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decribes about recent trends in valuation very important from valuation point of view
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M&A activity is driven by multiple macro-economic and industry forces and opportunities …
CHANGE IN INDUSTRY STRUCTURE
� Consolidation
� Pre-emptive M&A by competitors
� Technology advances
RISK OF UNDERPERFORMANCE
� Need to reduce debt (whilst preserving the core)
� Change in performance of different elements of the portfolio
REGULATORY AND POLITICAL PRESSURE
� Europe as a trading block post EMU
� Deregulation of global trade
� Interest in emerging markets: China etc
DESIRE FOR FOCUS AND SIMPLICITY
� Complexity of business unit
� Overload of business unit priorities
� Identification of synergies across the portfolio
Do we value them correctly?
CHANGE IN CAPITAL MARKET OPPORTUNITIES
� Availability of funding
� Investor expectations and sentiment
� Performance of stock market
� Relative values of stock prices versus hard assets
SEARCH FOR GROWTH OPPORTUNITIES
� Extend geographic coverage
� Acquire complementing assets
� Extend within or across industries
World M&A UK M&A
Note: Includes all cross border and domestic deals completed 1st Jan 2004 - December 2007. Excludes MBOs &
Privatisations.
Source: Datalogic, Thomsom Financial, KPMG analysis
0
UK Cross Border
UK Domestic
World Half-Year TotalTelecoms specific
2006 2007 20082004 20052004 2005 2006 2007
0
100
200
300
H1 H2 H1 H2 H1 H2 H1 H2 H1
£billion
200
600
1,000
1,400
£billion
H1 H2 H1 H2 H1 H2 H2 H1H1
2008
H2H2
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Buy-side deals are becoming more successful…
SELL-SIDE EXPERIENCE
� 35% of vendors completed their most recent disposal at a price significantly below their own valuation
� Of these, an average 20% price reduction from valuation to selling price was experienced
� 60% of all vendors suffer post deal issues
BUY-SIDE EXPERIENCE
Deals addingvalue
Deals that do not add value
Source: KPMG survey ‘Increasing value from disposals – A case study for professionalising the sell side’ - 2009
Source: KPMG survey ‘Beating the Bears’ - 2008
… but that sell-side activities are becoming more challenging
Value creation
17%31% 34%
30%
38% 34%
53%
31% 32%
0%
20%
40%
60%
80%
100%
1999 2004 2007
Enhance value Neutral Reduce value
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Almost 70% of deals add no value
Source: Financial News, Briefing Note 19, 17 Sept 2001, Offer Information Week
UK-WIDE M&A VALUE CREATION WHY MERGERS FAIL
Underestimating the management effort required to realise benefits is the primary reason for failure to deliver value from mergers
Deals destroyed value
Deals produced no discernible difference
Deals added value
Source: KPMG surveys
2001 2008
17
30
30
39
53
31
0%
20%
40%
60%
80%
100%
% of deals
Deals that do notadd value
Deals that do add value
60%
43%
38%
36%
33%
30%
28%
18%
14%
0 10 20 30 40 50 60 70
Resistance to Change
Limitations of Existing Infrastructure
Lack of Executive Alignment
Lack of Executive Champion
Unrealistic Expectations
Lack of Cross-Functional Teams
Inadequate Team and User Skills
Key Stakeholders Not Involved
Project Charter Too Narrow
Contribution to Merger Failure (%)
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Operational improvements:e.g, improved back office
processes, expanded customer service functionality, etc.
Operational performance improvement is recognised as being key to realising value from transactions
– “1992 was the last time the most
common form of exit was
receivership, as it is now.”(1)
– “The ability to supplement deal
skills with appropriate management
expertise will allow proactive
assistance to be given to portfolio
companies to add to product
value.”(2)
– “I wonder if people are coveting
operational skills simply because
they are more operationally
involved in the businesses at the
moment than they want to be
[because of under-performance].”(3)
Source: (1) Jon Moulton, Managing Partner, Alchemy
Partners, Super Return 2002 Conference
(2) KPMG/Manchester Business School Survey
(3) Simon Turner, joint Chief Executive
Inflexion, FT February 28
RATIONALE FOR DEAL
Consideration Value Creation
DealCosts
Price Paid
Premium
Standalone Value
SynergiesNew
Strategies
Value £m
Create Shareholder
Value
Destroy Shareholder
Value
Sales growth
Product development
Operational factors
Rationalisation of manufacturing
Almost 70% of deals add no value, why?
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Choosing Valuation Methods
Market MethodsMarket Methods
Economic MethodsEconomic Methods
Asset-Based MethodsAsset-Based Methods
There are basically three valuation methods (market, asset-based and economic methods) which contain many models.
For example, under economic methods, there are three main models - DCF, Economic Profit (EVA, ROIC and CFROI) and option pricing models.
Within DCF models there are further sub-models depending on whether you are discounting dividends, FCFE or FCFF.
Even within each sub-model, further choices can be made as to whether 2-stage, 3-stage or multi-stage explicit growth periods are used.
Economic Methods
Economic Profit
APV Model
DCF Models
FCFF
FCFE
Dividend
Discount
Option Pricing
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Prior Theories of valuation
• Miller and Modigliani – the “primitive firm” (1963)– Expected free cash flows from operations
– Discounted at a constant weighted average cost of capital
– Assumes that operating cash flows are unaffected by capital structure
– Optimal capital structure a tradeoff between the benefit of a debt tax shield and the present value of business disruption costs
• Leland – Four terms in the valuation equation (1998)– Value of the unlevered firm– PV of the tax shield on debt– Minus the PV of tax shield lost if debt becomes extreme– Minus the PV of business disruption costs (as a function of debt)
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• Schwartz and Moon (1999)
– The value of the primitive firm is enhanced by real options
– They model the value of an abandonment option
– Other real options are also important:
• Growth options (Myers 1977)
• Options to exit and re-enter
• Options to abandon (liquidate)
• Options to enter and exit Chapter 11
Prior Theories of valuation
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But are we happy with those theories?
• None of the prior theories does a very good job of explaining the significant and persistent differences in capital structure across industries
Confidential
Copyright © 2005 Monitor Company Group, L.P. — Confidential — CAMZKN-MFB-Stoll_Charts-5-18-05-TC 13
Market Debt-to-Equity (2002)A-rated Companies
0.0 0.5 1.0 1.5 2.0 2.5
Commercial Banking
Energy
Chemical
Food and Beverages
Media (Print)
Retail
Pharmaceutical Median = 0.07
Median = 0.13
Median = 0.13
Median = 0.20
Median = 0.34
Median = 0.87
Median = 1.21
Market Debt-to-Equity Ratio
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The Reality – a new theory of the firm
• A firm is like a three-layer cake:– The cost of debt is suboptimal exercise of the firm’s real options and the benefit is its tax
shield– Greater operating flexibility allows for greater debt capacity
Financial Options — Debt and Equity are options on the firm’s
portfolio of assets (with flexibility)
Real Options — Payouts on the portfolio of assets are modified by real options (e.g., capacity caps, expansion, and bankruptcy)
The primitive firm is modeled without flexibility (DCF)
Financial Options
Real Options
The Primitive Firm
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New trends in Valuation Methodologies
Comparable Multiples
Discounted Cash Flow (the primitive firm)
New trends such as APV, EVA and Monte Carlo
Option Pricing: real options
Option Pricing: financial options
The future of valuation: the firm as a 3-layer cake
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Comparable Multiples:
Valuation based on actual transactions
• First, we should acknowledge that
– There are rarely any close comparables
– Often neither the assets nor the liabilities have liquid markets for trading
• All comparables are going concerns
• Recommended approach is a multiple regression
V (houses) = a + b (number of square feet)
+ c (number of rooms)
+ d (age of house)
+ e (acreage)
+ f (number of fireplaces)
+ g (taxes)
+ h (swimming pool)
Entity multiple = a + b (earnings before interest and taxes)
+ c (growth in earnings)
+ d (capital turnover)
+ e (return on invested capital)
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Traditional DCFlow Valuation – the primitive firm
Most valuations of non-financial companies start with estimated free-cash flows to the entity, discount them at the weighted average cost of capital, then subtract out the value of debt
+CV=Entity Value
Discounted at the weighted average cost of capital
PV of (Expected Free Cash Flows + Continuing Value) = Entity Value
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DCF - Predicted FCF follow an irregular pattern
-10
0
10
20
30
40
50
60
70
1 2 3 4 5 6 7 8 9 10
($ millions, 2004-2014)
Free Cash Flows of company X could be
Revenue growth:-- one year 31.6%-- 3-5 years 17.5%-- long-term 10.2%
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DCF Valuation
The continuing value (CV) assumptions are also crucial
– Will the company’s ROIC fall to equal its WACC or remain at current levels?
– What is the cost of capital given the two alternatives?
– How will its cost of capital change, and what will its value drivers be? E.g., revenue growth, operating margin, capital turns?
– Which Continuing Value formula should one use?
– Are the ROIC and growth assumptions consistent with the assumed amount of earnings retention?
x
gWACC
rgNOPLATCV
1.3 multipleExit
x(243)1.10NOPLAT x multiple
)/1(
6.26ue/EBITDAMarket valEntity multipleEntry
11
=
==
−
−=
==
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Frequency Chart
.000
.009
.018
.026
.035
0
8.75
17.5
26.25
35
-75% -31% 13% 56% 100%
1,000 Trials 4 Outliers
Forecast: Expected Annual Return
DCF Valuation (Cont.)
• A model in evolution
– From fixed discount rate to iteration process
– From fixed WACC to changing wacc per year
– From mono input to Monte Carlo Analysis
31/12/2005 31/12/2006 31/12/2007 31/12/2008 31/12/2009 31/12/2010
Equity 1.184.838 2.963.995 3.092.459 3.277.123 3.497.139 3.752.617
Debt 1.066.826 803.598 2.643.064 2.727.972 2.637.111 2.497.997
Total 2.251.664 3.767.593 5.735.523 6.005.095 6.134.250 6.250.614
Ratio equity 52,6% 78,7% 53,9% 54,6% 57,0% 60,0%
Ratio debt 47,4% 21,3% 46,1% 45,4% 43,0% 40,0%
Levered beta 0,71 0,52 0,69 0,69 0,66 0,64
WACC 7,71% 9,14% 7,78% 7,82% 7,95% 8,12%
XYZ NV
Cash flows in EUR per : 31/12/2006 31/12/2007 31/12/2008 31/12/2009 31/12/2010 31/12/2011 31/12/2012 31/12/2013 31/12/2014 31/12/2015 RV
EBIT 457.502 365.590 510.021 703.419 723.840 921.384 827.735 831.074 834.476 837.939 837.939Depreciation 87.879 247.410 249.279 243.119 258.344 225.011 228.692 245.853 263.351 281.192 281.192
Taxes on EBIT (-) (142.614) (114.860) (161.168) (225.918) (230.519) (295.161) (259.580) (254.865) (250.320) (245.335) (245.335)
Net operating cash flow 402.768 498.140 598.133 720.620 751.665 851.234 796.847 822.062 847.506 873.796 873.796
Investment Formation Expenses 0 0 0 0 0 0 0 0 0 0
Investments Intangible Assets 0 0 0 0 0 0 0 0 0 0
Investments Tangible Assets 0 1.680.000 119.740 138.465 152.250 164.426 168.311 171.612 174.978 178.410 281.192
Investments Leasing 0 0 0 0 0 0 0 0 0 0
Divestment leasing 0 0 0 0 0 0 0 0 0 0
Investments Net Working Capital Long Term (695) (709) (723) (738) (752) (767) (783) (798) (814) (831)
Investments Net Working Capital Short Term (185.007) 440.979 287.081 213.634 186.047 31.372 62.900 49.063 49.839 51.939 0
Free Cash Flow 588.470 (1.622.130) 192.035 369.259 414.120 656.203 566.418 602.186 623.503 644.277 592.605
WACC 9,14% 7,78% 7,82% 7,95% 8,12% 8,45% 8,96% 9,53% 9,72% 9,69% 9,69%
Present Value of annual future FCF 539.176 (1.396.308) 153.179 271.829 280.230 403.134 310.570 290.537 270.385 255.354 2.423.625
Present Value of future FCFs 1.378.085
Present Value of Residual Value 2.423.625
Excess marketable securities as per 31-dec-05 0
Financial Assets (+) / Hidden liabilities (-) 0
Value of Company as per 31-dec-05 3.801.710 EQUITY VALUE AS OF 30/06/2006 2.763.708 EURDebt as at (-) 31-dec-05 (1.066.826)
Value of Equity as at 31-dec-05 2.734.884 in Euro 2.763.708 000 €
Equity value as of 31-dec-05 2.734.880
Equity value as of 30-jun-06 2.763.708
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But DCF tends to undervaluate
• The histogram below shows the DCF value of a company minus its market value as a percentage of its market value for 27,123 valuations between January 31, 2000 and July 31, 2004.
0100020003000400050006000700080009000
Number of Companies
x<-.8
-.8<x
<-.7
5-.7
5<x<
-.67
-.67<
x<-.5
-.5<x
<00<
x<.5
.5<x
<1
1<x<
2
2<x<
3
3<x<
4
4<x<
5
x>5
(DCF-Market)/Market
68.1%
3.2%
Lognormaldistribution
56.3%>0
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Bias in the DCF model?
• We hypothesize that DCF works well for large, diversified companies that have low volatility and low growth, but undervalues companies that have high volatility and high growth. Cells Contain median difference between DCF and market value at the end of a month scaled by market value.
Lowestg<5.3% g<7.9% g<10.9 g<16.3%
Highestg<113.4%
Lowestv<1.50x
5.4%1,463
1.1% 1,518
8.7%1,344
7.7%861
40.4%239
v<1.82x 12.9%
1,21810.6%1,384
13.6%1,281
18.4%1,044
3.0%497
v<2.22x27.6%1,091
19.9%1.197
20.2%1,130
15.8%1,150
9.4%857
v<2.91x50.7%
99434.7%
79816.7%1,031
2.7%1,326
-3.1%1,275
Highestv<660.5x
51.4%659
21.8%527
2.9%639
-7.3% 1,043
-21.7%2,555
Analyst projection of 3-5 year revenue growth
Volatility one
Year forwardas a % of
SPX volatility
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Criticism on DCF
False mutually exclusive scenarios
Volatility ignored
A key driver of value given option-pricing methodology
Difficult to incorporate in a DCF approach
Does not capture value of flexibility (real options)
Abandonment (divestiture, close-down)
Expansion/growth (greenfield, M&A)
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Adjusted Present ValueAdjusted Present Value……
Value of the projectas if financed only
with Equity
Interest tax shieldsInterest tax shields
Financial distress costsFinancial distress costs
Subsidies and guaranteesSubsidies and guarantees
HedgesHedges
Issue costsIssue costs
+/-
BaseBase--case valuecase value
Value of all financing side effectsValue of all financing side effects
Evolution from DCF to APV
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How Does the APV Model Work?
1. Value the firm as if it were financed entirely with equity
2. Evaluate the financing side effects of the interest tax shield
3. Assess the costs of financial distress
4. Estimate the other financing side effects
5. Aggregate the components to arrive at an enterprise APV value
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Specific Applications for the APV Model
1. Changing debt structures (eg. LBOs and MBOs)
2. Multi-business valuations (especially HQ functions)
3. Tax loss carry forward situations
4. Project finance
5. Optimizing debt levels
6. Presenting synergies
7. As a quick sanity check
WACCWACC
APV tends to APV tends to infinityinfinity
EnterpriseEnterprisevaluevalue
GearingGearinglevelslevels
The Gap The Gap betweenbetween APV APV and WACC and WACC isis the the costcost
of of bankruptcybankruptcyWACCWACC
APV tends to APV tends to infinityinfinity
EnterpriseEnterprisevaluevalue
GearingGearinglevelslevels
The Gap The Gap betweenbetween APV APV and WACC and WACC isis the the costcost
of of bankruptcybankruptcy
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What is EVA™
1. Registered trademark of Stern, Stewart & Co
2. Performance measure
3. Re-arrangement of DCF
4. Positive EVA implies shareholder value creation
5. McKinsey’s EVA is called ROIC Economic Profit Models
Residual Income Models
CFROI
EVAROIC
New trends in valuation …
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Economic Value Added defined
• EVA is the profit (or loss) remaining after deducting the cost of capital from the operating profit after taxes.
• EVA measures the shareholder value created (or destroyed) over a certain period. EVA shows that a company creates value only if operating earnings are sufficient to earn back its cost of capital
EVA = NOPAT – ((Cost of Capital) x (Capital))
EVA = Net assets x (RONA – WACC)
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Real Options (the second layer) -- Value trees
FCF -9 4 22 54
1320
Positive cash flows are dividends while negative cash flows are investments. All cashflows are proportional to the value in each state of nature so that expected cash flows
are preserved
Valueat year t
Company X
Volatility = 97%
U= 2.65 = eσ√T
D = .38 = 1/u
P=.32
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The firm’s real options…
1. Real options is the term used to denote the explicit valuation of
the opportunities associated with changing decisions in response
to the resolution of relevant uncertainty.
2. A real option is the right, but not the obligation, to take an action
(eg deferring, expanding, contracting or abandoning) at a
predetermined cost (exercise price), for a predetermined period
(Stewart Myers, MIT)
Invest
Don’tInvest
Bad news
Bad news
Good news
Good news Cash flow
Cash flow
Cash flow
Cash flow
Invest
Don’tInvest
Bad news
Good news
Cash flow
Cash flow
Cash flow
Cash flowInvest
Don’tInvest
This is not an option This is an option
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A real option is the right, but not the obligation, to take an action in the future upon the receipt of information. A call is the right to buy (or invest) at a fixed price, and a put is the right to sell.
Examples:
Defer
Expand
Extend
Shrink
Abandon
Five factors affect the value of an option
Value of an underlying asset (+)
Exercise price (-)
Volatility (+)
Time to expiration (+)
Risk-free rate (+)
What is a Real Option?
Simple OptionsProbability
of V
Higher volatility increases the probability of finishing in-the-
money where V > D
D V
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Compound Options are options on options
– Phased construction
– Research and development
– New product development
– Exploration and production
– Equity in a levered firm
– Call option on equity
Switching Options
– Shutting down and reopening
• Mines
• Automobile assembly plants
– Exit and reentry
– Turning off then on
• Peak load power plants
– Switching between modes of operation
• Dual fuel power plants
•Rainbow options (multiple sources of uncertainty)
– Price and quantity uncertainty
– Quadranomial
A Few War Stories That Introduce More Real Options
Sequential
Simultaneous
Examples
$650 million chemical plant
$7,000 million high-tech clean room
Examples
Valuation of peak-load power
Exit from PC assembly
Exit from aerospace division
Mine operation
Depends on
Switching cost
Volatility of underlying
Non-recombining binomial tree
Example
$1,000 million oil field development
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Despite the strong growth, consumer PC assembly players have found their market participation to be mostly dissatisfying as they are not earning their cost of capital
Switching Option – An Example of an Exit and Reentry Decision
Source: Analyst Reports; Annual Statements
-7.0%
-4.1%
-2.0%
29.7%
-11.0%
-20% 0% 20% 40%
Packard Bell
Apple
Compaq
Acer
Gateway
Consumer PC Assembly (Mid-1990s)
Spread: ROIC — WACC
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Real Options — A Four Step Process
Objectives
Comments
� Compute base case present value without flexibility at t = 0
� Value the total project using a simple algebraic
methodology
� Identify major uncertainties in each
stage� Understand how those uncertainties affect the
PV
� Analyze the event tree to identify and
incorporate managerial flexibility to respond to new
information
� Still no flexibility; this value should equal the value from Step 1
� Explicitly estimate uncertainty� Monte Carlo
analysis� Management
estimates
� Incorporating flexibility transforms event trees, which transforms them into
decision trees� The flexibility
continuously alters the risk characteristics of the project, and hence the cost of capital
� ROA includes the base case present value
without flexibility plus the option (flexibility) value
– Under high uncertainty and
managerial flexibility option value will be
substantial
Steps
Output � Project’s PV without flexibility
� Detailed event tree capturing the possible present values of the
project
� A detailed scenario tree combining
possible events and management responses
� ROA of the project and optimal contingent plan for the available real
options
Model theUncertainty
Using Event Trees
Identify and Incorporate Managerial
Flexibilities Creating a Value Tree
Calculate Real Option Value (ROA)
Compute Present Valueof PrimativeFirm
Using DCF
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Financial Options -- the third layer
• The cumulative cash flow along each possible path determines the cash available for payment of zero-coupon debt.
• The equity is an option on the second layer of the cake
• And the real options on the second layer are options on the primitive firm.
• Assumptions:
1. Cumulative cash flows calculated along each path
2. Zero coupon debt
• Due if liquidation occurs
• Otherwise due in year 10
• At face value
3. Liquidation value
4. Growth (Expansion) option
• Expansion factor = X%
• Execution cost = $xxx million
5. Equity is an option on the firm with real options – residual CF is valued
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With and Without Debt – Interactive boundary conditions
-100
0
100
200
300
400
500
600
700
800
900
0 1 2 3 4 5 6 7 8 9 10
Cumulative Cash w/o Debt Cumulative Cash w/ Debt
0
500
1000
1500
2000
2500
0 1 2 3 4 5 6 7 8 9 10
Entity Value w/o Debt Entity Value w/ Debt
This panel shows that the entity value (layer 2) is affected as one adds debt in layer 3 – the abandonment decision
without debt is altered when the firm takes on (zero coupon) debt because abandonment (liquidation) amounts to early payment, therefore abandonment
occurs later with debt.
Here abandonment takes place in year 7 when there is no debt. But if there is debt, abandonment is deferred because the entity
value is greater than the residual after liquidation and debt payment.
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Optimal Capital Structure
322
411
329
247
169
84
494
194145
102
52
169
172
217
160
102
67
320
100
200
300
400
500
0 500 1,000 1,500 2,000 2,500 3,000
Tax Benefit of Debt
Cost of Debt –suboptimal exercise of abandonment
Net Benefit of Debt
Parameters
Tax rate = 20%Abandonment price =
$1,100
$ Value
Debt
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Next Steps
• Extension from value branch to value tree
– Need to study ways of estimating volatility
– Model growth as a series of one-period European call options
– Capture inter-dependency between financial and real options
– Optimal capital structure is tradeoff between
• Cost of debt as suboptimal exercise of abandonment and growth options
• Benefit of debt as tax shelter
– Explains why
• DCF undervalues high growth and high volatility situations
• There are cross-sectional regularities in debt-to-equity ratios
• CFOs say that flexibility is the single most important variable
when considering capital structure