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Chapter 11

Chapter 11. APPLICATION OF REAL OPTION TECHNIQUES TO CAPITAL BUDGETING AND CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin. Do Managers Use Real Option Techniques?. Some do. Merck & Co. Hoffman-La Roche Texaco BP Amoco Anadarko Petroleum New England Electric

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Chapter 11

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  1. Chapter 11 APPLICATION OF REAL OPTION TECHNIQUES TO CAPITAL BUDGETING AND CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin

  2. Do Managers Use Real Option Techniques? • Some do. • Merck & Co. • Hoffman-La Roche • Texaco • BP Amoco • Anadarko Petroleum • New England Electric • Intel • Toshiba • Most don't. • 2000 and 2002 surveys of management techniques. • real options ranked 24/25. • 32% of real-options users abandoned the technique.

  3. Roundtable on Real OptionsExample: Sun Microsystems • 2000 Roundtable included CFO of Sun Microsystems. • Sun did not use real option techniques, but CFO indicated the firm was ready to learn. • A year later, CFO indicated that real options might have rationalized bubble prices, but offered no value to the firm.

  4. Example:A Levered Firm • Trees show value of cash flows to debt and equity. • Sum is value of firm. • Bottom node at Year 4 shows impact of default, when value of firm less than value of interest and principal. • Traced back to Year 0.

  5. Implied Put Option Risk neutral probability of up move = Risk free rate – Down Return .05 – (-.04) --------------------------------------- = ----------------- = .1667 Up return – Down return .5 – (-.04)

  6. Small New Project • Value of firm = 95. • New project • increases cash flow in Year 4 by 20 if up • decreases cash flow in Year 4 by 1.8 if down • requires a Year 3 investment of 1.75 • discount rate of 352% • NPV < 0, but close to 0. • Is probability of default affected? • No, it's still 0.

  7. Large New Project • Value of firm = 95. • New project • increases cash flow in Year 4 by 200 if up • decreases cash flow in Year 4 by 18 if down • requires a Year 3 investment of 17.5 • discount rate of 352% • NPV < 0, but close to 0. • Is probability of default affected? • Yes.

  8. Asset Substitution • If larger new project adopted, and down move occurs at Year 4, firm's value declines $9.45 million below debt obligation. • Implied put option increases by $9.45 at Year 4. • Value of put option at Year 3 is 7.5 = 0.833 x 9.45 / 1.05 where 0.833 = 1 – 0.1667. • Managers increase shareholder value, decrease value of debt, by adopting new larger project.

  9. Debt Overhang • Value of firm = 61 < debt obligation 68.25. • New project • increases cash flow in Year 4 by 20 if up • decreases cash flow in Year 4 by 1.8 if down • requires a Year 3 investment of 1.75 • discount rate of 352% • NPV < 0, but close to 0. • Value of put option increases. • Project adopted.

  10. Capital Structure • Debtholders anticipate possibility of asset substitution and debt overhang. • They respond by increasing the cost of debt. • Firms' managers choose to hold less debt than is optimal. • Value of firms' equity less as a result, due to foregone tax shields.

  11. Overconfidence andAsset Substitution • Value of firm = 96. • New project: overconfident beliefs vs. actual • increases up cash flow in Year 4 by 20 vs. 63 • decreases down cash flow in Year 4 by 1.8 vs. 12.6 • requires a Year 3 investment of 1.75 • NPV < 0 not affected by overconfidence. • Overconfident managers reject project, rational managers adopt project.

  12. Unbiased Decision Task • Investment policy obtained by exercising when value of exercising exceeds value of holding. • Optimal investment policy is to wait for an up-move before exercising.

  13. Excessive Optimism • Excessively optimistic managers underweight the value of waiting, and exercise in circumstances less favorable than is optimal. • In this example, managers exercise (invest) immediately.

  14. Biased Backdrop • Excessive optimism and overconfidence induce managers to • overestimate project NPV • overestimate tax shield benefits from debt • underestimate the costs associated with financial distress • These biases increase the tendency to be overleveraged. • Agency conflicts operate in the other direction.

  15. Behavioral Biases Counter Agency Conflicts • Once a debt contract is in place, investment policy can impact the value of the implicit put. • Shareholders and debtholders share the value of a positive NPV project, but the shares need not be positive amounts. • Agency conflicts increase the cost of debt. • Mild excessive optimism and overconfidence induce managers to behave more favorably towards debtholders, thereby leading to increased leverage.

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