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Firm Valuations and Real Options

Firm Valuations and Real Options. The Shutdown Decision in Chapter 11. The Shutdown Decision in Chapter 11. A firm enters Chapter 11 as an operating business At one or more points, someone asks the judge to pull the plug How should the judge approach this question?.

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Firm Valuations and Real Options

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  1. Firm Valuations and Real Options The Shutdown Decision in Chapter 11

  2. The Shutdown Decision in Chapter 11 • A firm enters Chapter 11 as an operating business • At one or more points, someone asks the judge to pull the plug • How should the judge approach this question? NCBJ: Baird, Morrison & Picker

  3. The Shutdown Decision in Chapter 11 • Timing is everything • Shut down the firm too soon, and a viable business is lost forever • Wait too long, and you have made a bad situation worse NCBJ: Baird, Morrison & Picker

  4. The Shutdown Decision in Chapter 11 • Judges must make the right decision at the right time • The judge is exercising what economists call a “real option” • This “real options” idea should be incorporated into net present value calculations • It provides a powerful intuition for analyzing many issues in Chapter 11 NCBJ: Baird, Morrison & Picker

  5. Measuring Present Value • Casual net present value calculations assume that you have to make an up-or-down decision today • The ability to wait itself affects the net present value calculations in Chapter 11 and elsewhere NCBJ: Baird, Morrison & Picker

  6. “and we do well, we are worth $250.” “and we do poorly, we are worth $80.” 10% 90% Hypo Debtor Firm Creditors $100 “If we operate …” “We can sell the assets for $100.” NCBJ: Baird, Morrison & Picker

  7. Operating the Firm Liquidate 10% x $250 = $25 90% x $80 = $72 Expected Total = $97 Present Value = $97/1.1 = $88 $100 Should We Liquidate the Firm? • “Casual” Net Present Value Calculation • Assume 10% Interest Rate NCBJ: Baird, Morrison & Picker

  8. Wrong! Ignores Choices and Benefits of More Info • Try a Different Approach • Key Assumption: After operating one period, firm can still be liquidated for $100 • Operating does not reduce liquidation value • Think of perhaps real estate or intellectual property NCBJ: Baird, Morrison & Picker

  9. If bad operations, liquidate instead Operating One Period Liquidate Succeeds: 10% x $250 = $25 Fails: 90% x $100 = $90 Expected Total = $115 Present Value = $115/1.1 = $105 $100 Better NPV Calculation NCBJ: Baird, Morrison & Picker

  10. Controlling Timing v. Now-or-Never Decisions • The Now-or-Never Decision • Liquidate Now with NPV of $100 • The Value of a One-Period Option to Wait • $4.54 • By operating the firm for one period, we increase PV by $4.54 • We gain info, and learn whether the firm can succeed NCBJ: Baird, Morrison & Picker

  11. From The Paper • “Some firms should be kept intact even though the expected earnings of the firm over time are less than the cash that can be realized from the piecemeal sale of its assets today.” NCBJ: Baird, Morrison & Picker

  12. Core Idea • “Sample” operations to try to grab the high end of the distribution and, if not, exit to liquidation • Sampling requires waiting • Waiting is costly, even when the assets don’t decline in value • But uncertainty makes some waiting desirable NCBJ: Baird, Morrison & Picker

  13. Searching for the Perfect Cup of Coffee Store B Store C Store A Store D We know, but X doesn’t know, that the coffee is worth at A: $10, B: $9, C: $8, D: $7 Price for Coffee: $6 X knows distribution of values It costs X $1 to visit a store Return to store for free NCBJ: Baird, Morrison & Picker

  14. What Should X Do? • X should go to at least one store • Worst outcome is find coffee worth $7 • Pay $6 for coffee + $1 for search and break even • 3 of 4 times find coffee worth 8, 9 or 10 and do better than that NCBJ: Baird, Morrison & Picker

  15. When Should X Stop? • X finds A in 1st Search • Suppose X stumbles on to A in her first search and finds coffee worth $10 • X cannot do better than A • She should should stop, pay $6, plus $1 search cost, and be $3 to the good NCBJ: Baird, Morrison & Picker

  16. Suppose X finds B in 1st Search • X has coffee worth $9 in hand • X could only do better by finding store A, with coffee worth $10 • She would have to pay $1 to look again, and could gain only $1, and 2/3 of the time she will not find A on her next search • X should stop if she finds B in her first search NCBJ: Baird, Morrison & Picker

  17. Suppose X finds C in 1st Search • X has coffee worth $8 in hand • X could only do better by finding store A or B, with coffee worth $10 or $9 • The cost of another search is $1 • The expected gain is (1/3) x $2 + (1/3) x $1 + (1/3) x $0 = $1 • She is indifferent between searching and not searching? NCBJ: Baird, Morrison & Picker

  18. Wrong! • After we find D on the second search, we know where A and B are and have the option to search again. • Once we know C and D, the expected gain from searching is (1/2) x 2 + (1/2) x 1 = 1.5 • The cost is 1, so the expected net gain from the search is 0.5 • So our calculation for C is (1/3) x $2 + (1/3) x $1 + (1/3) x $0.50 = 1.16 against a cost of $1, so we should search again if we find C on the first search NCBJ: Baird, Morrison & Picker

  19. Suppose X find D in 1st Search • X has coffee worth $7 in hand • X knows she will do better by going to another store. • The cost of another search is $1 • The expected gain is (1/3) x $3 + (1/3) x $2 + (1/3) x $??? > $1 • X should should look again if she finds D NCBJ: Baird, Morrison & Picker

  20. Search Rule So Far • Undertake first search • If find A or B, stop • If find C or D, search again NCBJ: Baird, Morrison & Picker

  21. The Rest of the Search Rule • After Finding C or D in First Search, in Second Search • If X finds A or B, stop. • If X finds C or D, expected gain from further search is (1/2) x 2 + (1/2) x 1 or 1.5, so search again • After Finding C or D in Second Search, after Third Search • Stop NCBJ: Baird, Morrison & Picker

  22. Tying this to Bankruptcy and Shutdown Decisions • The bankruptcy judge is presented with a proposed disposition of the assets of the estate • What is the likely distribution of better proposals? • What is the cost of considering each proposal? • When should the judge stop considering proposals? NCBJ: Baird, Morrison & Picker

  23. Pricing the Option to Wait • We wait to learn; if we are certain, there is nothing to learn, and no reason to wait • The more uncertainty—the more volatility—associated with the operations of the firm, the more valuable it is to wait • The Black-Scholes Option Pricing Formula gives us a formal way to value real options • But we don’t have the same amount of information that exists for financial options NCBJ: Baird, Morrison & Picker

  24. Real Options in Chapter 11 • What is the use of real options, given this absence of information? • We become more cautious about simple NPV valuations • We have a different benchmark by which to look at the shutdown decision NCBJ: Baird, Morrison & Picker

  25. Real Options in Chapter 11 • How long should a bankruptcy judge take to decide whether to shut a firm down? • The “Morrison” Conjecture • Real options, when sensibly exercised, leave a distinct footprint • The shutdown decisions of good bankruptcy judges should follow the same pattern NCBJ: Baird, Morrison & Picker

  26. The Footprint of a Real Option • How long do you stay in a job before looking for something better? • At the start, you don’t know enough to stop • As you continue, you get more and more information • The job is bad and is not getting better • The job is great and other jobs are not going to be better NCBJ: Baird, Morrison & Picker

  27. The Footprint of a Real Option • It doesn’t make sense to quit until you have enough information • As time goes on, you know more and more • After a certain point, you know enough so that if you have not left already, you aren’t going to NCBJ: Baird, Morrison & Picker

  28. The Footprint of a Real Option • We can translate this idea to a graph • The number of people who quit their new jobs is low initially • It rises as they learn more • It then falls as the only people left are those who like the job. • The graph is hump-shaped • The middle of the “hump” is the average amount of time it takes to learn whether the job is right for you NCBJ: Baird, Morrison & Picker

  29. The Footprint of a Real Option • This pattern—this inverted U-shaped graph—can be observed empirically when real options are sensibly exercised • The “Morrison” Conjecture • We should find the same pattern in shutdown decisions • The “hump” in the graph should peak at 3 months NCBJ: Baird, Morrison & Picker

  30. Why Three Months? • In assessing a firm and its prospects, the bankruptcy judge gathering information in the same way as an auctioneer • Auctioneers of firms take about three months to orchestrate a sale • The reorganization regime in Sweden uses auctions and they take place in about 3 months on average • The Bankruptcy Code itself posits that a plan can be assembled with 120 days NCBJ: Baird, Morrison & Picker

  31. The “Morrison” Conjecture Probability of Shutdown Months in Chapter 11 5 10 15

  32. Reality Check • Survey of Chapter 11 in N.D. Ill. (Eastern Division) • Corporations • Operating at time of petition • Filing in calendar year 1998 NCBJ: Baird, Morrison & Picker

  33. The “Morrison” Conjecture Probability of Shutdown Months in Chapter 11 5 10 15

  34. The Baird-Morrison-Picker Conjecture Probability of Shutdown Months in Chapter 11 5 10 15

  35. Cumulative Shutdowns 100% Firms Shutdown 50% Months in Chapter 11 15 5 10

  36. The Real Options Approach to Chapter 11 • Standard critiques of Chapter 11 ask how long they take and how many succeed • The real options approach says that this is wrong • If the shutdown decision is made sensibly, the losers are dismissed quickly at low cost • The firms that remain in Chapter 11 after a few months are winners NCBJ: Baird, Morrison & Picker

  37. The Real Options Approach to Chapter 11 • A Chapter 11 regime in which only a few firms emerge intact may be good if shutdown decisions are made well • Failures are OK if they are quick • The time it takes matters less if chances of success are high NCBJ: Baird, Morrison & Picker

  38. Firms with Debt Over $1 Million NCBJ: Baird, Morrison & Picker

  39. Fate of Reorganized Firms NCBJ: Baird, Morrison & Picker

  40. Do Judges Use Stochastic Calculus? • How do bankruptcy judges actually make shutdown decisions? • The bankruptcy judge uses different rules of thumb • These are all different ways of asking, “Have I seen enough to know that this firm isn’t going to make it?” NCBJ: Baird, Morrison & Picker

  41. Rules of Thumb • 13 O’Clock Rule • Cash-Flow Rule • Three Strikes (Maybe Two) and You’re Out • Meeting Milestones • The Company You Keep NCBJ: Baird, Morrison & Picker

  42. What Firms Reorganize Successfully in Chapter 11? • There must be a sound core business. • A well-established firm that has experienced a one-time shock is likely to succeed. • New businesses and those that can’t meet new competition are not. NCBJ: Baird, Morrison & Picker

  43. Why couldn’t you reach a deal outside of Chapter 11? • A firm with only one large institutional creditor is less likely to succeed. • A firm with non-financial judgment creditors and tax collectors is. NCBJ: Baird, Morrison & Picker

  44. Filings (by firm type) NCBJ: Baird, Morrison & Picker

  45. Precipitating Event NCBJ: Baird, Morrison & Picker

  46. Real Options in Action • There are many different motions, brought by many different parties that implicate the shutdown decision. • But all of them raise the same set of questions NCBJ: Baird, Morrison & Picker

  47. Real Options in Action • Consider a standard scenario • The operating statement shows a negative cash flow for your debtor • The U.S. Trustee brings a motion to dismiss • What is the judge thinking as you start to make your argument? NCBJ: Baird, Morrison & Picker

  48. Real Options in Action • Viable businesses don’t keep losing money • If things don’t change, I have to grant this motion (or another one just like it) sooner or later • I don’t want to find myself here a month from now doing then what I can do now • Unless this guy can tell me what is going to change, I might as well grant the motion now NCBJ: Baird, Morrison & Picker

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