Chapter 19

Financing and Valuation

Recall that there are three questions in
corporate finance.
The first regards what long-term investments
the firm should make (the capital budgeting
question).
The second regards the use of debt (the
capital structure question).
This chapter is the nexus of these questions.
1

The 3 Methods for Valuation

1. After Tax WACC
2. Flow of Equity Method
3. Adjusted Present Value

Method 1
After Tax WACC
Tax Adjusted Formula

E
D
WACC rD (1 Tc )
rE
V
V
3

After Tax WACC

Example - Sangria Corporation
The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and
the pretax cost of debt is 6%. Given the book and market value balance
sheets, what is the tax adjusted WACC?

After Tax WACC

Example - Sangria Corporation - continued

The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax.
Given an initial investment of $12.5 million, what is the value of the machine?

Remember with WACC Approach !

Since tax shield is accounted for in the
cost of capital, calculate cash flows as if
the company is all equity financed.
WACC approach values the assets and
operations of the company. If you are
interested in equity value, do not forget to
subtract the value of the companys debt.

Capital Budgeting
Valuing a Business or Project
The value of a business or Project is usually
computed as the discounted value of FCF out to
a valuation horizon (H).
The valuation horizon is sometimes called the
terminal value.
FCF
FCF
FCF
PV
FCF
FCF
FCF
PVHH
11
22
HH
PV

...

PV

...

11
22
HH
HH
((11wacc
)
(
1

wacc
)
(
1

wacc
)
(
1

wacc
)
wacc ) (1 wacc )
(1 wacc )
(1 wacc )

Valuing a Business
Example: Rio Corporation

OCF=Profit After Tax + Depreciation

Valuing a Business
Example: Rio Corporation continued - assumptions

Capital spending

Investment in NWC

Valuing a Business
Example: Rio Corporation continued

FCF = Profit after tax + depreciation - investment in fixed assets

- investment in working capital

FCF = 8.7 + 9.9 (109.6 - 95.0) (11.6 - 11.1) = $3.5 million

PV (FCF) = 3.5/(1.09) + 3.2/(1.09^2) + 3.4/(1.09^3) + 5.9/(1.09^4) + 6.1/(1.09^5)
+ 6.0/(1.09^6) = 20.3
10

Valuing a Business
Example: Rio Corporation continued
FCF
66..88
FCF
HH11
Horizon

113
HorizonValue
Value PV
PVHH
113..33
wacc
waccgg ..09
09..03
03
11
PV(horizon
113 .3 $67.6
PV(horizonvalue)
value)
66 113 .3 $67.6
1.09
1.09

PV(busines
PV(business)
s) PV(FCF)
PV(FCF) PV(horizon
PV(horizon value)
value)
2200..3367
67..66
$87.9
$87.9million
million
11

Things to Consider
1. Dont value mechanically for terminal
value it might be wise to use knowledge
about mature firms in the industry.
2. Liquidation value.

12

In Practice
How are costs of financing determined?

What is included in debt?

What if there are other securities?
How do we determine debt return?
How do we determine preferred stock return?
What if project has a different leverage ratio?
How do we determine equity return for a firm that
is not yet traded, or (and) had a different leverage
than what we observe in the stock market?

13

Project with Different Leverage

Perpetual Crusher project at 20% D/V

rD is constant at 6% (at all debt levels up to 40%)

At 40%: rE=12.4% ; Tc=35% WACC = 9%

1.

Step 1: unlever the firm to find rA, the cost of capital

(WACC) in an all equity firm.
Step 2: Find rE when Debt is 20% (note D/E =
0.2/0.8=25%)
Step 3: Recalculate WACC

2.
3.

14

Example : Calculating WACC

World-Wide Enterprises (WWE) is planning to enter
into a new line of business (widget industry)
American Widgets (AW) is a firm in the widget industry
with an estimated beta of 1.5.
WWE has a D/E of 1/3, AW has a D/E of 2/3.
Borrowing rate for WWE is10 %
Borrowing rate for AW is 12 %
Given: Market risk premium = 8.5 %, Rf = 8%, Tc= 40%
What is the appropriate discount rate for WWE to use
for its widget venture?

15

Example : Calculating WACC

A four step procedure to calculate discount
rates:
1. Determining AWs cost of Equity Capital (rE)
2. Determining AWs Hypothetical All-Equity
Cost of Capital. (rA)
3. Determining rE for WWEs Widget Venture
4. Determining rWACC for WWEs Widget
Venture.
16

Beta and Leverage: No [Link]

In a world without corporate taxes, and with riskless
corporate debt, it can be shown that the relationship
between the beta of the unlevered firm (beta of assets) and
the beta of levered equity is:
Asset

Equity

Equity
Asset

In a world without corporate taxes, and with risky

corporate debt, it can be shown that the relationship

between the beta of the unlevered firm and the beta of
levered equity is:
Asset

Debt
Equity

Debt
Equity
Asset
Asset

17

Beta and Leverage: with Corp. Taxes

In a world with corporate taxes, and riskless debt, it can
be shown that the relationship between the beta of the
unlevered firm and the beta of levered equity is:

Debt
1
(1 TC ) Asset
Equity

Equity

Since

Debt
1
(1 TC )
Equity
must be more than 1 for a

levered firm, it follows that

Equity Asset
18

Beta and Leverage: with Corp. Taxes

If the beta of the debt is non-zero, then:
Equity Asset (1 TC )( Asset

D
Debt )
E

19

Method 2
Flow to Equity Approach
Discount the cash flow from the project to the
equity holders of the levered firm at the cost of
levered equity capital, rE.
There are three steps in the FTE Approach:
Step One: Calculate the levered cash flows
Step Two: Calculate rE.
Step Three: Valuation of the levered cash
flows at rE.
20

Flow to Equity
Sangria Corporation - continued

The company would like to invest in a perpetual

crushing machine with cash flows of $1.731
million per year pre-tax. Given an initial
investment of $12.5 million, what is the value of
the machine?
Remember: rE = 12.4%, D=$5million (40% of
projects cost), rD = 6%, TC=35%.

21

Method 2
Adjusted Present Value
APV = Base Case NPV+ PV Impact
1. Base Case = All equity finance NPV
Discount unlevered cashflow by
unlevered cost of equity (rA), assuming
not tax world.
2. PV Impact = all costs/benefits directly
resulting from project
- Discount all cost/benefits of financing
according to their particular risk.
22

Sangria Corporation - continued

Adjusted Present Value

The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment
of $12.5 million, what is the value of the machine?
Remember: rE = 12.4%, D=$5million (40% of projects cost), r D = 6%, TC=35%.

23

Side Effects in APV Easy to Add Up

Example:
Project A has an NPV of $150,000. In
order to finance the project we must issue
stock, with a brokerage cost of $200,000.
Project B has a NPV of -$20,000. We can
issue debt at 8% to finance the project.
The new debt has a PV Tax Shield of
$60,000.

Summary: APV, FTE, and WACC

Initial Investment

APV
All

Cash Flows

Unlevered Unlevered Levered

Discount Rates
PV of financing effects

rA
Yes

WACC
All

FTE
Equity Portion

rWACC

rE

No

No

Which approach is best?

Use APV when the level of debt is constant
Use WACC and FTE when the debt ratio is constant
WACC is by far the most common
FTE is a reasonable choice for a highly levered firm
25

A Comparison of the APV, FTE, and

WACC Approaches
All three approaches attempt the same task: valuation in
the presence of debt financing.
Guidelines:
Use WACC or FTE if the firms target debt-to-value
ratio applies to the project over the life of the project.
Use the APV if the projects level of debt is known
over the life of the project.
In the real world, the WACC is the most widely used
approach by far.

26

The Three Methods

1. The APV formula can be written as:
Additional
Initial
UCFt
NPV
effects of
t
investment
t 1 (1 rA )
debt

2. The FTE formula can be written as:

Amount
Initial
LCFt

NPV

t
t 1 (1 rE )
investment borrowed

3. The WACC formula can be written as

Initial
UCFt
NPV

t
investment
t 1 (1 rWACC )

27

Some Practical Issues

1.
2.
3.
4.

APV and NPV basically mean the same thing.

The three approaches will most likely yield different
NPVs.
The APV is useful when special financing
considerations are tied to the particular project.
WACC most common has an intuitive appeal, a
project should be accepted if its rate of return is
higher than the weighted average cost of capital.

28

WACC Approach
WACC approach is the most widely used because of its
relative simplicity.
WACC is only appropriate as a discount rate for a project
when:
1. The project has similar systematic business risk as the
firm.
2. The project and firm have the same debt capacity.
3. The debt to equity ratio is presumed to stay constant
throughout the life of the project.

29

Discounting Safe Cash Flows

(for APV Approach)
Safe (risk-free) cash flows are discounted by the
after tax borrowing rate rD(1-TC). This may be
applied for issues such as subsidized loans and
depreciation tax shields.
Example: The company is granted a one-year
subsidized loan of $100k at 5%. The companys
borrowing rate is 13% and its tax rate 35%.
What is the NPV of the loan?

30

PMMs Project Valuation - APV

1.
2.

Suppose PMM Inc. has an investment that costs

$10,000,000 with expected EBIT (cash flows from
operations) of $3,030,303 per year forever. The
investment can be financed either with $10,000,000 in
equity or with $5,000,000 of 10% debt and $5,000,000
of internally generated (equity) cash flows. The
discount rate on an allequity-financed project with this
kind of risk is 20%. The firm's marginal tax rate is 34%.
Using the APV approach find whether the project
should be pursued if financed with equity only.
Using the APV approach find whether the project
should be pursued if financed with 50% debt.
31

PMMs Project Valuation with Subsidy

Extension 1 : Subsidized (or belowmarketrate)
financing
Suppose a municipal government decides that the
investment is socially (and politically) desirable and
agrees to raise the $5,000,000 debt financing as a
municipal bond, or 'muni.' PPM Inc. can effectively
borrow $5,000,000 at the municipality's borrowing rate,
rD = 7%. (Interest income on a muni is exempt from
Federal tax, so the muni rate is typically below the rate
on corporate debt.)
Using APV approach find the effect of this subsidy on
APV.
32

PMMs Project Valuation with Subsidy

Extension 2 : Flotation Costs
When a company raises funds through external debt or
equity, it must incur flotation costs. Assume that the
municipal government no longer sponsored the project
and PPM Inc. must obtain $5,000,000 with new debt at
the market interest rate of 10%. Flotation costs are
12.5% of gross proceeds. Assume that the Canadian tax
code allows this expense to be amortized over five
years.
Using APV approach find the effect of flotation costs on
APV.
33

PMMs Project Valuation Flow to Equity

Suppose PMM Inc. has an investment that costs
$10,000,000 with expected EBIT (cash flows from
operations) of $3,030,303 per year forever. The
investment can be financed with $5,000,000 of 10%
debt and $5,000,000 of internally generated (equity)
cash flows. The discount rate on an allequity-financed
project with this kind of risk is 20%. The firm's marginal
tax rate is 34%. Assume D/E = 50/67.
Using the Flow to equity approach find whether the
project should be pursued if financed with 50% debt.

34

PMMs Project Valuation WACC

Suppose PMM Inc. has an investment that costs
$10,000,000 with expected EBIT (cash flows from
operations) of $3,030,303 per year forever. The
investment can be financed with $5,000,000 of 10%
debt and $5,000,000 of internally generated (equity)
cash flows. The discount rate on an allequity-financed
project with this kind of risk is 20%. The firm's marginal
tax rate is 34%. Assume D/E = 50/67.
Using the WACC approach find whether the project
should be pursued if financed with 50% debt.

35

Pearson Company Project Valuation

Consider a project of the Pearson Company, the timing
and size of the incremental after-tax cash flows for an allequity firm are:
-$1,000
0

$125

$250

$375

$500

The unlevered cost of equity of Pearson is rA = 10%. The

firm plans to finance the project with $600 of debt
carrying an 8% interest. The overall debt to equity target
ratio of the firm is 1.5 and the corporate tax rate is
TC=40%. Calculate the NPV of the project according to
(1) APV, (2) Flow to equity, (3) WACC.
36

Pearsons - Flows to Equity Approach

Switching from unlevered to levered cash flows.

CF3 = $375 -28.80

CF2 = $250 -28.80
CF1 = $125-28.80
-$400
0

CF4 = $500 -28.80 -600

$96.20

$221.20

$346.20

-$128.80

37

Example: Worldwide Trousers

Worldwide Trousers, Inc. is considering a $5 million
expansion of their existing business. The initial
expense will be depreciated straight-line over five
years to zero salvage value. The pretax salvage value
in year 5 will be $500,000. The project will generate
pretax earnings (EBDIT) of $1,500,000 per year, and
not change the risk level of the firm. The firm can
obtain a five-year $3,000,000 loan at 12.5% to partially
finance the project. If the project were financed with all
equity, the cost of capital would be 18%. The corporate
tax rate is 34%, and the risk-free rate is 4%.
The project will require a $100,000 investment in net
working capital. Calculate the NPV using the APV,
WACC, and flow to equity approaches.
38

Relative Valuation
Valuing a company relative to
another company

39

Relative vs. Fundamental Valuation

The DCF (WACC, FTE, APV) model of valuation is
a fundamental method.
Value of firm (equity) is the PV of future cash
flows.
Ignores the current level of the stock market
(industry).
Appropriate for comparing investments across
different asset classes (stocks vs. bond vs. real
estate, etc).
In the long run, fundamental is the correct way of
value any asset.
40

Relative vs. Fundamental Valuation

Relative valuation is based on P/E ratios and a host of other
multiples.
Extremely popular with the press, CNBS, Stock brokers
Used to value one stock against another.
Can not compare value across different asset classes
(stocks vs. bond vs. real estate, etc).
Can not answer the question is the stock market over
valued?
Can answer the question, I want to buy a tech stock,
which one should I buy?
Can answer the question, Which one of these
overpriced IPOs is the best buy?
41

Relative vs. Fundamental Valuation

You are investing for your retirement. You
are planning to take a buy and hold
strategy which involves picking some fairly
priced stocks and holding them for several
years. Which valuation approach should
you use?
Relative or fundamental?

42

Relative vs. Fundamental Valuation

You are a short term investor. You trade
several times a week on your E-trade
account, and rarely hold a stock for more
than a month. Which valuation technique
should you use?
Relative or fundamental?

43

Relative Valuation
Prices can be standardized using a common variable such as earnings,
cashflows, book value, or revenues.
Earnings Multiples

Price/Earning ratio (PE) and variants

Value/EBIT

Value/EBDITA

Value/Cashflow

Enterprise value/EBDITA
Book Multiples

Price/Book Value (of equity) PBV

Revenues

Price/Sales per Share (PS)

Enterprise Value/Sales per Share (EVS)

Industry Specific Variables (Price/kwh, Price per ton of steel, Price per
click, Price per labor hour)
44

Multiples
Relative valuation relies on the use of multiples and a little
algebra.

For example: house prices.

House

Price

Sq ft

Price per sq ft

$ 110,000

1,700

$ 64.71

$ 120,000

1,725

$ 69.57

$ 96,000

1,500

$ 64.00

$ 99,000

1,550

$ 63.87

$ 105,000

1,605

$ 65.42

Average
What is the price of a 1,650 sq ft house?
Answer: 1650 65.51 = $108,092

$65.51
45

Multiples can be misleading

To use a multiple intelegantly you must:

Know what are the fundamentals that determine the

multiple.

Know how changes in these fundamentals change the

multiple.

Know what the distribution of the multiple looks like.

Ensure that both the denominator and numerator

represent claims to the same group

- OK: P/E Price equityholders, EPS equityholders

- Not OK: P/EBIT Price equityholders, EBIT All claimants

Ensure that firms are comparable.

46

Price Earnings Ratios

PE Market price per share / Earnings per share
There are a number of variants of the basic PE ratio in use.
They are based on how the price and earnings are
defined.

Price
- current price
- or average price for the year
Earnings
- most recent financial year
- trailing 12 months (Trailing PE)
- forecasted eps (Forward PE)
47

PE Ratio: Understanding the Fundamentals

To understand the fundamental start with the
basic equity discounted cash flow model.

With the dividend discounted model

Div1
P0
re g

Dividing both sides by EPS

P0
Payout ratio (1 g )

EPS 0
re g

48

PE Ratio: Understanding the Fundamentals

Holding all else equal
higher growth firms will have a higher PE ratio
than lower growth firms.
higher risk firms will have a lower PE ratio than
low risk firms.
Firms with lower reinvestment needs will have a
higher PE ratio than firms with higher
reinvestment needs.
Of course, other things are difficult to hold equal since
high growth firms, tend to have high risk and high
reinvestment rates.
49

50

V W _P E

1 00

1 50

Graph PE ratio (Amir Rubin)

1975q1

1980q1

1985q1

1990q1
stata_qtr

1995q1

2000q1

2005q1

50

Is low (high) PE cheap (expensive)?

A market strategist argues that stocks are

over priced because the PE ratio today is
too high relative to the average PE ratio
across time. Do you agree?
Yes
No
If you do not agree, what factor might
explain the high PE ratio today?
51

A Question
You are reading an equity research report on
Informix, and the analyst claims that the stock is
undervalued because its PE ratio is 9.71 while
the average of the sector PE ratio is 35.51.
Would you agree?
Yes
No
Why or why not?

52

Example: Valuing a firm using P/E ratios

In an industry we identify 4 stocks which are similar to
the stock we want to evaluate.
Stock A

PE=14

Stock B

PE=18

Stock C

PE=24

Stock D

PE=21

The average PE = (14+18+24+21)/4=19.25

Our firm has EPS of $2.10
P/2.25=19.25 P=19.25*2.25=$40.425
Note do not include the stock to be valued in the
average
Also do not include firm with negative P/E ratios
53

Value/Cashflow
PE ratios are from equityholders, while cash flow
measures are the whole firm.
Cash flow is from continuing operations before capital
expenditure.
FCF is uncommitted freely available cash flow after
capital expenditure to maintain operations at the same
economic level.
FCFF (cash flow from assets) is free cash flow to total
firm

Value
MV equity MVdebt

FCFF
FCFF
In the US in 1999, the mean value was 24.
54

Value/FCFF
For a firm with a constant growth rate

FCFF0 (1 g )
V0
wacc g
V0
(1 g )

FCFF0 wacc g
Therefore, the value/FCFF is a function of the
The cost of capital
The expected growth rate
55

Example: Valuing using value/FCFF

Industry average is 20
Firm has FCFF of $2,500
Shares outstanding of 450
MV of debt = $30,000

Using Value/FCFF=20
value = FCFF*20
MV equity + MV debt = FCFF*20
MV equity = FCFF*20 MV debt
Price = (FCFF*20-MV debt)/Shares
Price = ($2,500*20-$30,000)/450 = 44.44
56

Alternatives to FCFF : EBDITA and EBIT

Most analysts find FCFF to complex or messy to
use in multiples. They use modified versions.
After tax operating income: EBIT (1-t)
Pre tax operating income or EBIT
EBDITA, which is earnings before interest, tax,
depreciation and amortization.
Value
MV equity MVdebt

EBDITA
EBDITA
57

Value/EBDITA multiple
The no-cash version
Value
MV equity MVdebt cash

EBDITA
EBDITA

When cash and marketable securities are netted

out of the value, none of the income from the cash
or securities should be reflected in the
denominator.
The no-cash version is often called Enterprise
Value.
58

Enterprise Value
EV = market value of equity + market value of debt cash and
marketable securities
Many companies who have just conducted an IPOs have huge
amount of cash a war chest
EV excludes this cash from value of the firm
Cash +MV of non-cash assets = MV debt + MV equity
MV of non-cash assets = MV debt + MV equity - Cash
For example: Nasdaq AWRE (did IPO in 1996)
Its 1996 cash was $31.1 million, Total assets = $40.1 million, Debt=0
EV=$9 million.
For young firms it is common to use EV instead of Value.
59

Reasons for increased use of Value/EBDITA

1. The multiple can be computed even for firms
that are reporting net losses, since EBDITA are
usually positive.
2. More appropriate than the PE ratio of high
growth firms.
3. Allows for comparison across firms with
different financial leverage.

60

Price to Book Value Ratio

The measure of market value of equity to book value of
equity.

P MV equity

B BVequity

61

Price Book Value Ratio: Stable Growth Firm

Div1
P0
re g

Going back to dividend discount model,

Defining the return on equity (ROE)=EPS0/BV0 and realizing that

div1=EPS0*payout ratio, the value of equity can be written as

BV0 ROE payout ratio (1 g )

P0
re g
P0
ROE payout ratio (1 g )
PVB
BV0
re g

If the return is based on expected earnings (next period)

P0
ROE payout ratio
PVB
BV0
re g
62

Price Sales Ratio

The ratio of market value of equity to the sales

P
MV equity

S Total Revenue

Though the third most popular ration it has a fundamental

problem.
- the ratio is internally inconsistent.

63

Price Sales Ratio

Using the dividend discount model, we have

Div1
P0
re g

Dividing both sides by sales per share and remembering that

Profit margin

Earnings per share

Sales per share

We get

P0
Profit margin payout ratio (1 g )
PS
sales0
re g
64

Price Sales Ratio and Profit Margin

The key determinant of price-sales ratio is profit margin.

A decline in profit margin has a twofold effect

First, the reduction in profit margin reduces the price-sales ratio

directly
Second, the lower profit margin can lead to lower growth and
indirectly reduce price-sales ratio.

Expected growth rate = retention rate * ROE

retention ratio *(Net profit/sales)*( sales/book value of equity)
retention ratio * (profit margin) * (sales/ BV of equity)

65

Inconsistency in Price/Sales Ratio

Price is the value of equity

While sales accrue to the entire firm.
Enterprise to sales, however, is consistent.

EV0
MV equity MV debt - Cash

sales0
re g

To value a firm using EV/S

Compute the average EV/S for comparable firms
EV of subject firm = average EV/S time subjects firm projected
sales
Market value = EV market debt value + cash

66

Choosing between the Multiples

There are dozen of multiples

There are three choices
Use a simple average of the valuations obtained
using a number of different multiples
Use a weighted average of the valuations obtained
using a number of different multiples (one ratio may
be more important than another)
Choose one of the multiples and base your
valuation based on that multiple (usually the best
way as you provide some insights why that multiple
is important remember car industry video
segment)
67

Real Options Chapter 22

4 types of Real Options
1 - The opportunity to expand and make follow-up
investments.
2 - The opportunity to wait and invest later.
3 - The opportunity to shrink or abandon a project.
4 - The opportunity to vary the mix of the firms
output or production methods.
Value Real Option = NPV with option
- NPV w/o option
68

Microcomputer Forecasts
Example Mark I Microcomputer ($ millions)

69

Microcomputer Forecasts
Your comment If we do not launch the Mark I, it
will probably be too expensive to enter the micro
market later, when Apple and IBM are firmly
established. In other words, we lose the option to
produce the Mark II Microcomputer.
Assumptions:
1) The decision on Mark II will take place 3 years from now, in
1985.
2) The investment in Mark II is double that of Mark I, i.e., $900m.
3) Forecasted cash flows are also doubled, with PV of $807m in
1985, and $467m in 1982.
4) Assume standard deviation of 35% for cashflow uncertainty.
5) Annual riskfree rate is 10%.

70

Microcomputer Forecasts
Example Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982

NPV(1982) =PV(inflows) -PV(investment)

= 467 676
= - $209 million
71

Microcomputer Forecasts
Example Mark II Microcomputer (1985)
Distribution of possible Present Values
Probability

Present value in 1985

Expected value

Required investment

($807)

($900)

72

Restaurant Investment
You have negotiated a deal with a major restaurant chain to open one
of its restaurants in your home town. The terms of the contract
specify that you must open the restaurant either immediately or in
exactly one year. If you do neither, you lose the right to open the
restaurant. It will cost you $5 million to open the restaurant,
whether you open it now or in one year. If you open the restaurant
immediately, you expect to generate $600,000 in free cash flow the
first year. While future cash flow vary with the consumer tastes,
they are expected to grow at a rate of 2% per year. The risk free
rate is 5% , the appropriate cost of capital for this investment is
12%, and the return volatility of publicly traded comparable firms is
40%.
a. What is the NPV of the project if you open today?
b. What is the NPV of the project if you delay the opening and wait
the year?

73

Option Valuation
There are two ways to calculate the value of an option.
1. Find the combination of stock and loan that replicates
an investment in the option. Since the two strategies
give identical payoffs in the future, they must sell for
the same price today. This is basically how one derives
the B&S formula.
2. Since option pricing does not depend on risk aversion
of investors, we can pretend that all investors are
indifferent to risk, work out the expected future value of
the option in such a world, and discount it back at the
risk-free rate to give the current value. This is called
risk-neutral pricing.
74

Growth Option
StartUp Incorporated is a new company whose only asset is
a patent on a new drug. If produced, the drug will
generate certain profits of $1 million per year for the life
of the patent, which is 17 years (after then, competition
will drive profits to zero). It will cost $10 million to
produce the drug. Assume that the yield on a 17 year
risk free annuity is currently 8% per year.
a. What is the value of the patent?
b. Now assume interest rates will change in exactly one
year. At that time, all risk-free interest rates in the
economy will be either 10% per year or 5% per year,
and then will remain at that level forever. What is the
value of the patent?
75

Option to Wait
Malted Herring Plant Valuation
200 (NPV = 200-180 = 20)

The project costs $180, either

now or later. Waiting means
loss of first years cash flows.
Assume risk free rate is 5%.

Cash flow = 16

Cash flow = 160

Option value = 0

Cash flow = 25

Year 1 cash flows

Cash flow = 250

PV of Year 2 on
cash flows

Option value = 250-80=70

76

Option to Wait
Real Estate Development
Suppose you own a slot of vacant land
that can be used for a hotel or an office
building, but not for both. To convert a
hotel to an office, or an office to a hotel
involves high costs. You may be reluctant
to invest, even if both investments have
positive NPVs.
77

Option to Wait
Example Development option
Cash flow
Office Bldg

Office Bldg

240

NPV>0

Wait

100

NPV<0

100

240

Cash flow
from hotel

Hotel NPV>0

78

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Assume a discount rate of 10%

Year 0

Year 1

Year 2

120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4)

79

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Assume a 10% discount rate.

Year 0

Year 1

Year 2
120 (.6)

100 (.6)
90 (.4)
NPV = ?

150 (.4)
80

The Zircon Subductor Project

Information:
1)
The investment required is $12m and may last up to 10 years.
Throughout the project life the company can sell the asset for a
certain salvage value that depreciates over time. At year 10 it is
worth $5.99m.
2)
Revenues: $2.5 million per year (at todays prices). Revenues are
proportional to price. Risk-adjusted rate is 9%.
3)
The fixed cost are constant at $700k per year and are risk fee.
Risk free discount rate is 6%.
4)
NPV without abandonment option is negative at $ -1.108m.
5)
Prices of Subductor follow a random walk with a 20% standard
deviation. Assuming log normal distribution this leads to a
binomial tree of either 22% up or 82% down.

81

Option to Abandon
Example Ms. East - Revenues
3.73
3.05
2.50

2.50

2.05
1.68
82

Option to Abandon
Solving Procedure:
1) Have the salvage value in each of the years 1-10 (e.g.,
5% deprecation per year)
2) Start at far right (year t=10) and work recursively
backwards to the present. At year 10, the project is
valued at the ending salvage value.
3) Work backwards to year t-1, use risk neutral
probabilities to calculate PV of continuation project.
4) If salvage value of year t-1> PV of continuation value,
than the value at the nod=salvage value. If salvage
value< PV of continuation project then value at nod =
PV of continuation project.
83

Temporary Abandonment
Suppose you own an oil tanker and you
charter your service. The tanker costs $5
million a year to operate and produces
$5.25 in revenue.
What happens if tanker rates go down by
10%, do you close the business
immediately?

84

Tanker Example
Value of
Tanker

Value in
operation
Cost of
reactivating

Mothballing
costs

Value if
mothballed

Tanker
Rates

85