F6: Real options, International JVs and M&A Flashcards
What is a JV?
Joint ventures are entities created by investment from two firms (in IJVs, at least one is not local to the environment of the new entity)
Normally we will see two firms, one international and one a local partner, who together set up a joint subsidiary that will operate under joint management of the companies.
There are synergies between the skills the multinational corporation brings into the picture and the skills the local partner has.
What is the value of a JV?
There is value in the future operations of the JV as an independent venture
And, there is a synergy value from the firms joining forces
The tricky thing here is to figure out the value to the participants given ownership, but ownership will depend on the value assigned
What are the complicating factors of JVs?
Restrictions on foreign equity ownership, royalty ceilings, etc.
Tax differences between countries and types of income (e.g. dividends versus royalties)
Capital market segmentation leading to different cost of capital
How are profits shared in a JV?
In the contract negotiations, no partner will accept less than it would get from an investment alone (or another alternative investment). This value is the lower bound for the value of the JV: the threat point (NPV_A and NPV_B). This means that there have to be positive synergy effects, which need to be divided
One of the assumptions is that if a company can generate more profits from working on its own then it will not participate in the JV. See below picture
How are profits shared if company A can proceed without company B but not the other way around?
See below formula
How are profits distributed when there is a tax differential and A can continue without B but not the other way around?
See below formula
We see that, even if the alternative investments are of equal value, A gets a larger share if it pays higher tax (i.e. NPV_(JV,A)< NPV_(JV,B)).
That is because we have this equal gains assumption B has to compensate A for its higher tax burden
So if firm A comes from a country with a higher tax rate firm A will tend to get more of its fair share of the profits of the JV.
What is licensing?
JVs tend to be instable forms of entry so there might be a benefit to shift payments to an upfront or continuous fee (license)
Risk sharing: if one partner is close to financial distress, he will prefer low-risk income
Information asymmetries: the better informed partner takes on more risk and the partner with less information gets a license income
How are profits shared in licensing?
See below
What does it mean going from a static to a dynamic analysis?
CF are not stable and known for the future
Good managers maintain flexibility in investments to adapt to new developments so if demand increases beyond expectations, an additional investment could be made
You develop an optimistic and a pessimistic scenario for the JV where the NPV of the optimistic evaluation can be considered as the NPV of a growth option (NPV_GO)
Explain what a real option is
Flexibility is valuable. If a small investment might lead to another, profitable investment, this possibility has a value. The possibility will only be there if we make the first small, initial investment. The real option approach allows us to integrate this value into an NPV framework
JVs = options?
JVs are often seen as buying call-options on buying out the local partner from the venture.
If the JV is profitable it may lead to later acquisitions. So JVs are looked on as call-options where there is the option to buy out the other partner.
In a new market entry, a lot of things are uncertain
If the investment turns out to be profitable, an entrant might buy out the JV partner (or the other way around)
Describe the two elements that makes up the value of an option
The option value is made up of the sum of the intrinsic value of the investment and the time value
Intrinsic value is the value if exercised immediately. This is the 4m in the oil example above.
Time value is the additional value that could be reaped if we wait. This is 6m in the oil example above. When the total value is 10m and the intrinsic value is 4m then the time value has to be 6m
What is meant with “Market entry as options to unlock information”
Negative-NPV investments into emerging markets are often call options where finding out about something is contingent on the initial investment.
If conditions turn out to be unfavorable, the investment is withdrawn (or not increased)
If conditions turn out to be favorable, the investment is increased (e.g. by buying out the JV partner)
