Final Exam #2

Weeks 5-11

Financial Tools to help analyse project risk 

• Sensitivity analysis 

• Break-even analysis 

• Simulation analysis 

Sensitivity Analysis 

How changes in input factors (like price, interest rates, or costs) affect the outcome (like profit, investment return, or system behavior).

1. Estimate NPV using optimistic variables

2. Estimate NPV using pessimistic variable

3. Calculate range

4. Repeat

Scenario Analysis  

• A specific form of sensitivity analysis  

• Imagine a scenario – for example when best (worst) values are simultaneously realised for all variables of interest 

• Compute the NPV under the imagined scenario 

Break-even Analysis 

Shows the point where a project or business neither makes a profit nor a loss—i.e., where NPV = 0. 

• Fixed costs / Selling price - Variable Cost

Simulation Analysis 

simulation changes many variables at once, using random values within realistic ranges

Decision Tree Analysis 

A visual way to map out choices, risks, and outcomes in uncertain situations

• Rectangle = decision point 

• Circle = denotes a probabilistic event where something will happen with some probability 

Benefits: 

• Makes you think beyond just “today”—you have to connect today’s decision with future choices.  

  Limitations: 

  • Can get very complex fast

  • Uncertainty with discount rates: By using the same discount rate (I.e. cost of equity) for everything, we’re assuming that all the cash flows have the same level of risk and that the risk doesn’t change over time. 

Payoff from a Call Option 

A call option is a contract that gives you the right (but not the obligation) to buy an asset (like a stock) at a set strike price before a certain date. 
→ You use a call when you think the price will go up. 

Payoff from a Put Option 

A put option is a contract that gives you the right (but not the obligation) to sell an asset at a set strike price before a certain date. 
→ You use a put when you think the price will go down. 

Motivation for Real Options 

Real options are choices a company has inside a real project — like the option to wait, expand, shrink, abandon, or change the project later, depending on how things turn out. 

• They are opportunities, not obligations (the company doesn’t have to act if it doesn’t want to). 

Standard NPV vs Real Option Analysis 

• Standard NPV analysis is static 
• Real option analysis is dynamic

Two issues with Real Options 

Identification 

• First, you have to spot if there are any real options hidden in the project. 

Valuation 

• After finding the options, you need to figure out how much they’re worth  

Four types of real options 

1. Option to delay making an investment (a timing option) 

2. Option to expand operations by making follow-up investments (a growth option) 

3. Option to abandon the project (an exit option) 

4. Option to vary the output or production methods (a flexibility option)  

Importance of Real Options 

Real Options Analysis (ROA) is more important when: 

• There is lots of uncertainty about the future (like prices, costs, demand, etc.). 

• Managers can change their decisions later based on new information

• Long-term

• Industry is fast-changing

Types of takeovers

Horizontal takeovers: Target and acquirer are in the same industry  

Vertical takeovers: Target’s industry buys from or sells to acquirer’s industry  

Conglomerate takeovers: Target and acquirer operate in unrelated industries

Friendly takeovers: approved by target’s management  

Hostile takeovers: not approved

Reverse takeovers: A private company acquires a public company 

Financing a Takeover / Stylised Facts

Cash bid: Pays cash to the target’s shareholders for their shares  

• Adv:  Certain and clearly understood by the target management and shareholders 

• Disadv:  Raising the necessary cash can be difficult for the bidder if the target is large, bidder’s debt rating will go down if it borrows more to fund  

Share bid ("script bid): Acquiring company proposes to exchange its own shares for the target’s shares

• Adv:  Avoids strain on the cash position of the bidder  

• Disadv:  Equity issue is an expensive way of raising capital  

Stylised Facts

• Takeovers happen in "waves"

• Takeover waves usually focus on just a few industries at a time. 

• When a takeover is announced: 

  • Shareholders of the target company usually gain

  • Shareholders of the acquiring company often lose a little

Reasons for Takeovers 

Sensible Reasons 

• Operating synergies (decrease cost, increase revenues) 

  -Economies of scales/scope

• Replace poor current target management 

• Market Power (big competitor means less competition)

• Tax Savings 

Dubious (hesitant) Reasons 

• Diversification: owning different kinds of businesses (shareholders can do this on their own - unnecessary, expensive)

• Managerial Motives (Empire-building, Overconfidence)

Valuation Techniques 

Market Capitalisation (Market Cap) 
– The value of a company’s equity (shares).

Enterprise Value (EV) 
– The total value of the whole company (both debt and equity).

Intrinsic valuation (DCF analysis): Estimates a firm’s intrinsic value that is determined by its fundamentals – cash flows, growth, and risk  

• Providing a benchmark to assess whether the takeover price is fair 

Forecast Period – Project cash flows for the next 5–10 years 

Terminal Value – Estimate the value of the business beyond the forecast period

Pros and Cons – DCF Method 

Relative valuation 

Comparable Companies Market Multiples Method 

Estimates a firm’s market value by comparing with similar publicly traded comparable companies, using certain ratios 

• Based on the idea that similar businesses should be worth similar amounts 

• Adv: common, convenient

• Disadv:

Comparable Transactions Method 

• Looks at past takeover deals for similar companies to estimate a target’s value. 

• shows the actual prices paid in real acquisitions

Economic Evaluation of Takeovers 

Synergy value is the extra value created when two companies merge

Acquisition premium is the extra amount paid above the target company’s value before the offer (usually based on its stock price). 

• A takeover only makes financial sense if the synergy value is greater than the premium paid. 

Paying with stock 

Fixed Shares: 

• The number of shares is fixed, but their value can change with the market.

Fixed Value: 

• The dollar amount is fixed, but the number of shares changes based on the buyer's share price before closing. 

Collars, Floors, and Ceilings 

• These are built-in protections in stock deals to avoid one side getting too much or too little if share prices change. 

EPS bootstrapping refers to where an acquirer buys a company with a low PRICE/EARNINGS RATIO through a STOCK SWAP in order to boost the post acquisition EARNINGS PER SHARE (EPS) of the newlyformed group and create a rise in the stock price.

Regulatory Issues in Takeovers 

Merger activity is influenced by local laws and regulations. 

Key Regulatory Areas to Consider: 

1. Anti-monopoly 

2. Foreign investment 

3. Employment protection 

4. Special industry protection 

5. State protection 

The ACCC (Australian Competition and Consumer Commission) monitors mergers to prevent reduced competition in markets or monopolies

Mergers that reshape markets or reduce competitive pressure may face regulatory challenges. 

Corporate Restructuring

Reorganizing the legal, ownership, operational, financial or other structures of a company for the purpose of making it more profitable, or better organized for its present needs  

 

Three distinct groups of activities: 
• Business (or operational) restructuring  

• Financial restructuring 
• Organizational restructuring 

Types of Restructuring 

Business (or operational) restructuring  

• Changes in the mix of assets owned by a firm or the lines of business (mergers, acquisitions, spin-offs, etc.)

Financial restructuring  

• Improvements in the capital structure and/or ownership/control of the firm  

• Leveraged transactions (LBO/MBOs) and debt restructuring  

Organizational restructuring 

• Significant changes in the organizational structure of the firm 

• Divisional redesign and employment downsizing  

Restructuring motivations: 

• Align shareholder and manager interests (solve agency problem) 

• Transfer assets to more efficient owners 

• Sharpen management focus when lacking diverse skillsets 

• Bad past acquisitions causing losses (negative synergy) 

• Breaking up firms can "unlock" hidden value, known as addressing the diversification discount

Business (or Operational) Restructuring 

Divestitures (Asset Sales) 

• Selling a business unit or asset to another company 

• Seller retains the funds but loses all control over the sold asset 

 

Spin-offs 

• A company splits off part of its business into a new, separate listed company 

• Existing shareholders get shares in the new company pro-rata (based on what they already own) 

• No cash/fund is received by the parent company 

Equity Carve-outs 

• Similar to a spin-off, but instead of giving shares to existing shareholders, the parent sells a portion of a subsidiary’s shares to the public (via IPO) 

• The parent company keeps a majority stake and receives cash (retains funds) from the sale 

• Ownership of shareholders are unaffected and they benefit from subsidiary

Financial Restructuring 

Leveraged Transactions (LBOs/MBOs) 

What is a Leveraged Transaction? 

• A small group of investors buys a company using mostly borrowed money (debt) and a small amount of their own (equity). The assets of the company being acquired, along with those of the acquiring company, are often used as collateral for the loans. 

• The company often goes private (temporarily). 

  Two types: 

• LBO (Leveraged Buyout) – led by private equity (PE) firms 

• MBO (Management Buyout) – led by existing management 

Debt Restructuring 

A company reorganizes its debt when it's struggling to make payments (i.e., in financial distress) → Debt settlement, Debt-for-equity swap, Modified debt terms (Lower interest, Extended repayment period)

• Goal: 

  • Help the company survive 

  • Avoid costly legal proceedings like bankruptcy 

  • Allow creditors to recover at least part of their money 

Overoptimism 

Overoptimism means overestimating the chances of good outcomes or underestimating bad ones. 

• Entrepreneurs often overestimate how successful they’ll be. 

Insolvency 

Stock-based insolvency: The company's total assets are worth less than its total debts. 

Flow-based insolvency: The company’s cash flow isn’t enough to make required payments on time. 

Investment Distortions When a Firm Is Close to Bankruptcy 

Excessive Risk-Taking (Asset Substitution) 

Debt Overhang (Underinvestment) 

Companies have several ways to manage distress, including: 

-Selling major assets to raise cash. 

-Merging with another company. 

-Issuing new shares or bonds. 

Liquidation vs. Reorganization 

When a firm can't pay its debts, it has two main choices: 

-Liquidation: Shuts down the company and sells its assets. 

• Absolute Priority Rule (APR) 

  • Sets the order in which claims are paid in liquidation: 

  -Secured creditors (backed by collateral) are paid first, from the sale of that collateral. 

-Reorganization: Tries to keep the company running by restructuring its finances. 

Corporate risk

exposure of a company's earnings, cash flows, or market value to uncertain external factors or events  

Types of Corporate risk 

Market risks: 

• Price movements in financial markets (e.g. interest rate, exchange rate, and commodity price risks)

• Managed using financial derivatives or other financial contracts  

 

Commercial (or operational) risks: 

• Risks from running the business caused by internal processes or unexpected competitor actions. 

• Managed by company as they partly control these risks. 

• Can't be hedged with financial tools like derivatives

 

External event risks: 

• Stem from non-market events such as natural catastrophes or changes in tax or regulatory policies  

• Managed using insurance products

What is Risk Management? 

• Risk management = reducing uncertainty in future business outcomes. 

• Goal: remove bad outcomes, keep good ones. 

• Works like options: can limit losses (future payoff can’t go below zero), but still allows gains. 

Risk management can add value in real (imperfect) markets via cash flow by: 

1. Tax savings (due to tax non-linearity) 

   • Risk management that stabilizes income can reduce or eliminate taxes, especially when tax preferences (like carry-forwards) are involved

2. Lower bankruptcy costs 

3. Avoiding underinvestment (protects future projects) 

4. Better monitoring and reduced managerial risk-taking 

• Also improves WACC by managing debt/equity more efficiently

Risk Management Tools 

Derivatives: contracts whose value depends on (or “derives from”) the price of an underlying asset 

• Derivatives help manage risk by cutting losses, like options. 

• Common derivatives: forwards, futures, options, swaps. 

 

Hedging: strategy used to reduce or eliminate the risk of adverse price movements in an asset. It’s like buying insurance to protect yourself from financial losses 

• Hedging is costly, so firms hedge only net exposure, not everything. 

• Natural hedges occur by matching revenues and costs in same currency or location. 

• Example: Making goods in Australia to sell in Germany → open factory in Germany, borrow in euros → reduces currency risk naturally, less hedging needed. 

Valuation of Takeover - STEPS

1. Calculate Free Cash Flows in forecast period (t=1,...T) - FCF formula

2. Terminal value (estimating the value after the forecast period, using perpetuity/TV formula) 

3. Discount all cash flows to Present Value 

• Take all the projected FCFs (from forecast years and terminal value) and discount them back to today using the WACC (Weighted Average Cost of Capital). 

This gives you the present value of the entire firm — the Enterprise Value.