Advanced Valuation Erasmus

1.
Question 1
The questions in this quiz are example problems that you will learn to answer in greater detail
after you finish the entire course. For now, we will consider how to express a strategy as a
combination of real options, adding elements of game theory. These are reflective open
questions and the focus is on your thought process, rather than on you providing the exact same
answer as the answer sheet. The questions will provide you with a first intuition on how DCF,
Real Options and Game Theory can be applied.
Real Options in Venture Capital
Real options refer to choices on whether and how to proceed with business investments. Real
options analysis gives management the flexibility to decide to delay, expand, abandon or
reposition investments. Like financial options, real options have value under uncertainty.
Depending on the resolution of uncertainty in the future, management has the choice – but not
the obligation – to exercise its options.
An example involves a venture capitalist deciding whether to finance the next stage in a start-
up.In order to deal with uncertainty the investor stages the investments in A, B, and C rounds as
is shown below.
Observe that, from a real options perspective, each round is an option where the investor can get
access to the next option, which will only be pursued it if it is favorable to do so. Please describe
the growth options value of staged financing under uncertainty as a real option.
Startups are really risky at the beginning. Because financing for a startup is also full of risk, it
will be divided into different phases. There are usually 4 phases as in the diagrams. The risk
of loss will be lower as they are moving from startup financing to A round, B round and C
round. After each phase/round is reviewed and it is satisfied, the start-up can ask for more
capital from investors in the next round. For example, B round generally takes place when
the company has accomplished certain milestones in developing its business and is past the
initial startup stage.
The growth options value of the current investors is to realize growth value in their
investment when the review successful. If the review is not ok, it means the startup has
failed, the investors do not have to continue the investment in the startups and follow the
predecided terms( defer the investment until review is ok, abandon investment or continue
to invest at a predetermined price).
2. Growth Option Value in a Serial Acquisition Strategy
In 2001, Xstrata was a nondescript Swiss-listed ferrochrome and zinc business attached to
Glencore, a metals trading house. Subsequently Xstrata completed a series of acquisitions,
including Glencore’s coal assets in 2002; MIM – the Australian coal, copper and zinc group – in
2003; the Tintaya copper mine in Peru, a one-third share of the Cerrejon coal mine in Colombia
and the acquisition of Falconbridge in Canada, all in 2006. In the short time span of five years,
this journey transformed Xstrata from a minor into a major miner. These transactions were part
of an acquisition strategy known as “buy-and-build,” in which an equity investor initially
undertakes a “platform” acquisition in an industry and then leverages core competencies or
efficiencies onto follow-on acquisitions in a broadened geographical base. The goal of such a
strategy is targeted industry consolidation.
While individual investment opportunities can be viewed as simple real options, a serial
investment strategy can be viewed as a chain of real options. The early deal in the chain
represents a compound real option: it is a real option that creates a subsequent real option (i.e.
the underlying asset of the first option is the next option it creates). Try to consider a platform
acquisition and follow-on acquisitions as a chain of real options and describe what drives their
(option) value.
When a firm acquire another firm, it usually wants to expand its business via acquisitions
instead of built-in.
The real option in here is reflect via the option to defer for example, defer domestic
expansion or international expansion if the domestic market isn't a good choice. Or the
option to abandon or defer or expand geographic markets.
Buy acquiring another firm, the real option is an instinct value when compared to built-in
operation.
3. Understanding Expanded NPV
What are the components of an expanded NPV of a platform acquisition?
4. Calculating Present Value of Growth Opportunities

With the “market method” we can back out the market’s perception of strategic growth option
value from share prices. Any value that is embedded in a company’s market value and cannot be
reconciled for by the value of its assets in place represents the value of its growth opportunities.
Suppose that the market value (share price multiplied by outstanding shares) of the company
equals $80 billion. The value of assets in place of the company, estimated as the discounted
value of earnings under a no-growth policy, equals $50 billion.
Estimate the strategic growth option value (also known as the present value of the growth
opportunities, or PVGO) for this company.
The present value of the growth opportunities is the difference between the market value of the
company and the discounted value of earnings under a now-growth policy which value
respectively at 80 billion and 50 billions. That makes the present value of the growth
opportunities and strategic value for this company are around 30 billions.
5.Question 5
Real Option to Defer in the Oil Industry
In 2012 the company Artic Oil contemplates to start exploration drillings in Nova Scotia. This
allowed them to invest a limited amount in 2012 to perform initial explorations before fully
investing in 2015 a complete drilling platform and start production. That is, they purchased an
option on the value of future oil production.
Management is analyzing the initial decision in 2012 to start exploration drillings. As their
financial expert you explain to the management of Artic Oil how in 2012 the initial explorations
were viewed as obtaining a real option. You decide to explain it to them using option theory and
draw them a graph of the option where they can decide to invest in the future depending on the
evolution of oil prices.
Use the figure below to explain how the future investment in the production facilities in 2015
depends on the evolution of the oil price. Draw the time (option) value (as of 2012) of this pay-off
in the figure.
- From the chart, the angle of the payoff is 45o, it means for 1 buck further invest in 2015
the option payoff is 1 buck more.
- The real option in this investment is option if the company doesn't want to continue invest
if the oil price is low, or there are not as much oil as it was expected.
6.Question 6
Real Options and the Resolution of Uncertainty
In 2012 the company Artic Oil started exploration drillings in Nova Scotia, based on your
analysis. That is, they purchased an option on the value of future oil production in 2015.
In the years. 2012 until 2015, the oil industry has been under pressure with prices dropping
significantly. What happened with the value of the option?
it equals zero, because the oil price droping, so the project will be postponed.
7. The Value of Mining Options Under High Uncertainty

For a long time the oil industry had been characterized by highly volatile oil prices. The
uncertainty in oil prices is often expressed as volatility or degree of variation. The graph below
presents the monthly volatility of oil prices over time. The y-axis represents the volatility, while
the x-axis represents time. In the graph there are two distinct periods, period 1 and period 2.
Consider the development of an oil field as a real option.Disregarding other parameters, in which
period would the real option value be higher? Explain your answer (Hint: A higher volatility
suggests a wider future pay-off distribution).
The higher volatility will make the real option value higher as it increase the value.
8. Game Theory in Bidding Contests

Consider a piece of land in which both a farmer and a project developer are interested. The
project developer wants to buy the piece of land so that he can use it for the development of a
real estate project, such as a large shopping mall. The farmer wants to buy the piece of land to
build himself a new home; he would like to shift from his old land, since he likes the
neighborhood of the new land better. Both bidders assign different values for the piece of land
based on their plans.
In an acquisition, how can the fact that the bidders have different plans with the target affect the
outcome of the bidding game and the acquisition premium?
The project developer will have more motives to put a higher price to acquire the land because
he has more plans for expansion than the farmer has. For example, he can build more stores in
the land to have more vacant while the farmer only has a motivation to build a house.
9.A Bidding Contest as a Game

Now consider how to solve a bidding situation using principles of game theory. In a bidding
game, two competing investors (A and B) enter into a bidding game for a target by submitting
either a high bid or a low bid for the target company at the same time. The payoff (= value -
price) in each scenario is presented in the game in the matrix below. What is the best strategy for
Bidder A? (Hint 1: which row does Bidder A prefer, given the decisions Bidder B can make?)
(Hint 2: depending on the preference of Bidder A, which column will Bidder B prefer?).
The bidder A will prefer high bid, because the expected value of A is higher in row high bid.
Bidder B will prefer low bid because the expected value of value B is higer in column low bid.

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1.

Real Options in Venture Capital

2. Growth Option Value in a Serial Acquisition Strategy

3. Understanding Expanded NPV

What are the components of an expanded NPV of a platform acquisition?

4. Calculating Present Value of Growth Opportunities

7. The Value of Mining Options Under High Uncertainty

8. Game Theory in Bidding Contests

9.A Bidding Contest as a Game

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