5021fb4568565db33fcc7ee9975fcf48.ppt

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Real Options and Mergers P. V. Viswanath Class Notes for FIN 648: Mergers and Acquisitions

Stock Options w A call option on a stock is the right to buy a share of stock at a pre-specified price (exercise price) within a specified time period (time to maturity). w Thus, a call on Sprint with an exercise price of $22. 50 and an expiration date of May 19, 2006 traded at a price of $2. 15 at close on Feb. 22, 2006. w The closing price of the stock on that day was $23. 80, so if the call had been exercised right away, it would have resulted in a loss. Still the option has value because the stock price might well go up before May 19, 2006. P. V. Viswanath 2

Call option P. V. Viswanath 3

Real options w A real option is similar to a stock option. The primary difference is that the real option is not traded on a market and, often, w The underlying asset may not be traded on a market, either. w Thus, a patent grants the owner an option because s/he has the sole right for a certain amount of time (time to maturity) to develop a product based on the patented idea by investing the necessary capital (exercise price). w The patent may or may not be traded; w The underlying asset in this case, is the product based on the patent. In this case, the underlying asset is not traded, either. P. V. Viswanath 4

Importance of Real Options w Real options are pervasive; for example, flexibility usually implies a real option. w Real options have a big effect on firm value where the firm is growing and/or has unique assets. w Real options capture effects that DCF doesn’t. DCF analysis alone misestimates the value of an asset. P. V. Viswanath 5

Using real options in M&A w Estimate the value of optionality. n The right to take action, the triggering of which is contingent on some other event. w Structure critical thinking about company values and/or deal design. n Even if valuing the options is difficult, thinking of the transaction in terms of real options can help qualitatively. w Guide negotiation and problem-solving. n Helps in deal negotiation and in coming up with solutions to impasses. P. V. Viswanath 6

How to identify an option § An option is a right regarding some other asset or good; can you identify it? § Options give the owner a special right that others do not have. Is this right exclusive to you? § The value of an option derives from the value of an uncertain underlying asset. What is the contingency or uncertainty in this case? § Options are valuable, and are costly to acquire. Was the right costly to acquire? § An option has a finite life. P. V. Viswanath 7

Options and opportunities P. V. Viswanath 8

Example of option w Right to start up a business under an exclusive fastfood franchise that you purchased, that expires within three years unless you own one or more outlets and that requires further spending to exercise. You are the exclusive franchisee in your territory. Whether and where you exercise the right is contingent on the results of a market survey, on zoning rulings by government, and on actions by competitors. w Needs to be valued using real option analysis. P. V. Viswanath 9

Example of opportunity w Opportunity to open a restaurant in your community under a generic name, “Downtown Grille. ” You didn’t pay to acquire this opportunity. There is not much uncertainty: you can rent the perfect location that will deliver a steady clientele. It looks like a good deal already. w Can be valued using DCF analysis. P. V. Viswanath 10

Decision Tree: Option to Delay w You must decide whether to invest now in new manufacturing capacity, for an outlay of $20 million, or wait a year. If you delay, you must engage a contract manufacturer that will cost your firm $1 m. More to produce goods than if they were produced at the new plant. Demand for the product is uncertain. There is a 50 -50 chance of the demand generating a new business with either a present value of $100 million or a present value of zero. If you delay, the new plant will cost $25 m. next year. P. V. Viswanath 11

Decision Tree: Option to Delay P. V. Viswanath 12

The Option to Delay: Deciding w Value of Wait = -$1 + [0. 5 x($100 -$25)]+(0. 5 x$0) = $36. 50 w Value of Invest = -$20 + (0. 5 x$100) + (0. 5 x$0) = $30 m. w It pays to wait because of the high uncertainty regarding the value of the underlying asset, i. e. new demand. w How to take time value of money into account. w How to adjust for risk; riskiness of the option is not the same as the riskiness of the underlying asset. P. V. Viswanath 13

Option Valuation: Binomial Method w http: //webpage. pace. edu/pviswanath/class/648/note s/options. htm#dcfvaluation w http: //webpage. pace. edu/pviswanath/class/648/note s/options. htm#arbitrage P. V. Viswanath 14

Option Valuation: Black-Scholes w http: //webpage. pace. edu/pviswanath/class/648/note s/options. htm#blackscholes P. V. Viswanath 15

Lucent: Assessing Latent Optionality w Why is the actual market value different from intrinsic value (break-up value of assets)? w The reason might be real options. w Shortly after Lucent was spun off from AT&T in 1996, the firm traded at $60, but assets-in-place were worth $11. w If the difference is due to a real option, what do the option characteristics have to be? P. V. Viswanath 16

Lucent: Assessing Latent Optionality w Assumptions: n n n Current Value of underlying asset: $60 Life of option: 3 years Exercise price: $15/share/yr. for the next 3 years (PV = $34. 24) Project volatility: 75% per annum. Risk-free rate of return = 3% w Estimated Option Value = $38. 70 w See spreadsheet from Blackboard: Class Documents P. V. Viswanath 17

EM. TV w In March 2000, EM. TV bought 50% of SLEC for € 1. 88 b. w At the same time, EM. TV also got a call to buy another 25% of SLEC for € 1. 16 b by Feb. 28, 2001 (in 4 quarters). w Ecclestone got a put option to sell 25% of SLEC to EM. TV for € 1. 16 b by May 2001 (in 5 quarters). w When the original acquisition was announced in March 2000, EM. TV fell by € 2 b. w When news of the put option came out somewhat later, EM. TV dropped in value by € 2. 2 b. w Is the market reaction due only to the put grant? P. V. Viswanath 18

EM. TV w Assumptions: n n Value today of 25% of SLEC today is € 0. 97 b. Exercise price: € 1. 16 b. Volatility: 25% per yr; quarterly volatility is 0. 25(1/5)0. 5 Quarterly euro risk free rate is 0. 985% per year. w The sum of the values of the long call and short put works out to -€ 0. 138 b. w Modifying the initial values changes the values of the options, but cannot explain the price changes. w What amount of the price drop is due to a negative signal? w Look at spreadsheet on Blackboard under Class Documents. P. V. Viswanath 19

Binomial Method w Grow the tree n n n Up value u = exp( t); down value = d = exp(- t) Pseudo. Prob{move = up}= [(1+rf)-d]/(u-d) Pseudo. Prob{move = down}= [u-(1+rf)]/(u-d) w This achieves two things: n n i) the volatility period is exactly ii) the price in any period can be obtained by using the pseudoprobabilities and discounting the values next period by the riskfree rate. w We have changed the probabilities in such a way that discounting can now be done using the riskfree rate, instead of the actual required rate of return. w Since the option value is conditional on the true value, we can value the option also similarly. P. V. Viswanath 20

Value options on SLEC w What is the value of the call that EM. TV got, and what is the value of the put that EM. TV gave? w We don't really have enough information here to estimate these values precisely since along with the actual transfers of money and options, there is also updating by the market on the value of the other assets that EM. TV has w However, we can evaluate certain hypotheses -- for example, did the change in value reflect on the value of the options or was there an information component, as well? P. V. Viswanath 21

Valuing options on SLEC w Suppose the original price that EM. TV paid for the options and the 50% share of SLEC was fair, and the entire reduction in the value of EM. TV. w Then we can compute the value of the put option and ask if the change in value at the later date was due to the market’s reevaluation of EM. TV’s worth in November 2001 or not. P. V. Viswanath 22

MW Petroleum: Structuring the Deal w In 1991, Amoco wanted to sell its subsidiary MW Petroleum. Apache was the intended buyer. w The initial asking price of $1 billion was beyond Apache’s ability to finance. w Even after negotiations, the gap between asking price and offered price was more than 10% of the transaction value. w Amoco, as the seller, was naturally more optimistic about future pricing trends than Apache. w How to structure the deal so that both parties would be willing to proceed? P. V. Viswanath 23

MW Petroleum: Structuring the Deal w The two sides negotiated a price support agreement that protected Apache on the downside in return for guaranteeing Amoco a portion of the upside. w Under the terms of this agreement, Apache would receive support payments if oil prices fell below specified reference prices for any year during the two-year period ended June 30, 1993, and Amoco would receive payments if oil prices rose above specified reference prices for any year during the eight-year period ending June 30, 1999, or in the event gas prices exceeded specified reference prices for any year during the five-year period ending June 30, 1996. P. V. Viswanath 24

Some details of the price-sharing deal w Oil price sharing payments due Amoco for contract years ending 6/30/1994 to 6/30/1999, would be based on per barrel oil prices starting at $24. 75 and increasing to $33. 13. w Annual oil volumes would decline from approx 3. 3 million barrels to 1. 4 million barrels over the remaining term. w Gas price sharing payments would be based on gas volumes starting from approximately 13. 4 Bcf for the year ending 6/30/1994, and declining to 10. 5 Bcf in 1996. w The referenced gas price would increase from $2. 18 per Mcf in 1994 to $2. 68 per Mcf in the final year. w If price sharing payments are due to Amoco, the volumes listed above would be doubled until Amoco recovers its net payments to Apache ($5. 8 million through the contract year ended June 30, 1993) plus interest. P. V. Viswanath 25

Interpreting the deal w Apache, which believes that oil prices are not likely to increase will arrive at a lower estimate of the PV of the payments to be made to Amoco; and at a higher estimate of the PV of the payments that Amoco has to pay to Apache. w Amoco’s estimates are the opposite. w Hence, the price sharing agreements constitute a price reduction for Apache and a price increase for Amoco. w Alternatively, we could say that Amoco is selling Apache price-protection – in case oil prices don’t stay high. w Apache is able to pay for this insurance in the form of “cheap” securities – an agreement to pay Amoco if oil prices increase. P. V. Viswanath 26