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Lecture Notes

Valuation

WS 2009
Dr. Alex Stomper
Introduction
What does this course offer?
 Scientific tools and techniques for
valuing financial assets
 We focus on
• Valuation of publicly traded firms
• Value of equity
• Value of total company (debt+equity)
• Valuation of investment projects

Valuation Alex Stomper 3


Relevance of valuation
 Valuation and portfolio management
• Central role in fundamental analysis
• Useful input for technical analysis
 Valuation and corporate finance
• Corporate objective: value maximization
• Capital budgeting
• Mergers and aquisitions
• Other corporate restructurings
Valuation 4
Valuation and market efficiency
(1)
 In an „efficient“ market, the market price is the
best estimate of the true value of an asset.
 Deviations of market price from true value are
random.
• Weak form: the current price reflects all information in
past prices (i.e., past prices do not help to identify
under or over value stocks)
• Semi-strong form: the current price reflects all public
information
• Strong form: currect price reflects all information,
public as well as private.

Valuation 5
Valuation and market efficiency
(2)
 Strong-form market efficiency is theorectically
impossible: Grossman and Stiglitz (1980).
 However, the market is usually smarter than
you think.
 Therefore, compare your valuation results with
the market price whenever possible
• Do you know something that the market does not
know?
• Or do you make a mistake?

Valuation 6
Approaches to valuation
 Discounted cashflow valuation, relates the
value of an asset to the present value of
expected future cash flows on that asset.
 Relative valuation, estimates the value of an
asset by looking at the pricing of 'comparable'
assets relative to a common variable like
earnings, cash flows, book value or sales.
 Real options approach to valuation,
quantifies the value of managerial flexibility
using option pricing models.

Valuation 7
1. Discount cash flow
valuation
Generic DCF valuation formula
 The value of an asset is determined by the present
value of expected future cash flows generated by the
asset.
N
E (CFt )
V =∑
t =1 (1 + r )
t

where CFt is the cash flow in period t, r is the


appropriate discount rate.
 Underlying principle: valuation is additive!

Valuation 9
Key components in DCF
valuation
 Relevant cash flows
• All cash flows from and to investors (inflows and
outflows)
• Difference between cash flow and profit/loss
 Appropriate discount rate
• Account for the time value of cash flows (earlier cash
flows are more valuable)
• Account for the uncertainty (risk) of cash flows
 Matching principle: different valuation models
use different combinations of cash flows and
discount rates.

Valuation 10
DCF valuation models
 Free cash flow valuation model
 Capital cash flow valuation model
 Adjusted present value model
 Divident discount model
 Economic-profit-based valuation model

Valuation 11
Key steps in FCF valuation
 Estimating current free cash flows
 Estimating growth rate
 Estimating cost of capital
 Estimating residual value (company value at
the end of the explicit forecast period)
n
E ( FCFt ) RV
V0 = ∑ +
t =1 (1 + WACC ) t
(1 + WACC ) n

Valuation 12
I. From earnings to free cash
flows
EBIT (earnings before interest and taxes)

- Corporate tax rate* EBIT


= NOPLAT (net operating profit less adjusted taxes)
+ accounting deductions that did not involve a cash outflow (depreciation,
amortization)

- accounting income that did not involve a cash inflow


= Gross Cash Flow
- Gross investments (net investment + depreciation)
= Free Cash Flow
- (1-Corporate tax rate)* Interest expense
- Repayment of principal
= Free Cash Flow to Shareholders

Valuation 13
Firm value vs equity value
 Value of firm:
N
E ( FCFt )
V =∑
t =1 (1 + WACC ) t

 Value of equity
N
E ( FCFEt )
E=∑
t =1 (1 + k e ) t

Valuation 14
Taxes in FCF valuation
 FCF are calculated as if firms are all-equity
financed
 Marginal corporate tax rate is applied to EBIT,
without taking into account that interest
payments are tax deductiable
 Debt tax shields are recognized through the
discount rate
 Alternatively, one can include the debt tax
shields in cash flows, then the discount rate
should be the pretax discount rate (Capital
cash flow valuation model, see later).

Valuation 15
Investment expenditures
 Gross investment
= capital expenditures + change in working capital
 Working capital = current assets (inventory, cash and
account receivable) - current liabilities (account payable,
short-term debt)
 Capital expenditures minus depreciation is called net
capital expenditures
 Gross investment minus depreciation is called net
investment
 If depreciation is the only noncash expense/income then
FCF = NOPLAT - net investment

Valuation 16
Estimating current FCF:
example
EBIT 1500
Tax rate 40%
NOPLAT 900
Depreciation 300
Gross cash flow 1200
Capital expenditure 500
Change in working capital 100
FCF 600
Interest expense 120
repayment of principal 150
FCF to shareholder 378

Valuation 17
II. Estimating growth rate
 Look at historical growth rate
 Look at forecasts by analysts
 Look at fundamental drivers of growth rate
• Reinvestment rate:
IR = Net investment / NOPLAT
• Return on invested capital (ROIC)
ROIC = NOPLAT / Invested capital
⇒IR*ROIC = Net investment / Invested capital
= capital growth rate

Valuation 18
Invested capital
 Invested capital = total assets – excess cash –
marketable securities – noninterest bearing
short term liabilities
 Excess cash and marketable securities are
excluded because it is easier to value them
seperately
 noninterest bearing short term liabilities are
excluded because they are financed by
suppliers and their costs may have already
been reflected in NOPLAT

Valuation 19
ROIC: example

NOPLAT in year t 900


total asset at the end of year t-1 3000
excess cash (t-1) 20
marketable security (t-1) 100
noninterest-bearing liabilities (t-1) 150
Invested capital at the end of year
t-1 2730
ROIC in year t 0.3

Valuation 20
Determinants of ROIC

EBIT Re venues
ROIC = (1 − t ) × ×
Re venues Invested Capital

Profit margin Asset turnover

Valuation 21
Fundamental growth rate
 The case of constant ROIC
gNOPLAT = IRt * ROIC
 Return on new invested capital (RONIC)
≠ ROIC
gNOPLAT = IRt * RONIC
 The case of changing ROIC
gNOPLAT = IRt * ROICt+1+(ROICt+1 -ROICt)/ROICt

Valuation 22
Forecasting FCFs: example

year 2004 2005 2006 average


invested capital
(beginning) 400.00 450.00 530.00

NOPLAT 150.00 200.00 205.00

ROIC 0.38 0.44 0.39 0.40

Net investment 50.00 80.00 70.00

IR 0.33 0.40 0.34 0.36

FCF 100.00 120.00 135.00

Valuation 23
Forecasting FCFs: example
 Forecast FCFs in the next three years,
assuming alternatively that
(1) IR and ROIC are the same as in 2006
(2) IR and ROIC are the same as in 2006,
RONIC equals to 0.3
(3) IR and ROIC equal to the average levels in
2004-2006

Valuation 24
Forecasting FCFs: solution

Valuation 25
III. Estimating cost of capital

 The expected FCFs to the firm are discounted using


the weighted average cost of capital (WACC) to
get the firm value.
 The expected FCFs to equityholders are discounted
using cost of equity to get the equity value.
 The weight of each financing form is defined as the
ratio between the market value of that financing form
to the total market value of the firm.
 Noninteresting-bearing liabilities are not considered
when computing WACC.
 The tax advantage of debt financing is reflected in
WACC.

Valuation 26
WACC
D P E
WACC = k d (1 − t ) + k p + k e
V V V
where
kd = pre-tax cost of debt
kp = cost of preferred stock
ke = cost of equity
t = corporate tax rate
D/V = target debt ratio using market values
P/V = target preferred stock ratio using market values
E/V = target equity ratio using market values
V = market value of the firm (D+P+S)

Valuation 27
Weights in WACC
 The target weights instead of the current weights should
be used.
 Weights should be calculated using market values.
 The market value may not exist, especially for the debt.
Possible estimation procedure:
• Identify all payment obligations to debt holders
• Estimate the credit risk of debt-type financing instruments
• Find market-traded instruments that have similar credit risk
and time to maturity
• Use the market returns to discount the outstanding
payments to debt holders

Valuation 28
Cost of debt/preferred stocks
 Cost of debt = expected return on debt *(1-t)
• Expected return on debt ≠ coupon rate
• Expected return on debt ≠ promised yield
 Investment-grade debt (debt rated at BBB or better): use
yield to maturity of the company‘s long-term, option-free
bonds
 If the bond rarely trades, use the average yield to maturity
on a portfolio of long term bonds with the same credit
rating
 Below-investment-grade debt: use CAPM to estimate the
expected return
 Adjust for interest tax shields
 Preferred stocks: preferred dividend devided by the
market price of preferred stocks
Valuation 29
Cost of equity: CAPM

ke = rf + β [ E ( rm ) − rf ]
where
rf = risk-free rate
ß = the sensitivity of the stock return to market return
E(rm) = expect return of the market portfolio
E(rm)-rf = market risk premium

Valuation 30
CAPM: implementation (1)
 Risk-free rate: use long-term goverment bond
 Market risk premium: historical data
• Use the longest period possible: short-term estimates
are very noisy (annual standard deviation of stock
returns 20%).
• Use geometric average instead of arithmetic average
• Adjust for survivorship bias.
• Nomally used numbers: 4.5-5.5%

Valuation 31
CAPM: implementation (2)
 Beta: estimated from the market model

rit = α + βrmt + ε it
• Normally five-year monthly data are used
• Adjustment for low trading frequency (Dimson(1979))
 Market portfolio
• In theory, all assets must be included
• In practice, well-diversified stock indexes are used as a
proxy: S&P 500, MSCI world index, MSCI Europe index,
etc

Valuation 32
Beyond CAPM: APT model
n
ri = α + ∑ β ik Fk + ε
k =1
n
E ( ri ) = rf + ∑ β ik λk
k =1
where Fk = the k-th systematic factor that drives security return,
λk = risk premium of the k-th factor

 Difficulty in implememtion: not clear


• What are the factors?
• How to measure them?

Valuation 33
Beyond CAPM: Fama-French model

E ( ri ) = rf + β1[ E ( rm ) − rf ] + β 2 [ E ( rS ) − E ( rB )] + β 3[ E ( rH ) − E ( rL )]

where β , β , β are exposures to the market portfolio, size portfolio and


1 2 3

book-to-market portfolio repectively, rm , rS , rB , rH , rL are returns on the


market portfolio, small stock portfolio, large stock portfolio, high
book-to-market stock portfolio, low book-to-market stock portfolio
respectively.

 An empirical model designed to capture the size


and book-to-market effects in stock return
 Theoretical fundation still not clear

Valuation 34
Capital structure and cost of
capital
 Modigliani and Miller theorem: In a perfect market without tax,
capital structure has no impact on either the firm value or the cost
of capital.
 An easy way to understand this fundamental result in corporate
finance: In a perfect market without tax, capital structure has no
impact on the expected cash flows to the firm.
 In the MM world, when the more expensive equity is substituted by
the less expensive debt, the cost of equity increases according,
leaving the weighted cost of capital unchanged.
 In a world with tax, debt increases the cash flows to the firm by
reducing taxes. This is not reflected in FCFs, therefore it must be
reflect in WACC.
 In the real world (with both tax and market imperfections), an
optimal capital structure is determined by the trade-off between the
tax advantage of debt and the cost of high leverage.

Valuation 35
MM world

ke

WACC
kd

D/E

Valuation 36
MM world with corporate tax

ke

WACC
kd(1-t)

D/E

Valuation 37
Real world with tax and other frictions

ke

WACC

kd(1-t)

D/E
(D/E)*

Valuation 38
Leverage and equity beta
 Industry beta is often used to improve the
estimation of company beta.
 However, firms in the same industry may have
different leverage ratio
 Procedure for inferring beta from comparable
firms
• Estimate beta for each comparable firm
• Back out the unlevered beta
• Calculate the relevered beta using the target leverage
ratio

Valuation 39
Two alternative leverage policies
 The relation between levered- and unlevered-beta
depends on the assumed leverage policy.
 MM assumption(Modigliani and Miller 1963): constant
debt value
 ME assumption (Miles-Ezzell 1980): constant debt ratio
 Note that ME assumption is different from MM
assumption even if expected growth rate is zero.
 Failing to recognize this difference has led to confusion
even among experts (Fernandez 2004, Cooper and
Nyborg 2006)

Valuation 40
Unlevered beta: constant debt level
(1)
 If the debt value is constant, then interest tax shields
should be discounted by cost of debt, therefore
VL = E + D = VU + VTS = VU + tD
E D V tD
⇒ βC = β E + βD = βU U + β D
VL VL VL VL
E (1 − t ) D
⇒ βU = β E + βD
VU VU
E (1 − t ) D
= βE + βD
E + (1 − t ) D E + (1 − t ) D
1 (1 − t ) D / E
= βE + βD
1 + (1 − t ) D / E 1 + (1 − t ) D / E
D
⇒ β E = βU + ( βU − β D ) (1 − t )
E

Valuation 41
Unlevered beta: constant debt level
(2)

 If βD = 0 , then we have
• Hamada (1972) formula
1
βU = β E
1 + (1 − t ) D / E
• Relevered beta
D
β E = βU [1 + (1 − t ) ]
E

Valuation 42
Unlevered (levered) cost of
equity
 Unlevered cost of equity can be derived
either using unlevered beta or directly
from the following formula
1 (1 − t ) D / E
ku = k e + kd
1 + (1 − t ) D / E 1 + (1 − t ) D / E
D
⇒ ke = ku + ( ku − kd ) (1 − t )
E
tD
=> WACCL = ku (1 − )
E+D

Valuation 43
Unlevered beta: example
 A privately-held company has a leverage ratio
(D/E) of 60%.
 A comparable publicly-traded company with a
leverage ratio of 40% has an equity beta of 1.2.
 The comparable firm is assumed to maintain
the current debt level (in value) in the future.
 The corporate tax rate is 35%.
 What is the beta of equity for the private
company?

Valuation 44
Unlevered beta: solution

Valuation 45
Unlevered beta: constant debt ratio
(1)

 If the debt ratio is constant, then interest tax


shields should be discounted using
unlevered cost of equity, therefore
VL = E + D = VU + VTS
E D V V
⇒ βC = β E + βD = βU U + βU TS = βU
VL VL VL VL
E D
⇒ βU = β E + βD
D+E D+E
E D
⇒ ku = k E + kD = pretax WACC
D+E D+E

Valuation 46
Unlevered beta: constant debt ratio
(2)
 Relevered beta
D
βe = βu + (βu − βd )
E

 Levered cost of equity


D
k e = ku + (ku − k d )
E
 WACC of the levered firm
tkd D
WACCL = ku −
E+D

Valuation 47
Constant leverage ratio:
example

 Redo the previous exercise assuming


that the comparable firm is going to
maintain the current debt ratio in the
future

Valuation 48
IV. Estimating residual value
 Method 1
NOPLATT +1 (1 − g / RONIC )
RVT =
WACC − g
 Method 2
FCFT +1
RVT =
WACC − g
 Since FCFT +1 = NOPLATT +1 * (1 − IRT +1 ) = NOPLAT * (1 − g / RONIC )
these two methods are equivalent.
 Since the reinvestment rate in the residual period may be different
from that in the explicit forecast period, FCFT+1 may not equal
FCFT*(1+g)
 Method 1 automatically takes this into account.

Valuation 49
Residual value: example
 FCFT = 100, NOPLATT = 200
 From year T+1 on, g = 5%, RONIC=
12%
 WACC = 10%

Valuation 50
Residual value: other methods
 If RONIC = WACC, then method 1 reduces to the
convergence formula

RV = NOPLATT +1 / WACC

This method assumes that new investment in the


residual period does not creat any value
 Liquidation value: only if liquidation is very likely
 Replacement cost: no good economic reason

Valuation 51
Other DCF valuation model
 Capital cash flow valuation model
 Adjusted present value model
 Economic-profit-based valuation model
 Discount dividend model

Valuation 52
Capital cash flow valuation
model
 CCF = FCF + interest tax shield
 Firm value is derived by discounting the CCF using
unlevered cost of equity
 Given that interest tax shield are discounted using
unlevered cost of equity, it follows that unlevered
cost of equity equals pretax WACC.
 Advantage: no need to adjust discount rate for
changes in financial structure.

Valuation 53
CCF valuation model: example
 Example: Current FCF of a firm is 200,
interest expense is 50, tax rate is 40%.
The firm has a pretax WACC of 10% and
an expected growth rate of 5%. Value
this firm using CCF valuation model.

Valuation 54
Adjusted present value model
 Valuation by components approach:

VL = VU + VTS
where VU is the expected FCF discounted using unlevered
cost of equity, VTS is the present value of interest tax shields
 Possible discount rates for interest tax shields:
• Pretax cost of debt: varying or risky debt
• Unlevered cost of equity: costant debt ratio (in this case, APV
model is equivalent to CCF valuation model)
 Advantage:
• No need to adjust discount rate for changes in capital structure
• Can easily be combined with a variety of valuation models

Valuation 55
APV model: example
year1 year2 year3 year4

Unlevered cash flows 100 100 1000 1000

2000 2000
(at (at
debt 0 0 8%) 8%)

unlevered cost of equity 0.14

tax rate 0.34

Valuation 56
Economic-profit-based valuation
model
 Economic profit (or Economic Value Added)
= Invested capital * (ROIC-WACC)
= NOPLAT – invested capital * WACC

 Firm value and economic profit



E ( Economic profitt )
V0 = Invested capital0 + ∑
t =1 (1 + WACC ) t

 Important message: a project creates value for


shareholders iff its return is higher than its cost of capital

Valuation 57
Discount dividend model
 General model

E ( DPS t )
P0 = ∑
t =1 (1 + k e ) t

where DPS is dividend per share, ke = cost of


equity
 Gordon growth model: for stocks with a stable
growth rate E ( DPS )
P0 = 1
ke − g

where E(DPS1) is expected dividend next


period, g is growth rate in dividends forever

Valuation 58
Gordon growth model

 Works best for companies


• in stable growth
• in stable leverage
• pays out dividend regularly
 Limitations
• Extremely sensitive to the input for growth
rate
• Extremely simple growth pattern

Valuation 59
Two-stage growth mdoel
 Assumption: high growth rate (g) in the first n
periods and normal growth rate (gn) in the
rest periods
n
E ( DPS t ) Pn
P0 = ∑ +
t =1 (1 + k e ) t (1 + k e ) n
1+ g n
E ( DPS1 )[(1 − ( ) ]
1 + ke E ( DPS n +1 )
= +
ke − g (1 + k e ) n ( k e − g n )

Valuation 60
2. Relative valuation
How does it work?
 In relative valuation, you try to figure out the
value of the firms being analyzed by looking at
the market values of similar or comparable
firms.
 Steps in relative valuation
• Identify comparable firms
• Calculate the „multiples“
• Compare the multiples and control for factors that
might affect the multiples
 Implicit assumption: market is on average right

Valuation 62
Most popular multiples
 Earnings multiples
• Price/earnings ratio and variants
• Value/EBITDA
• Value/FCF
 Book value multiples
• Price/book value (PBV, or market-to-book equity)
• Value/book value
• Value/replacement cost (Tobin‘s Q)
 Revenues multiples
• Price/sales
• Value/sales

Valuation 63
Price / Earnings ratio
 PE = market price per share / Earnings per
share
 Price can be
• Current price (most of the time)
• Average price for the year
 Earnings per share (EPS) can be
• EPS in most recent financial year
• EPS in trailing 12 months (trailing PE)
• Forecast EPS next year (forward PE)

Valuation 64
Distribution of PE ratio: US
stocks

source: Damodaran 2002

Valuation 65
PE ratio across countries: July 2000
 Developed markets  Emerging markets

source: Damodaran 2002

Valuation 66
Determinants of PE ratio

P0 DPS 0 (1 + g ) Payout ratio (1 + g )


PE = = EPS 0 =
EPS 0 (k e − g ) ke − g

 Other things equal, PE ratio is higher for


firms with
• High growth potential
• High payout ratio
• Low cost of equity (low equity risk, low risk free rate)

Valuation 67
PE ratio: regression analysis
 Advantage of regression analysis: the informatíon in the entire
cross-section instead of a few comparable firms can be used
 Problem: the coefficients may be unstable
 Example: regression results for Compustat sample
(Damodaran 2002)

Valuation 68
PEG ratio
 PEG = PE / Expected growth rate in earnings
 A simple way to control for the influence of growth
rate on PE ratio
 But not completely neutralize it since PE is not a
linear function of expected growth rate
Payout ratio (1 + g )
PEG =
g (k e − g )

 No standard time frame for measuring expected


growth rate

Valuation 69
Value multiples
 V / EBITDA = (E + D) / EBITDA
 V / FCF = (E + D) / FCF
 FCF = EBIT (1-t) – (CAP EX – D&A) - ∆ working capital
= (EBITDA – D&A)(1-t) - (CAP EX – D&A) - ∆working
capital
= EBITDA(1-t) + t (D&A) – CAP EX - ∆working capital
 Advantages
• Less firms with negative EBITDA than firms with
negative earnings
• not influenced by difference in depreciation schemes
• Not influenced by differences in capital structure

Valuation 70
Determinants of V/FCF ratio
 Stable growth case
V0 FCF0 (1 + g ) 1+ g
= =
FCF0 FCF0 (WACC − g ) WACC − g

 Two stage growth case


(1 + g ) n
(1 + g )(1 − )
V0 (1 + WACC ) n
(1 + g ) n (1 + g n )
= +
FCF0 WACC − g (1 + WACC ) n (WACC − g n )

Valuation 71
Value multiples: Example
 Consider a firm with the following
characteristics
• Tax rate = 33%
• Capital Expenditure/EBITDA=30%
• Depreciation&Amortization/EBITA=20%
• Cost of capital=10%
• No requirement for working capital
• Stable growth rate=5%
 Calculate V/EBITDA & V/FCF

Valuation 72
Value multiples: solution

Valuation 73
Price-to-book ratio

 Price-to-book ratio (market-to-book ratio)


=market value of equity / book value of equity
 For a stable growth firm
P0 Earnings1 * Payout ratio ROE1 * Payout ratio
PBV = = =
BV0 BV0 ( k e − g ) (k e − g )

 Since g=(1-Payout ratio)*ROE, we can further derive

ROE − g
PBV =
ke − g

Valuation 74
PBV and ROE: S&P 500 (Damodaran
2002)

Valuation 75
Value-to-book ratio
 Definition
Value market value of equity + market value of debt
=
Book value book value of equity + book value of debt

 For stable growth firm


V0 FCF1 EBIT1 (1 − t )(1 − g / ROIC ) ROIC − g
= = =
BV0 BV0 (WACC − g ) BV0 (WACC − g ) WACC − g

Valuation 76
Value-to-book ratio: example
 Example: Consider a stable growth firm
with the following characteristics:
ROIC=12%, WACC=10%, g=5%.
Estimate its Value-to-book ratio.

Valuation 77
Tobin‘s Q ratio
 Definition
Market value of assets in place
Tobin' s Q =
Re placement cos t of assets in place

 If Tobin‘s Q is smaller than 1, then a firm destroys


value; if it is bigger than 1, then it creates value
 Advantage: replacement costs provide a more
updated measure of asset value than do book
values
 Disadvantage: replacement costs are hard to
estimate

Valuation 78
Revenue multiples
 Price-to-sales ratio
= market value of equity / total revenues
• Internally inconsistent, since the market value of
equity is divided by the total revenues of the firm.
=> High leverage leads to low price-to-sales ratio
 Value-to-sales ratio
= market value of firm/ total revenues
 Advantages
• Available even for young or troubled firms
• Not heavily influenced by acounting rules
• Relatively stable
Valuation 79
Determinants of revenue
multiples
 For a stable growth firm

P0 Earnings1 * Payout ratio Net m arg in * Payout ratio


= =
Sales Sales( k e − g ) ke − g

V0 EBIT1 (1 − t ) * (1 − IR ) After tax operating m arg in * (1 − IR )


= =
Sales Sales(WACC − g ) WACC − g

Valuation 80
Choosing between multiples
 There are many potentially useful multiples
 Which ones to use in valuation?
• Use a simply average of valuations obtained using
different multiples
• Use a weighted average of valuations obtained using
different multiples
• Rely entirely on one of the multiples
• Most relevent one
• Most accurately estimated one

Valuation 81
Choosing the comparison firms
 Three possible choices
• A few very similar firms
• All firms in the same sector
• All firms in the market
 Regression analysis is necessary if you
choose the second or third approach
 It is recommended to check whether the firm is
over or under valued at both the sector and
market level.

Valuation 82
3. Real options approach
to valuation
Managerial flexibility (strategic
options)

 Managers react to changes in economic


environment
 DCF valuation and relative valuation do not
explicitly account for this.
 Real options theory provides an useful
framework to quantify the value of flexibility.
 This approach is particularly relevant for the
valuation of individual businesses and projects.

Valuation 84
Strategic options: examples
 Option to postpone a project
 Option to abondon a project
 Option to temporarily shut down a
project
 Option to expand a project
 Option to downsize a project
 Option to change input or output factors
.....
Valuation 85
Certainty equivalent method
 Option pricing is based on the Certainty Equivalent Method
as opposed to the Risk-Adjusted Discount Rate Method.
 Instead of discounting the expected cash flowes using a
risk-adjusted discount rate, the certainty equivalent
method discounts the certainty equivalent of future
uncertain cash flows at the risk-free rate.

CEQ (CFt )
V =∑
t =1 (1 + r f ) t

 The certainty equivalent of some uncertain payoff is defined


as a sure amount of payoff that is considered to be as
valuable as the uncertain payoff.
 This alternative method can be very useful even in the
absence of strategic options.

Valuation 86
Obtaining certainty equivalents

 How can we obtaint certainty


equivalents?
• By looking at prices in the forward or futues
market (when forward or futures market
exists)
• Expected value minus dollar value of risk
premium (when risk premium and risk
exposure are known)
• Expected value under the risk-neutral
probabilty (when markets are complete)
Valuation 87
Example: two-period gold mine

period
1 2
output
1000 1000
price
S1 S2
revenue
1000S1 1000S2
Costs
300 300
NCF 1000S-300 1000S2-300

Valuation 88
Example: two-period gold mine
(2)
 Suppose that risk free rate is 10%, the
current forwards prices are 320 for a
one-year contract and 350 for a two-year
contract. What is the value of this mine?

Valuation 89
Option pricing methods
 Binomial model
 Black-Scholes formula
 Monte Carlo simulation

Valuation 90
I. Binomial model
Su Cu= max(Su-X,0)

p p

S0 C0

1-p 1-p

Sd Cd= max(Sd-X,0)

X = exercise price, C = call option value, S = underlying value,


p = probability that underlying value goes up (irrelevant for valuation!)

Valuation 91
Binomial model (2)
 The risk-neutral probability q is given by
S 0 (1 + rf ) = qS u + (1 − q ) S d
S 0 (1 + rf ) − S d
⇒q=
Su − Sd

 The call option value is thus given by


qCu + (1 − q )C d
C0 =
1 + rf

Valuation 92
II. Black-Scholes formula
 For European call and put, Black and Scholes (1973) derive the
following formula

− rf T
C = SN ( d 1 ) − Xe N (d 2 )
− rf T
P = Xe N ( − d 2 ) − SN ( − d 1 )
S 1
ln + ( rf + σ 2 )T
d1 = X 2
σ T
d 2 = d1 − σ T
S = underlying price, K = Exercise price, _ = annualized volatility of the
underlying, T = time to maturity, rf = continuously-compounded risk-free rate,
N(.) = cumulative standard normal distribution

Valuation 93
III: Monte Carlo Simulation
 Monte Carlo simulation can be used to value
more complex options.
• Step 1: simulate the distribution of underlying value
under the risk neutral probablity by generating a
large number of underlying price paths following
1 ~
~ r f − σ 2 +σZ
S it = S i ,t −1 R = S i ,t −1e 2

~
where Z is a normally distributed random variable.

Valuation 94
Monte Carlo Simulation (2)
• Step 2: calculate the net cash flow in each period on
each sample path
NCFit = max( S it − X t ,0)
where Xt is the production cost in period t.
• Step 3: calculate the option value for each sample
path i T
Vi = ∑ e
−r t
f
NCFit
i =1

• Step 4: calculate the average option value over all


sample paths
1 N
V = ∑Vi
N t =1

Valuation 95
Example: option to shut down
 Value a gold mine with the following
characteristics
• Produces gold in two periods
• Temporary shut-down possible
• Current gold price 300
• Annual gold price volatilty 20%
• Annually compounded risk free rate 10%
• Annual production 1000
• Annual Production cost 300

Valuation 96
Solution: Binomial model

u = eσ t
= 1.2214, d = e −σ t
= 0.8187
Suu

Su

S Sud,Sdu

Sd

Sdd

Valuation 97
Solution: Binomial model (2)
1 + rf − d
q=
u−d
qVuu + (1 − q )Vud
Vu = max( S u − 300,0) +
1 + rf
qVud + (1 − q )Vdd
Vd = max( S d − 300,0) +
1 + rf
qVu + (1 − q )Vd
V0 =
1 + rf

Valuation 98
Solution: Black-Scholes

rf = ln(1 + 10%) = 0.0953


V = 1000[300 N ( d 11 ) - 300e -0.0953 N ( d 12 )]
+ 1000[300 N ( d 21 ) - 300e -0.0953*2 N ( d 22 )]
ln(300 / 300) + ( rf + 0.5σ 2 )t
d t1 =
σ t
d t 2 = d t1 − σ t

Valuation 99
Solution: Monte Carlo simulation
~
S it = S i ,t −1 R
1 ~
~ r f − σ 2 +σZ
R=e 2
~ ~
Z = NORMSINV (U )
~
U = RAND()

 Function RAND() generates a random realization of a random


variable uniformly distributed over the interval [0,1].
 NORMSINV(U) generates a random realization of a random
variable following a standard normal distribution.

Valuation 100
Monte Carlo simulation: a sample
path

period t=1 t=2


U 0.2679 0.7208
Z -0.6193 0.5853
R 0.9526 1.2121
S 285.78 346.40
Production cost 300 300
NCF 0 46.40
PV 0 38350.41
V 38350.41

Valuation 101
Option to delay: example
 Panel A: Invest now
10 15 15 per year for ever

good
-100
10 2.5 2.5 per year for ever

bad

 Panel B: wait one year and invest only in good state


-100 15 15 per year for ever

good
0
0 0 0 per year for ever

bad

Valuation 102
Option to delay (2)
 Risk free rate = 5% per year.
 $1 invested in the market portfolio will be
worth either $1.3 (when the state is good)
or $0.8 (when the state is bad) in one
year.
 Should we invest now or should we wait
until next year?
 What is the value of the option to wait?
Valuation 103
Option to delay: solution

Valuation 104
Option to expand: example
 A project can generate the following CFs:

200

good

-140 150

bad

100
 The firm has the option to double its capacity by investing another 140
in year 1 if the economy looks good.

Valuation 105
Option to expand (2)
 Risk free rate 5%.
 Risk neutral probabilities: q=0.6 in both
periods.
 What is the value of the project without
considering the option value?
 What is the value of the project after
considering the option value?
 What is the value of the option to expand?

Valuation 106
Option to expand: solution

Valuation 107

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