Real Options and Long-Term Financing I

1. Real Options and Long-Term Financing I C15.0008 Corporate Finance Topics Summer 2006

2. Outline • Valuing real options • Equity, debt and preferred stock • Raising capital

3. Valuing Real Options Why not value real options using a DCF approach (i.e., decision trees)? • In principle, a DCF approach will work • In practice, the discount rate may be a problem. The required return on the option is generally not the same as the required return on the underlying asset (project). Solution:  Use a binomial approach

4. Example: Product Introduction Underlying project: 0DemandProb.123... -100 High 1/3 24 24 24... Low 2/3 1.5 1.5 1.5... Abandonment option: project can be abandoned at time 1 and the equipment salvaged for 19.5 Expansion option: a second factory can be built at time 1 that will also operate at full capacity if demand is high 0DemandProb.123... High 1/3 -100 24 24...

5. The Option to Abandon • The abandonment option is a put option where the underlying asset is an operating bowling ball factory and the exercise price is the salvage value, i.e., it is the right to sell (salvage) the factory and receive the salvage value. • Conceptually it is a quasi-American option, i.e., it can be exercised starting in 1 year and at any time thereafter. If exercised at all, will the option be exercised immediately? How would you handle a salvage value that varies over time?

6. Inputs • exercise price = salvage valueE = 19.5 • underlying asset = operating factoryvalue (time 0) = PV(expected cash flows)0123... 9 9 9…S = 9/0.1 = 90 • t = 1, rf = 2%

7. The Option to Expand • The expansion option is a call option where the underlying asset is a new (second) operating bowling ball factory and the exercise price is the initial investment required, i.e., it is the right to buy (build) the factory and receive the resulting future cash flows. • Conceptually it is a quasi-American option, i.e., it can be exercised starting in 1 year and at any time thereafter. If exercised at all, will the option be exercised immediately?

8. Inputs • exercise price = initial investment E = 100 • underlying asset = operating factory (built at time 1)value (time 0) = PV(expected cash flows)0123... 9 9…S = (9/0.1)/1.1 = 90/1.1 = 81.82Assumption: the second factory looks just like the first • T = 1, rf = 2%,  = 130%

9. 0 24 24 24… 264 P 90 90 4.5 1.5 1.5 1.5… 16.5 240 15 The Option to Abandon E=19.5

10. Option Value rf = 2%  H = -0.018, B = -4.71, P = 3.07 Note: replicate with the cum-dividend values of the underlying asset, calculate the put payoff based on the ex-dividend values

11. 140 C 0 The Option to Expand E=100 0 24 24… 81.82 0 1.5 1.5… 240 81.82 15

12. Option Value rf = 2%  H = 0.622, B = 9.15, C = 41.76

13. Project Value base abandon expand total DCF -10 2.73 42.42 35.15 binomial -10 3.07 41.76 34.83 Note: • DCF uses the wrong discount rate

14. When is There a Real Option? • There has to be a clearly defined underlying asset whose value changes over time in a predictable way • The payoffs on this asset have to be contingent on a specific observable event, i.e, there has to be a resolution of uncertainty about the value of the asset

15. When Does the Option Have Value? • For an option to have significant economic value, there has to be a restriction on competition in the event of the contingency (in a perfectly competitive market, no option generates positive NPVs) • Real options are most valuable when there is exclusivity

16. The Importance of Financing • Given a financing structure, the costs and relative weights of the various sources of financing determine the opportunity cost of capital, i.e., the discount rate, .e.g, WACC • The goal of the firm is to optimize this financing structure in order to maximize the value of the firm, i.e., to minimize the cost of capital—this is the capital structure decision • The upfront costs of raising capital may also be important for maximizing firm value

17. Sources of Long-Term Financing • Equity/common stock • Debt • Preferred stock • Leasing • Warrants • Convertible debt and convertible preferred stock

19. Characteristics of Equity Common shareholders have control rights • Elect the Board of Directors • Vote on major decisions (e.g., takeovers) Variations • One share, one vote • Dual class equity (super-voting shares) Common shareholders have cash flow rights • Share proportionally in dividends • Residual claimant in liquidation

20. Characteristics of Dividends Dividends are • Paid at the discretion of the Board (i.e., not a contractual obligation) • Not deductible at the corporate level for tax purposes • Taxable at a lower rate than ordinary income for an individual and partially or fully non-taxable for corporations

21. Some terms • Authorized vs Common • Cumulative, Straight and Proxy Voting • Market value = (price)  (# of shares) • Book value = assets - liabilities • Ratio: B/M, i.e., book-to-market (or market-to-book)

22. Characteristics of Debt • A contractual obligation to make/receive a pre-specified set of payments (interest and principal) • No ownership rights • No control rights

24. Debt Covenants The debt contract (bond indenture) often contains provisions restricting the actions of the debtor (firm) • Amount and seniority of additional debt • Dividend payments • Assets sales • Financial ratios (technical default triggers)

25. Interest Payments • Deductible as an expense at the corporate level (for tax purposes) • Taxable to the recipient as ordinary income • Failure to pay triggers default

26. Debt Features • Maturity • Sinking funds • Callability • Convertibility • Fixed or floating rate • Priority/seniority • Security/collateralization • Rating

27. Preferred Stock • A kind of equity • “Preference” over common stock in terms of dividend payment and bankruptcy • Stated Value • Cumulative/non-cumulative dividends • Tax Code quirks, regulation for utilities, bankruptcy avoidance

28. Preferred Stock Combines the features of debt and equity • Like equity • Dividend payments non-deductible • Missed payment does not trigger bankruptcy • Perpetual • Like debt • Pays a fixed dividend • No voting rights • Sinking funds, callability, convertibility

29. Costs of Raising Capital • Direct costs, .e.g., underwriter fees, legal costs • Indirect costs • Underpricing, i.e., selling a security for less that its “value” • Signaling, i.e., the effect of the announcement of a security offering on the price of existing securities

30. Costs of Debt vs. Equity Capital The costs of raising new debt capital are small relative to outside equity (not retained earnings) capital • Low direct costs • No significant announcement effects • No underpricing

31. Financing Implications The pecking order theory suggests that financing sources are used in the following order: (1) retained earnings (internal cash flow) (2) debt (3) external equity What increases as we go from (1) to (3)?

32. Financing Implications When financing needs are unpredictable, firms • Retain more earnings to fund possible future projects without resorting to external financing • Maintain excess debt capacity to avoid expensive equity issuances

33. Assignments • Reading • RWJ: Chapter 19, 24 • Problems: 19.6, 19.8, 24.3, 24.9 • Group formation