Lecture 10| Resturcting with real options Flashcards
What kinda of restructuring are there?
There is corporate, business, financial
what is corporate restructuring?
It is to recognize the legal ownerhsip, operational, financial or other structures of a company for the purpose of making it more profitable
What are three restructuring falling under corporate restructuring?
Business:
- significant changes in the mix of assets owned by a firm or the lines o f business which a frim operates
- expansion: mergers. acquisitions, joint ventures
contractions: divestitures, spin-offs, equity carve outs
Financial restructuring:
- improvements in the capital structure and/or ownership/control of the firm
- leveraged transactions (LBO/MBOs) and debt restructuring
Organizational restructuring:
- significant changes in the organizational structure of the firm
- divisional redesign and employment downsizings
What motivates restructuring?
- to better align interests of shareholders and managers (agency problems)
- to transfer assets to owners who can better utilize these assets
- to provide a sharper focus for management who may lack the skill set to manage different types of business
- to correct strategic mistakes of management
- reflects new info about value of various part of company to another party
What are the three types of the business restructuring method
divestitures
spin-offs
equity carve outs
How may divestitures occur?
Divestitures may occur when:
- negative synergies arise from poor decisions on past acquisitions
- management’s lack of expertise to run the company in its current state
- needs for funds for the company (e.g pursuing other investments or paying off some of existing debt, in particular after LBOs)
- regulatory authorities demanding divestitures, to create competition
What are spin-offs? What options do shareholders get in spin-offs?
A firm establishes one of its operating units as a separate listed entity. Shareholders have the option to keep their current shares or exchange them for shares in the divesting company
No money comes into parent company
What are the benefits of a spin-off?
it widens investor’s choice by allowing them to invest in just one part of the business
For companies with multiple business lines it will increase transparency for investors
What is an equity carve-out? Does parent company hold a significant shareholding in the entity?
A company establishes a new listed entity- similar to spin-offs however the shares in the new entity are sold off to the market.
Parent company typically holds a significant shareholding in the new entity
What do you sell a partial share in equity carve outs?
- this is an alternative to equity financing, parent company can get funds by issuing its subsidiary’s equity
- showcase subsidiaries to prospective future buyers as part of a two stage process:
- get stock market to understand the subsidiary business
- once subsidiary is re-valued, the parent may also be revalued because it still owns remaining shares
- may subsequently spin-off remaining shares to existing shareholders
What are the types of financial restructuring?
- leveraged transactions
- debt restructuring
What is leveraged transactions?
When a small group of investors purchase a company by using a relatively small portion of equity and relatively large portion of outside debt.
What is the basic structure of an LBO?
Private equity fund->private equity > target company > LBO purchase price proceeds > selling shareholders
What is debt restructuring?
-reorganisation of companies outstanding liabilities when they are facing difficulties in repaying their debt payments (in financial distress)
usually less expensive and preferbaly alternative to bankruptcy for shareholders
debt for equity swap: creditors accept the company’s equity instead of receiving debt payments
debt may still exist but with modified terms
-bondholder haircuts: reduce or delay the promised interest payments and principal repayment
What are real options?
Discretionary/strategic opportunities or options embedded in a firm’s real investment project
- there options are a right, not an obligation
- option exercise decisions can be optimally made to maximize project value after receiving new info in the future
What is the standard NPV analysis?
NPV=PV(inflows) -PV(outflows)
Whta is the difference between standard NPV analysis and real option analysis?
standard NPV analysis: treats each project as a now-or-never decision
only based on info available now (decide now and hope for the best)
Real option analysis is dynamic (wait for uncertainty to be resolved and then decide)
-captures managements flexibility to adapt to its future action in response to future market conditions
-expands project value by assuming that at each stage in the future, management actively improve its upside potential while limiting downside losses
What are the four types of real options?
- Option to delay making an investment
- Option to expand operations by making follow-up investments
- option to abandon the project
- option to vary output or production methods
Introduce option to delay(advantage, disadvantage)
Firms often have the right to delay the timing of their investment in a project
- An advantage is: it provides the firm a chance to respond to new market information
A disadvantage is: delaying could reduce PV of cash flows (bc u miss the early cash flows)
firm may also need costs to maintain updated info of market
What MUST you always do when valuing the NPV of a real option?
FIND THE VALUE OF THE NPV WITH REAL OPTION AND NPV WITHOUT REAL OPTION TO YEAR 0!!! WHICH IS STAGE 1
(all NPV to year 0)
How would you compare the real option with a financial option? (Hint, what would eb the exercise price, the corresponding underlying asset term and payoff for the real option?) This is a call option btw)
Exercise price: initial investment required
y-axis: net payoff from option
x-axis: PV of cash flows from project
the premium you pay is the cost of the right to delay your investment
The time of expiry of the option is the life of the license or patent
What is the option to expand?
Taking a project today may allow the firm to expand
How would you compare the real option of the firm to expand with a financial option? (This is a call option btw)
The exercise price of the real option is the cost of expansion
The premium paid by the firm is the cost of establishing right to expand operations (X)
The y-axis is the net payoff from option
The x-axis is the PV of expected incremental cash flows from expanded project (V)
What is the option to exit?
A firm may sometimes have the option to exit and realise salvage value and abandon project when project isn’t successful
How would you compare the exiting option with a financial option? Note: this is a put option
The exercise price would be recovery value of assets(X)
The premium paid would be cost of establishing right to abandon operation
The x-axis would be PV of expected cash lows from project (V)
The y-axis would be net-payoff from option
X-V payoff
What is the option to vary?
When a firm can revise its operating decisions for a fixed cost in response to market conditions
e.g
option to alter production rate
option to differentiate/alter production
option to switch inputs/technology
How would you compare the real option to vary with a financial option? This is a call option btw
The exercise price of the option would be the cost to vary/switch production
The premium paid would be the right to switch production
The x-axis would be present value of incremental cash flow from new alternative
The y-axis would be net payoff from option
How do you value real options?
work with deicision tree analysis
Whta is the NPV with real option equal to/
NPV with real option= NPV without real option + Value of real option
