IS

Corporate Finance, L6

Advanced Corporate Finance: Using Options in Corporate Finance

1. Introduction to Portlandia Ale

Idea is to launch a new business, launching the product is like a call option

  • Business Overview: Microbrewery requiring funding for development and launch.

    • Initial Investment: €4 million needed for product development (€0.5 million quarterly over 2 years).

    • Launch Cost: €12 million to introduce the product 2 years later.

    • Expected Sales: €6 million annually.

    • Established Company Value: €22 million based on market value-to-sales ratio (3.66).

3. NPV Rule and Assumptions

  • NPV Definition: Measure of value creation characterized by the difference between the present value of cash flows and the initial investment.

  • NPV Zero Condition: Invest when NPV > 0.

  • Key Assumptions:

    • One-time investment decision.

    • Cash flows are uncertain and can only be estimated.

    • Delay in investment could have value.

→ So this chapter is about the valuation of different strategy options, bc the NPV is all about just identifying 1 scenario and we want to consider multiple ones

2. Discounted Cash Flow (DCF) Valuation

  • Investment Timeline: Evaluating the project's cash flow over time.

    • Cash Flows: Negative cash flow from investment at intervals leading up to launch.

    • Terminal Value: Evaluated as €22 million two years after initial investment.

  • Net Present Value (NPV) Calculation:

    • Formula: NPV = Present Value (cash flows) - Investment.

    • Initial Results: NPV calculated under various interest rates; suggest potential abandonment of the project if NPV is negative.

      → NPV is negative, so based on this indicator shouldn’t start the business

4. Real Options Approach

  • Investment Decision as a Call Option:

    • option applied to business decisions(interesting for start up valuation)

    • Spending on product development equates to acquiring a right—not an obligation—to launch.

    • if the value of the product in the future is higher than the exercise price (i.e expectation of future value), then we have the right to launch (exercise) it!

      → like a European call option

  • Valuing the Option to Launch:

    • Use of Black-Scholes formula for option pricing(only valid for European options, not American ones)

    • Important inputs include(5):

      • Current value of terminal value: €14.47 million

      • Cost to launch: €12 million

      • Launch date: 2 years from now.

      • Risk-free interest rate: 5%.

      • Volatility of underlying asset: 40%.→ the expected value of the firm varies with its volatility

  • Calculated Value of Option: €4.97 million.

5. Real Options in Project Evaluation

  • Traditional vs. Real Options NPV:

    • Traditional NPV shows -€0.22 suggesting project abandonment.

    • Including real options (to launch and abandon) gives a positive NPV of +€1.74.

      → so launching in two years generates a positive results(a positive NPV), suggesting a go-ahead for launching the project

  • Importance of Flexibility in Investment:

    • Flexibility allows for adjustments based on market conditions, enhancing project value

      → so adding flexibility, will always increase the NPV’s value of the project!!

6. American Options and Compound Options

  • American Option Characteristics:

    • Can be exercised at any time, relevant in the context of Portlandia Ale's potential to abandon the project

      → meaning that it meets the condition for an American option by adding an additional option that allows us to abandon the project every quarter year

  • Valuation of Compound Options:

    • Each quarterly payment (€0.5 million) is akin to a call option on the decision to launch the product.

    • Now we compute in total 2 options in the NPV computation

  • Valuation using numerical methods

    • Binomial Model Usage≠ Black-Scholes

    • Building trees to visualize value movement over time.

    • Analysis of Delaying Investment:

      → Use binomial trees to evaluate whether to mothball projects or invest immediately based on expected future values

      → at each nod of the branch of the binomial model, you decide to abandon the project (=0)or you continue waiting(option alive, continue to invest 0.5)

  • Strategic Waiting:

    • Valuing the project if started after one or two years shows potential for improved NPV with appropriate evaluations.

8. Options on Risky Debt in Corporate Finance

  • Use of Options in Risky Debt:

    • Comparisons made between equity and debt under the Merton model—equity as a call option.

  • Decomposing Risky Debt:

    • Understanding components: face value, market value, and probability of default for comprehensive assessment.

9. Example Case: Debt Valuation Using the Merton Model

  • Company Valuation Parameters:

    • Market value of assets, risk-free rates, and asset volatility used to assess debt value.

  • Debt and Equity Valuation:

    • Use of binomial pricing to evaluate varying debt scenarios, resulting in specific equity and debt values based on potential company outcomes.

  • the relationship between these elements is : Risky Debt= Risk-free debt- Put

  • the put value : to be protected in case of bankruptcy

  • Example: we would like to compute the value of the debt & equity

    • idea is to use the binomial tree, and apply the up or down factor

    • So we always start at the maturity where we compute E&D, if mulitplied by d(bankrupt), if mulitplied by u(partly financed by debt, partly still by equity)

    • purpose is to compute the value of today: compute risk neutral probability to find the p probability, and then apply that to E&D

    • the D here is on risky debt

    • Question often at THE EXAM: based on that example, what is the p of the company to bankrupt? 0.538!!

    • Another use for the Merton-Model is computing the yield to maturity: if you buy a risky bond, need to keep in mind that won’t get all CF, so need to use risky debt

Conclusion

  • The use of options and flexibility in investment decisions, particularly through the lens of projects like Portlandia Ale, showcases the benefits of employing advanced financial models for more informed decision making.