Advance Corporate Finance

Lecture 2

3rd Feb, 2020

Mid-sem March 2018

- Focus of the firm- Maximization of shareholders wealth ( shareholder value

maximization)
- Compared with Alternative View- Stakeholder Theory
- Stakeholder theory- they are other stakeholders in the firm who has a vested
interest in the firms performance. Managers of the firm should take explicit account
of the interest that these varies stakeholder has. There ought not to be a single focus
- They argue that is too narrow of a view to be the focus of the firm
- Other stakeholders- employees, customers, suppliers, local communities and
government.
- Other stakeholders have a vested interest – since they considered major
constituencies of the firm—their concerns should be internalized
- Theory contends that the company success should be access by taking account of the
contributions of all stakeholders
-

March 16 2019

Question 2 a& B- RESEARCH

Read Value Maximization and Stakeholder Theory: Compatible or Not &&& “ The
Corporate Objective…”

Corporate Social Responsibility- stake holder theory & performance on the firm -READ
Donaldson, T and Preston, L

CAPITAL BUDGETING

Motivation for the use of real options.

- The essence of real options- the applications of real options analysis, pros & cons of
real options, Real options and the escalation of commitments, empirical on capital
budgeting techniques, where does real options stands in term of practical use
- Read: ALL ARTICLES ON REAL OPTIONS.
- Limitations on discounted cash flow analysis (read)
- Capital projects can be evaluated based on-NPV, IRR, PAYBACK, DISCOUNTED
PAYBACK, PROFITABILITY INDEX.
 - Remember the formula for NPV

Discounted cash flow assumptions

3. Once launched, all projects are passively managed- Cash flow analysis is static in nature-
in Discounted Cash Flow Analysis, it assumes that decisions are taken once and for all
pertaining the project- without any possibility of modifying it. Managers don’t have
flexibility

The reality is that they are actively managed through the projects life cycle.

4. Cash flows are highly predictable and deterministic; therefore a simple formula can be
used. Anticipated streams and application of a discount rate. Difficult to estimate- risky in
nature- stochastic

5. Project discount rate…. Multiple sources of risk

6. At the beginning of the period of decision- certainty about the risks that would accrue to
the project. Which is extremely restrictive- reality- project risk can change in the course of
the project.

7. Restrictive nature- Reflected in the discounted cash flow module. Reality – Project may
be complex. – difficult to quantify what would affect the project. As the project unfold…
better able.;.

** DCF analysis- Decisions are made once and for all at the beginning- application of a
simple formula – make decision- NPV >0 = invest , passivity on part of the manager, firms
cannot make adjustments after they commit to the project. Uncertainty that prevails
volatile environment in which management make strategic investment decision is not taken
into account.

Look @ pg 4 - That flexibility which management has is not taken into account in
discounted cash flow analysis. ( DCF does not take this into account) The flexibility that
management has would underestimate the value of the project.

SUMMARY ( pg 4)

-Real options analysis is an approach to valuing investment projects ( capital budgeting

technique)

-recognizes the role of uncertainty in investment activities

- Triantis and Borison (2003), they define real options as a tool that captures a firms ability
to respond to new information and also to deal with projects uncertainty.

- Real options recognizes that investment projects can evolve overtime, do not have to
make the decision upfront. Hence, management has flexibility to respond to different
scenarios when making future decisions. This flexibility of management to alter the path of
a project increases the overall value of the project.

-Utilization of real options – adds value.

- real options analysis has mushroomed in the business world and force managers to think in
a more strategic way.

- Real options analysis makes management more reactive and management becomes more
reactive because they are able to respond effectively as new relevant information comes to
light and also as uncertainties are resolved overtime. Management is also more proactive in
building flexibility into projects.

-If investment projects becomes a more strategic activity—new info comes to light- can
comes from functional areas of the firm ( Real options analysis should come from functional
areas)

- Real options analysis has the advantages of incorporating various individuals from within
varying divisions of the firms in the decision making process. ( Triantis and Borison)

-within real options analysis- the option value increases with the level of uncertainty.
Similarly, as the value of a financial option increases with the volatility of the underlying
asset.

-[OPTION THEORY] – READ

Real option theory shows that firms can take advantage of uncertainty rather than trying to
avoid it.

- Many types of options. Real option analysis value investment projects

- Must be some level of prudence on investments taken, some investments would
take place on a stage basis (e.g. – oil and gas)
- Major areas of application- Real option analysis
1. Exploration and development of natural resource reserve ( minerals, oil, gas)

Types of options: ( not allowed in DCF analysis)

1. Option to delay- we might want to delay the investment in the project until
changes in prices and other circumstances makes the investment more
profitable.
2. Option to expand- the firm may want to exercise this option if the initial
investment turns out more promising than originally anticipated. Or if the
investment reveals more opportunities.
3. Option to abandon- If things does not work out as planned. The firm would not
get stuck in committing to a loss making venture. The firm would not be
escalating commitments to a failing project.
4. Option to vary production- depending on the circumstances.
 5. Option to switch- After commencement of the project, there may be
opportunities to switch to other technologies should they become value ..
6. Options that relate to maturity adjustments- projects can be completed over
flexible time frames.

If the financing for a project is on a floating rate- they can access to resources- b/c its
a floating rate basis- if interest rate falls t principles of the project they may want to
capitalize. Accelerate the project to take advantage of the rate. Therefore, they
would shorten the maturity of the project. If the opposite occurs, response would
be the opposite.

Prof Mon article

Real options applied in various industries

1. Option to switch in the oil and gas industry- Companies would spend large sums
to add new technology to create the option to switch. Depending on the market
conditions—which of the final output appears to be for profitable- they would
switch to that. ( built in). Similarly, the automobile and manufacturing industries
also has the built in switching option ( general motors- in producing new lines of
automobiles)
2. Growth option- Telecommunications industry in installing more advance
telecommunications infrastructure—in order to create a growth option in the
future—by providing a secure and extensive network. Create a high barrier to
entry.
3. Real estate industry company many exercise the option to delay. They can delay
by leaving land undeveloped so as to utilize that land at a later date when the
returns are more lucrative

E-BUSINESS- Real options can be used to create incremental investment stages

compared to a large lumpy investment, thus creating. Options to abandon or
growth options in the future.

If things don’t work out as planned, an abandonment option can be exercised

where the firm is sold for its intellectual property and other tangible assets. On
the other hand, if the firm is highly successful, it can be used in the vertical
integration process within the acquired firm, or it can be used In the
development of new products and services through the execution of an
expansion option. [READ AND UNDERSTAND THIS]

Common features of real option projects:

- They involved significant upfront investment that often does not lead to immediate
cash flows.
 - They tend to have well defined stages where the framing of the problem can be
logically laid out and where they are major well defined sources of uncertainty
whose resolution is expected to contribute significantly to the outcome and ultimate
value of the project.
- Data is readily available to estimate key parameters of the module.
- Real options can be module more accurately in firms which has proprietary
opportunities such as the right to develop such as a physical or intellectual property.
- Real options has gain more applications in companies where the majority of
managers and other employees have science, mathematics, and engineering
backgrounds and thus are comfortable dealing with probability theory and
quantitative module.
- Most simple form—Evaluation techniques: Financial options theory to value real
options. Monto Carlo, Latis Methods,

Essence of real options:

1. Real options refer to the use of options valuation techniques E.g. Black Scholes
Method, Monte-Carlo simulation, risk adjusted decision tree analysis. In valuing real
investments.

Criticism of real options analysis

1. Reflect perfection rather than economic reality. Managers are assumed to be

completely rational and loyal to the firms shareholders. Confirm a certain way in
which managers would behaves ( interest of shareholders) to ensure the best
interest of the shareholders is acted on through the maximization of shareholders
wealth. Setting out to minimize the loses. Management is assumed to know when
to intervene – Management can indeed be counted on to make the right decision at
the right time. Possession of complete information set to exercise the right option
at the right time (restrictive assumption)
2. These modules are extremely complex; incorporating real options makes the
decision process very complex. ( depending on the nature of investment project-
many risk factors, sources of uncertainty- -for it to be complete- the module would
have to capture the complexity of the real world- the more risk factors to be taken
into account the more complex you are making the problem to be solved. ) The more
possible events that can take place.

MISSING NOTES HERE

If the problem involves many different outcomes or scenario we are dealing with a
complicated situation.

A typical capital investment project may have many embedded real option simultaneously
and it may be impractical to consider all of it.
Real options and escalation of commitments

- Escalation of commitments occurs when decision makers continue to commit

resources to a project after receiving negative feedback about the effects of prior
resource commitment.
- Read Denison article on commitment,2009
- Decision maker incorporate real option into their capital budgeting analysis exhibit
less connection to a failing course of action than users to a NPV analysis . ( check
with gis) \
- Others have argued that real options can help overcome an anti- failure bias which
suggest that managers using real options analysis may be less likely to escalate
commitments to a failing project.
- Counter position: Conversely, others argue that because there is no specific exercise
date or expiration date on an abandon option managers may delay abandoning
projects past the time when they should abandon.