikelytoshowupwhensomeoneisheldresponsiblefordeliveringthesynergy.
¨ Youaremorelikelytogetashareofthesynergygainsinanacquisitionwhenyouareasinglebidderthanifyouareoneofmultiplebidders.
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Lesson7:Foracquisitionstocreatevalue,youhavetostaydisciplined..
Aswath Damodaran
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1. Ifyouhaveasuccessfulacquisitionstrategy,stayfocusedonthatstrategy.Don’tletsizeorhubrisdriveyouto“expand” thestrategy.
2. Realisticplansfordeliveringsynergyandcontrolhavetobeputinplacebeforethemergeriscompleted.Byrealistic,wehavetomeanthatthemagnitudeofthebenefitshavetobereachableandnotpipedreamsandthatthetimeframeshouldreflecttherealitythatittakesawhilefortwoorganizationstoworkasone.
3. Thebestthingtodoinabiddingwaristodropout.4. Someone(preferablythepersonpushinghardestforthemerger)
shouldbeheldtoaccountfordeliveringthebenefits.5. Thecompensationforinvestmentbankersandothersinvolvedin
thedealshouldbetiedtohowwellthedealworksratherthanforgettingthedealdone.
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AReallyBigDeal!
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TheAcquirer(ABInBev)
LatinAmerica42%
Africa0%
AsiaPacific11%
Europe11%
NorthAmerica36%
RevenueBreakdown(2014)
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TheTarget(SABMiller)
CapitalMix Operating MetricsInterest-bearingDebt $12,550 Revenues $22,130.00LeaseDebt $368 OperatingIncome(EBIT) $4,420.00MarketCapitalization $75,116 OperatingMargin 19.97%DebttoEquityratio 17.20% Effectivetaxrate 26.40%DebttoCapitalratio 14.67% After-taxreturnoncapital 10.32%BondRating A3 ReinvestmentRate= 16.02%
LatinAmerica35%
Africa31%
AsiaPacific14%
Europe19%
NorthAmerica
1%
RevenueBreakdown(2015)
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Settingupthechallenge
¨ SABMiller’smarketcapitalizationwas$75billiononSeptember15,2015,thedayABInBev announceditsintenttoacquireSABMiller.
¨ Thedealwascompleted(pendingregulatoryapproval)amonthlater,withABInBev agreeingtopay$104billionforSABMiller.
¨ CanABInBev create$29billioninadditionalvaluefromthisacquisitionandifsowherewillitfindthevalue?¤ Themarketseemstothinkso,adding$33billioninmarketvaluetothecombinedcompany.
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TheThree(Value)ReasonsforAcquisitions
¨ Undervaluation:Youbuyatargetcompanybecauseyoubelievethatthemarketismispricingthecompanyandthatyoucanbuyitforlessthanits"fair"value.
¨ Control:Youbuyacompanythatyoubelieveisbadlymanaged,withtheintentofchangingthewayitisrun.Ifyouarerightonthefirstcountandcanmakethenecessarychanges,thevalueofthefirmshouldincreaseunderyourmanagement
¨ Synergy:Youbuyacompanythatyoubelieve,whencombinedwithabusiness(orresource)thatyoualreadyown,willbeabletodothingsthatyoucouldnothavedoneasseparateentities.Thissynergycanbe¤ Offensivesynergy:Highergrowthandincreasedpricingpower¤ Defensivesynergy:Costcutting,consolidation&preemptingcompetitors.¤ Taxsynergy:Directlyfromtaxclausesorindirectlythroughdent
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Fournumberstowatch
1. AcquisitionPrice:Thisisthepriceatwhichyoucanacquirethetargetcompany.Ifitisaprivatebusiness,itwillbenegotiatedandprobablybasedonwhatothersarepayingforsimilarbusinesses.Ifitisapubliccompany,itwillbeatapremiumoverthemarketprice.
2. StatusQuoValue:Valueofthetargetcompany,runbyexistingmanagement.
3. RestructuredValue:Valueofthetargetcompany,withchangestoinvesting,financinganddividendpolicies.
4. Synergyvalue:Valueofthecombinedcompany(withthesynergybenefitsbuiltin)– (Valueoftheacquiringcompany,asastandaloneentity,andtherestructuredvalueofthetargetcompany)
¨ TheAcidTest¤ Undervaluation:Pricefortargetcompany<StatusQuoValue¤ Control:Pricefortargetcompany<RestructuredValue¤ Synergy:Pricefortargetcompany<RestructuredValue+ValueofSynergy
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SABMillerStatusQuoValue
SABMiller +CoorsJV +ShareofAssociates SABMillerConsolidatedRevenues $22,130.00 $5,201.00 $6,099.00OperatingMargin 19.97% 15.38% 10.72%OperatingIncome(EBIT) $4,420.00 $800.00 $654.00InvestedCapital $31,526.00 $5,428.00 $4,459.00Beta 0.7977 0.6872 0.6872ERP 8.90% 6.00% 7.90%CostofEquity= 9.10% 6.12% 7.43%After-taxcostofdebt= 2.24% 2.08% 2.24%DebttoCapitalRatio 14.67% 0.00% 0.00%Costofcapital= 8.09% 6.12% 7.43%
After-taxreturnoncapital= 10.33% 11.05% 11.00%ReinvestmentRate= 16.02% 40.00% 40.00%Expectedgrowthrate= 1.65% 4.42% 4.40%Numberofyearsofgrowth 5 5 5ValueoffirmPVofFCFFinhighgrowth= $11,411.72 $1,715.25 $1,351.68Terminalvalue= $47,711.04 $15,094.36 $9,354.28Valueofoperatingassetstoday= $43,747.24 $12,929.46 $7,889.56 $64,566.26+Cash $1,027.00- Debt $12,918.00- MinorityInterests $1,183.00Valueofequity $51,492.26
Price on September 15, 2015: $75 billion > $51.5 billion
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SABMiller:PotentialforControl
SABMiller ABInBevGlobal Alcoholic Beverage Sector
Pre-taxOperatingMargin 19.97% 32.28% 19.23%
EffectiveTaxRate 26.36% 18.00% 22.00%
Pre-taxROIC 14.02% 14.76% 17.16%
ROIC 10.33% 12.10% 13.38%
ReinvestmentRate 16.02% 50.99% 33.29%
DebttoCapital 14.67% 23.38% 18.82%
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SABMiller:ValueofControl
Status Quo Value Optimal valueCost of Equity = 9.10% 9.37%After-tax cost of debt = 2.24% 2.24%Cost of capital = 8.09% 8.03%
After-tax return on capital = 10.33% 12.64%Reinvestment Rate = 16.02% 33.29%Expected growth rate= 1.65% 4.21%
Value of firmPV of FCFF in high growth = $11,411.72 $9,757.08Terminal value = $47,711.04 $56,935.06Value of operating assets today = $43,747.24 $48,449.42+ Cash $1,027.00 $1,027.00+ Minority Holdings $20,819.02 $20,819.02- Debt $12,918.00 $12,918.00- Minority Interests $1,183.00 $1,183.00 Value of Control
Value of equity $51,492.26 $56,194.44 $4,702.17Price on September 15, 2015: $75 billion > $51.5 + $4.7 billion
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TheSynergies?
Inbev SABMiller
Combined firm (status
quo)Combined firm
(synergy)LeveredBeta 0.85 0.8289 0.84641 0.84641Pre-taxcostofdebt 3.0000% 3.2000% 3.00% 3.00%Effectivetaxrate 18.00% 26.36% 19.92% 19.92%DebttoEquityRatio 30.51% 23.18% 29.71% 29.71%
Revenues $45,762.00 $22,130.00 $67,892.00 $67,892.00
OperatingMargin 32.28% 19.97% 28.27% 30.00%OperatingIncome(EBIT) $14,771.97 $4,419.36 $19,191.33 $20.368
After-taxreturnoncapital 12.10% 12.64% 11.68% 12.00%ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%ExpectedGrowthRate 6.17% 4.21% 5.09% 6.00%
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Thevalueofsynergy
Inbev SABMiller
Combined firm (status
quo)Combined firm
(synergy)CostofEquity= 8.93% 9.37% 9.12% 9.12%After-taxcostofdebt= 2.10% 2.24% 2.10% 2.10%Costofcapital= 7.33% 8.03% 7.51% 7.51%
After-taxreturnoncapital= 12.10% 12.64% 11.68% 12.00%
ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%
Expectedgrowthrate= 6.17% 4.21% 5.09% 6.00%
Value of firmPVofFCFFinhighgrowth= $28,733 $9,806 $38,539 $39,151Terminalvalue= $260,982 $58,736 $319,717 $340,175Valueofoperatingassets= $211,953 $50,065 $262,018 $276,610
Value of synergy = 276,610 – 262,018 = 14,592 million
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PassingJudgment
¨ Ifyouadduptherestructuredfirmvalueof$56.2billiontothesynergyvalueof$14.6billion,yougetavalueofabout$70.8billion.
¨ Thatiswellbelowthe$104billionthatABInBev isplanningtopayforSABMiller.
¨ Oneofthefollowinghastobetrue:¤ Ihavemassivelyunderestimatedthepotentialforsynergyinthismerger(eitherintermsofhighermarginsorhighergrowth).
¤ ABInBev hasoverpaidsignificantlyonthisdeal.Thatwouldgoagainsttheirhistoryasagoodacquirerandagainstthehistoryof3GCapitalasagoodstewardofcapital.
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VALUEENHANCEMENTANDTHEEXPECTEDVALUEOFCONTROL:BACKTOBASICS
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PriceEnhancementversusValueEnhancement
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Themarketgives… Andtakesaway….
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ThePathstoValueCreation
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¨ UsingtheDCFframework,therearefourbasicwaysinwhichthevalueofafirmcanbeenhanced:¤ Thecashflowsfromexistingassetstothefirmcanbeincreased,byeither
n increasingafter-taxearningsfromassetsinplaceorn reducingreinvestmentneeds(netcapitalexpendituresorworkingcapital)
¤ Theexpectedgrowthrateinthesecashflowscanbeincreasedbyeithern Increasingtherateofreinvestmentinthefirmn Improvingthereturnoncapitalonthosereinvestments
¤ Thelengthofthehighgrowthperiodcanbeextendedtoallowformoreyearsofhighgrowth.
¤ Thecostofcapitalcanbereducedbyn Reducingtheoperatingriskininvestments/assetsn Changingthefinancialmixn Changingthefinancingcomposition
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ValueCreation1:IncreaseCashFlowsfromAssetsinPlace
Aswath Damodaran
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Revenues
* Operating Margin
= EBIT
- Tax Rate * EBIT
= EBIT (1-t)
+ Depreciation- Capital Expenditures- Chg in Working Capital= FCFF
Divest assets thathave negative EBIT
More efficient operations and cost cuttting: Higher Margins
Reduce tax rate- moving income to lower tax locales- transfer pricing- risk management
Live off past over- investment
Better inventory management and tighter credit policies
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ValueCreation2:IncreaseExpectedGrowth
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Reinvestment Rate
* Return on Capital
= Expected Growth Rate
Reinvest more inprojects
Do acquisitions
Increase operatingmargins
Increase capital turnover ratio
PricingStrategiesPriceLeaderversusVolumeLeaderStrategiesReturnonCapital=OperatingMargin*CapitalTurnoverRatio
GametheoryHowwillyourcompetitorsreacttoyourmoves?Howwillyoureacttoyourcompetitors’moves?
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ValueCreatingGrowth…EvaluatingtheAlternatives..
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III.BuildingCompetitiveAdvantages:Increaselengthofthegrowthperiod
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137
Increase length of growth period
Build on existing competitive advantages
Find new competitive advantages
Brand name
Legal Protection
Switching Costs
Cost advantages
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ValueCreation4:ReduceCostofCapital
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Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital
Change financing mix
Make product or service less discretionary to customers
Reduce operating leverage
Match debt to assets, reducing default risk
Changing product characteristics
More effective advertising
Outsourcing Flexible wage contracts &cost structure
Swaps Derivatives Hybrids
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Current Cashflow to FirmEBIT(1-t) : 1414- Nt CpX 831 - Chg WC - 19= FCFF 602Reinvestment Rate = 812/1414
=57.42%
Expected Growth in EBIT (1-t).5742*.1993=.114411.44%
Stable Growthg = 3.41%; Beta = 1.00;Debt Ratio= 20%Cost of capital = 6.62% ROC= 6.62%; Tax rate=35%Reinvestment Rate=51.54%
Terminal Value10= 1717/(.0662-.0341) = 53546
Cost of Equity8.77%
Cost of Debt(3.41%+..35%)(1-.3654)= 2.39%
WeightsE = 98.6% D = 1.4%
Cost of Capital (WACC) = 8.77% (0.986) + 2.39% (0.014) = 8.68%
Op. Assets 31,615+ Cash: 3,018- Debt 558- Pension Lian 305- Minor. Int. 55=Equity 34,656-Options 180Value/Share106.12
Riskfree Rate:Euro riskfree rate = 3.41% +
Beta 1.26 X
Risk Premium4.25%
Unlevered Beta for Sectors: 1.25
Mature riskpremium4%
Country Equity Prem0.25%
SAP: Status Quo Reinvestment Rate 57.42%
Return on Capital19.93%
Term Yr5451354318261717
Avg Reinvestment rate = 36.94%
On May 5, 2005, SAP was trading at 122 Euros/share
First 5 yearsGrowth decreases gradually to 3.41%
Debt ratio increases to 20%Beta decreases to 1.00
Year 1 2 3 4 5 6 7 8 9 10EBIT 2,483 2,767 3,083 3,436 3,829 4,206 4,552 4,854 5,097 5,271EBIT(1-t) 1,576 1,756 1,957 2,181 2,430 2,669 2,889 3,080 3,235 3,345 - Reinvestm 905 1,008 1,124 1,252 1,395 1,501 1,591 1,660 1,705 1,724 = FCFF 671 748 833 929 1,035 1,168 1,298 1,420 1,530 1,621
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SAP:OptimalCapitalStructure
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Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 1.25 8.72% AAA 3.76% 36.54% 2.39% 8.72% $39,08810% 1.34 9.09% AAA 3.76% 36.54% 2.39% 8.42% $41,48020% 1.45 9.56% A 4.26% 36.54% 2.70% 8.19% $43,56730% 1.59 10.16% A- 4.41% 36.54% 2.80% 7.95% $45,90040% 1.78 10.96% CCC 11.41% 36.54% 7.24% 9.47% $34,04350% 2.22 12.85% C 15.41% 22.08% 12.01% 12.43% $22,44460% 2.78 15.21% C 15.41% 18.40% 12.58% 13.63% $19,65070% 3.70 19.15% C 15.41% 15.77% 12.98% 14.83% $17,44480% 5.55 27.01% C 15.41% 13.80% 13.28% 16.03% $15,65890% 11.11 50.62% C 15.41% 12.26% 13.52% 17.23% $14,181
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Current Cashflow to FirmEBIT(1-t) : 1414- Nt CpX 831 - Chg WC - 19= FCFF 602Reinvestment Rate = 812/1414
=57.42%
Expected Growth in EBIT (1-t).70*.1993=.114413.99%
Stable Growthg = 3.41%; Beta = 1.00;Debt Ratio= 30%Cost of capital = 6.27% ROC= 6.27%; Tax rate=35%Reinvestment Rate=54.38%
Terminal Value10= 1898/(.0627-.0341) = 66367
Cost of Equity10.57%
Cost of Debt(3.41%+1.00%)(1-.3654)= 2.80%
WeightsE = 70% D = 30%
Cost of Capital (WACC) = 10.57% (0.70) + 2.80% (0.30) = 8.24%
Op. Assets 38045+ Cash: 3,018- Debt 558- Pension Lian 305- Minor. Int. 55=Equity 40157-Options 180Value/Share 126.51
Riskfree Rate:Euro riskfree rate = 3.41% +
Beta 1.59 X
Risk Premium4.50%
Unlevered Beta for Sectors: 1.25
Mature riskpremium4%
Country Equity Prem0.5%
SAP: Restructured Reinvestment Rate70%
Return on Capital19.93%
Term Yr6402416122631898
Avg Reinvestment rate = 36.94%
On May 5, 2005, SAP was trading at 122 Euros/share
First 5 yearsGrowth decreases gradually to 3.41%
Year 1 2 3 4 5 6 7 8 9 10EBIT 2,543 2,898 3,304 3,766 4,293 4,802 5,271 5,673 5,987 6,191EBIT(1-t) 1,614 1,839 2,097 2,390 2,724 3,047 3,345 3,600 3,799 3,929 - Reinvest 1,130 1,288 1,468 1,673 1,907 2,011 2,074 2,089 2,052 1,965 = FCFF 484 552 629 717 817 1,036 1,271 1,512 1,747 1,963
Reinvest more in Reinvest more in emerging marketsemerging markets
Use more debt financing.Use more debt financing.
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Current Cashflow to FirmEBIT(1-t) : 163- Nt CpX 39 - Chg WC 4= FCFF 120Reinvestment Rate = 43/163
=26.46%
Expected Growth in EBIT (1-t).2645*.0406=.01071.07%
Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%
Terminal Value5= 104/(.0676-.03) = 2714
Cost of Equity8.50%
Cost of Debt(4.10%+2%)(1-.35)= 3.97%
WeightsE = 48.6% D = 51.4%
Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%
Op. Assets 2,472+ Cash: 330- Debt 1847=Equity 955-Options 0Value/Share $ 5.13
Riskfree Rate:Riskfree rate = 4.10% +
Beta 1.10 X
Risk Premium4%
Unlevered Beta for Sectors: 0.80
Firmʼs D/ERatio: 21.35%
Mature riskpremium4%
Country Equity Prem0%
Blockbuster: Status Quo Reinvestment Rate 26.46%
Return on Capital4.06%
Term Yr184 82102
1 2 3 4 5EBIT (1-t) $165 $167 $169 $173 $178 - Reinvestment $44 $44 $51 $64 $79 FCFF $121 $123 $118 $109 $99
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Current Cashflow to FirmEBIT(1-t) : 249- Nt CpX 39 - Chg WC 4= FCFF 206Reinvestment Rate = 43/249
=17.32%
Expected Growth in EBIT (1-t).1732*.0620=.01071.07%
Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%
Terminal Value5= 156/(.0676-.03) = 4145
Cost of Equity8.50%
Cost of Debt(4.10%+2%)(1-.35)= 3.97%
WeightsE = 48.6% D = 51.4%
Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%
Op. Assets 3,840+ Cash: 330- Debt 1847=Equity 2323-Options 0Value/Share $ 12.47
Riskfree Rate:Riskfree rate = 4.10% +
Beta 1.10 X
Risk Premium4%
Unlevered Beta for Sectors: 0.80
Firmʼs D/ERatio: 21.35%
Mature riskpremium4%
Country Equity Prem0%
Blockbuster: Restructured Reinvestment Rate 17.32%
Return on Capital6.20%
Term Yr280124156
1 2 3 4 5EBIT (1-t) $252 $255 $258 $264 $272 - Reinvestment $44 $44 $59 $89 $121 FCFF $208 $211 $200 $176 $151
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TheExpectedValueofControl
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The Value of ControlProbability that you can change the management of the firm
Change in firm value from changingmanagementX
Takeover Restrictions
Voting Rules & Rights
Access to Funds
Size of company
Value of the firm run optimally
Value of the firm run status quo-
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Whytheprobabilityofmanagementchangingshiftsovertime….
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¨ Corporategovernancerulescanchangeovertime,asnewlawsarepassed.Ifthechangegivesstockholdersmorepower,thelikelihoodofmanagementchangingwillincrease.
¨ Activistinvestingebbsandflowswithmarketmovements(activistinvestorsaremorevisibleindownmarkets)andofteninresponsetoscandals.
¨ Eventssuchashostileacquisitionscanmakeinvestorsreassessthelikelihoodofchangebyremindingthemofthepowerthattheydopossess.
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EstimatingtheProbabilityofChange
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¨ Youcanestimatetheprobabilityofmanagementchangesbyusinghistoricaldata(oncompanieswherechangehasoccurred)andstatisticaltechniquessuchasprobits orlogits.
¨ Empirically,thefollowingseemtoberelatedtotheprobabilityofmanagementchange:¤ Stockpriceandearningsperformance,withforcedturnovermorelikelyinfirms
thathaveperformedpoorlyrelativetotheirpeergroupandtoexpectations.¤ Structureoftheboard,withforcedCEOchangesmorelikelytooccurwhenthe
boardissmall,iscomposedofoutsidersandwhentheCEOisnotalsothechairmanoftheboardofdirectors.
¤ Ownershipstructure,sinceforcedCEOchangesaremorecommonincompanieswithhighinstitutionalandlowinsiderholdings.Theyalsoseemtooccurmorefrequentlyinfirmsthataremoredependentuponequitymarketsfornewcapital.
¤ Industrystructure,withCEOsmorelikelytobereplacedincompetitiveindustries.
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ManifestationsoftheValueofControl
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¨ Hostileacquisitions:Inhostileacquisitionswhicharemotivatedbycontrol,thecontrolpremiumshouldreflectthechangeinvaluethatwillcomefromchangingmanagement.
¨ Valuingpubliclytradedfirms:Themarketpriceforeverypubliclytradedfirmshouldincorporateanexpectedvalueofcontrol,asafunctionofthevalueofcontrolandtheprobabilityofcontrolchanging.¤ Marketvalue=Statusquovalue+(Optimalvalue– Statusquovalue)*
Probabilityofmanagementchanging¨ Votingandnon-votingshares:Thepremium(ifany)thatyouwould
payforavotingshareshouldincreasewiththeexpectedvalueofcontrol.
¨ MinorityDiscountsinprivatecompanies:Theminoritydiscount(attachedtobuyinglessthanacontrollingstake)inaprivatebusinessshouldbeincreasewiththeexpectedvalueofcontrol.
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1.HostileAcquisition:Example
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¨ Inahostileacquisition,youcanensuremanagementchangeafteryoutakeoverthefirm.Consequently,youwouldbewillingtopayuptotheoptimalvalue.
¨ Asanexample,Blockbusterwastradingat$9.50pershareinJuly2005.Theoptimalvaluepersharethatweestimatedas$12.47pershare.Assumingthatthisisareasonableestimate,youwouldbewillingtopayupto$2.97asapremiuminacquiringtheshares.
¨ Issuestoponder:¤ Wouldyouautomaticallypay$2.97asapremiumpershare?Whyorwhynot?
¤ Whatwouldyourpremiumpersharebeifchangewilltakethreeyearstoimplement?
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2.MarketpricesofPubliclyTradedCompanies:Anexample
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¨ Themarketpricepershareatthetimeofthevaluation(May2005)wasroughly$9.50.¤ Expectedvaluepershare=StatusQuoValue+Probabilityofcontrol
changing*(OptimalValue– StatusQuoValue)¤ $9.50=$5.13+Probabilityofcontrolchanging($12.47- $5.13)
¨ Themarketisattachingaprobabilityof59.5%thatmanagementpoliciescanbechanged.ThiswasafterIcahn’ssuccessfulchallengeofmanagement.Priortohisarriving,themarketpricepersharewas$8.20,yieldingaprobabilityofonly41.8%ofmanagementchanging.
Value of Equity Value per s hare
Status Quo $ 955 million $ 5.13 per share
Optimally mana ged $2,323 million $12.47 per share
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Valueofstockinapubliclytradedfirm
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¨ Whenafirmisbadlymanaged,themarketstillassessestheprobabilitythatitwillberunbetterinthefutureandattachesavalueofcontroltothestockpricetoday:
¨ Withvotingsharesandnon-votingshares,adisproportionateshareofthevalueofcontrolwillgotothevotingshares.Intheextremescenariowherenon-votingsharesarecompletelyunprotected:€
Value per share = Status Quo Value + Probability of control change (Optimal - Status Quo Value)Number of shares outstanding
€
Value per non - voting share = Status Quo Value # Voting Shares + # Non - voting shares
€
Value per voting share = Value of non - voting share + Probability of control change (Optimal - Status Quo Value)# Voting Shares
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3.VotingandNon-votingShares:AnExample
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¨ Tovaluevotingandnon-votingshares,wewillconsiderEmbraer,theBrazilianaerospacecompany.AsistypicalofmostBraziliancompanies,thecompanyhascommon(voting)sharesandpreferred(non-votingshares).¤ StatusQuoValue=12.5billion$Rfortheequity;¤ OptimalValue=14.7billion$R,assumingthatthefirmwouldbemoreaggressivebothinits
useofdebtandinitsreinvestmentpolicy.
¨ Thereare242.5millionvotingsharesand476.7non-votingsharesinthecompanyandtheprobabilityofmanagementchangeisrelativelylow.Assumingaprobabilityof20%thatmanagementwillchange,weestimatedthevaluepernon-votingandvotingshare:¤ Valuepernon-votingshare=StatusQuoValue/(#votingshares+#non-votingshares)=
12,500/(242.5+476.7)=17.38$R/share¤ Valuepervotingshare=StatusQuovalue/sh+Probabilityofmanagementchange*(Optimal
value– StatusQuoValue)=17.38+0.2*(14,700-12,500)/242.5=19.19$R/share
¨ Withourassumptions,thevotingsharesshouldtradeatapremiumof10.4%overthenon-votingshares.
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4.MinorityDiscount:Anexample
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¨ AssumethatyouarevaluingKristinKandy,aprivatelyownedcandybusinessforsaleinaprivatetransaction.Youhaveestimatedavalueof$1.6millionfortheequityinthisfirm,assumingthattheexistingmanagementofthefirmcontinuesintothefutureandavalueof$2millionfortheequitywithnewandmorecreativemanagementinplace.¤ Valueof51%ofthefirm=51%ofoptimalvalue=0.51*$2million=
$1.02million¤ Valueof49%ofthefirm=49%ofstatusquovalue=0.49*$1.6million
=$784,000¨ Notethata2%differenceinownershiptranslatesintoalarge
differenceinvaluebecauseonestakeensurescontrolandtheotherdoesnot.
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AlternativeApproachestoValueEnhancement
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¨ Maximizeavariablethatiscorrelatedwiththevalueofthefirm.Thereareseveralchoicesforsuchavariable.Itcouldbe¤ anaccountingvariable,suchasearningsorreturnoninvestment¤ amarketingvariable,suchasmarketshare¤ acashflowvariable,suchascashflowreturnoninvestment(CFROI)¤ arisk-adjustedcashflowvariable,suchasEconomicValueAdded(EVA)
¨ Theadvantagesofusingthesevariablesarethatthey¤ AreoftensimplerandeasiertousethanDCFvalue.
¨ Thedisadvantageisthatthe¤ Simplicitycomesatacost;thesevariablesarenotperfectlycorrelated
withDCFvalue.
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EconomicValueAdded(EVA)andCFROI
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¨ TheEconomicValueAdded(EVA)isameasureofsurplusvaluecreatedonaninvestment.¤ Definethereturnoncapital(ROC)tobethe“true” cashflowreturnoncapitalearnedonaninvestment.
¤ Definethecostofcapitalastheweightedaverageofthecostsofthedifferentfinancinginstrumentsusedtofinancetheinvestment.
¤ EVA=(ReturnonCapital- CostofCapital)(CapitalInvestedinProject)
¨ TheCFROIisameasureofthecashflowreturnmadeoncapital¤ ItiscomputedasanIRR,baseduponabasevalueofcapitalinvestedandthecashflowonthatcapital.
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Thebottomline…
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¨ Thevalueofafirmisnotgoingtochangejustbecauseyouuseadifferentmetricforvalue.Allapproachesthatarediscountedcashflowapproachesshouldyieldthesamevalueforabusiness,iftheymakeconsistentassumptions.
¨ Iftherearedifferencesinvaluefromusingdifferentapproaches,theymustbeattributabletodifferencesinassumptions,eitherexplicitorimplicit,behindthevaluation.
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ASimpleIllustration
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¨ Assumethatyouhaveafirmwithabookvaluevalueofcapitalof$100million,onwhichitexpectstogenerateareturnoncapitalof15%inperpetuitywithacostofcapitalof10%.
¨ Thisfirmisexpectedtomakeadditionalinvestmentsof$10millionatthebeginningofeachyearforthenext5years.Theseinvestmentsarealsoexpectedtogenerate15%asreturnoncapitalinperpetuity,withacostofcapitalof10%.
¨ Afteryear5,assumethat¤ Theearningswillgrow5%ayearinperpetuity.¤ Thefirmwillkeepreinvestingbackintothebusinessbutthereturnon
capitalonthesenewinvestmentswillbeequaltothecostofcapital(10%).
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FirmValueusingEVAApproach
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CapitalInvestedinAssetsinPlace = $100EVAfromAssetsinPlace=(.15– .10)(100)/.10 = $50
+PVofEVAfromNewInvestmentsinYear1=[(.15-– .10)(10)/.10] = $5
+PVofEVAfromNewInvestmentsinYear2=[(.15-– .10)(10)/.10]/1.1= $4.55+PVofEVAfromNewInvestmentsinYear3=[(.15-– .10)(10)/.10]/1.12= $4.13
+PVofEVAfromNewInvestmentsinYear4=[(.15-– .10)(10)/.10]/1.13= $3.76+PVofEVAfromNewInvestmentsinYear5=[(.15-– .10)(10)/.10]/1.14= $3.42
ValueofFirm = $170.85
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FirmValueusingDCFValuation:EstimatingFCFF
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BaseY ear
1 2 3 4 5 Term.Y ear
EBIT (1-t) : Assets in Place $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00
EBIT(1-t) :Investments- Yr 1 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50
EBIT(1-t) :Investments- Yr 2 $ 1.50 $ 1.50 $ 1.50 $ 1.50
EBIT(1-t): Investments -Yr 3 $ 1.50 $ 1.50 $ 1.50
EBIT(1-t): Investments -Yr 4 $ 1.50 $ 1.50
EBIT(1-t): Investments- Yr 5 $ 1.50
Total EBIT(1-t) $ 16.50 $ 18.00 $ 19.50 $ 21.00 $ 22.50 $ 23.63
- Net Capital Expenditures $10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 11.25 $ 11.81
FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81
After year 5, the reinvestment rate is 50% = g/ ROC
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FirmValue:PresentValueofFCFF
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Year 0 1 2 3 4 5 Term Year
FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81
PV of FCFF ($10) $ 5.91 $ 6.61 $ 7.14 $ 7.51 $ 6.99
Terminal Value $ 236.25
PV of Terminal Value $ 146.69
Value of Firm $170.85
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Implications
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¨ Growth,byitself,doesnotcreatevalue.Itisgrowth,withinvestmentinexcessreturnprojects,thatcreatesvalue.¤ Thegrowthof5%ayearafteryear5createsnoadditionalvalue.
¨ The“marketvalueadded” (MVA),whichisdefinedtobetheexcessofmarketvalueovercapitalinvestedisafunctionofttheexcessvaluecreated.¤ Intheexampleabove,themarketvalueof$170.85millionexceedsthebookvalueof$100million,becausethereturnoncapitalis5%higherthanthecostofcapital.
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Year-by-yearEVAChanges
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¨ Firmsareoftenevaluatedbaseduponyear-to-yearchangesinEVAratherthanthepresentvalueofEVAovertime.
¨ Theadvantageofthiscomparisonisthatitissimpleanddoesnotrequirethemakingofforecastsaboutfutureearningspotential.
¨ Anotheradvantageisthatitcanbebrokendownbyanyunit-person,divisionetc.,aslongasoneiswillingtoassigncapitalandallocateearningsacrossthesesameunits.
¨ WhileitissimplerthanDCFvaluation,usingyear-by-yearEVAchangescomesatacost.Inparticular,itisentirelypossiblethatafirmwhichfocusesonincreasingEVAonayear-to-yearbasismayendupbeinglessvaluable.
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Gamingthesystem:DeliveringhighcurrentEVAwhiledestroyingvalue…
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¨ TheGrowthtradeoffgame:ManagersmaygiveupvaluablegrowthopportunitiesinthefuturetodeliverhigherEVAinthecurrentyear.
¨ TheRiskgame:ManagersmaybeabletodeliverahigherdollarEVAbutinriskierbusinesses.ThevalueofthebusinessisthepresentvalueofEVAovertimeandtheriskeffectmaydominatetheincreasedEVA.
¨ TheCapitalInvestedgame:ThekeytodeliveringpositiveEVAistomakeinvestmentsthatdonotshowupaspartofcapitalinvested.Thatway,youroperatingincomewillincreasewhilecapitalinvestedwilldecrease.
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DeliveringahighEVAmaynottranslateintohigherstockprices…
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¨ TherelationshipbetweenEVAandMarketValueChangesismorecomplicatedthantheonebetweenEVAandFirmValue.
¨ ThemarketvalueofafirmreflectsnotonlytheExpectedEVAofAssetsinPlacebutalsotheExpectedEVAfromFutureProjects
¨ TotheextentthattheactualeconomicvalueaddedissmallerthantheexpectedEVAthemarketvaluecandecreaseeventhoughtheEVAishigher.
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Whenfocusingonyear-to-yearEVAchangeshasleastsideeffects
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¨ 1.Mostoralloftheassetsofthefirmarealreadyinplace;i.e,verylittleornoneofthevalueofthefirmisexpectedtocomefromfuturegrowth.¤ ThisminimizestheriskthatincreasesincurrentEVAcomeatthe
expenseoffutureEVA¨ 2.Theleverageisstableandthecostofcapitalcannotbe
alteredeasilybytheinvestmentdecisionsmadebythefirm.¤ ThisminimizestheriskthatthehigherEVAisaccompaniedbyan
increaseinthecostofcapital¨ 3.Thefirmisinasectorwhereinvestorsanticipatelittleor
notsurplusreturns;i.e.,firmsinthissectorareexpectedtoearntheircostofcapital.¤ ThisminimizestheriskthattheincreaseinEVAislessthanwhatthe
marketexpectedittobe,leadingtoadropinthemarketprice.
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TheBottomline…
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¨ Valuecreationishardwork.Therearenoshortcuts.¨ Investmentbanks/Consultants/Expertswhoclaimtohaveshortcutsandmetricsthatallowforeasyvaluecreationareholdingbackonhardtruths.
¨ Valuecreationdoesnothappeninfinancedepartmentsofbusinesses.Everyemployeehasaroletoplay.