Question 4: Discuss the implications of the real options likely to be embedded in a multi-million pound capital budgeting decision on whether or not to accept such a proposed investment project and compare and contrast real-options with financial options (25 marks)
Real option techniques are increasingly being used as the standard method of evaluating investment decisions whose uncertainties are quantifiable. Capital budgeting decisions are long-term strategic decisions that impact directly on the organization’s efficiency of its daily operations, cash flow, income statement, and the taxable income for the subsequent years; however, most organizations treat them as operating budget decisions. They relate to the decisions on whether an organization should or should not invest in long-term projects and capital facilities, equipment, and machinery. Capital budget decisions greatly affect the future position of the organization’s operations. The identification of the capital projects depend on the opportunities or the needs; however, much consideration is given to risk evaluation and strategic planning.
A multi-million pound capital budgeting decision requires thorough evaluation of the issues that are most likely to arise. This, being a very large venture, has very large risks associated to it and should be considered with a lot of seriousness. Most investments involve asserts that are depreciable with little resale value, if any, once their useful life ends. For proper capital budgeting decisions, it is an obligation that the assets generate enough cash to provide return on investment and to compensate the total amount of the initial (original) investment itself.
The real options analysis (also called real option valuation) brings in techniques of option valuation to capital budgeting decisions. Real option is the right to undertake business decision. The business decision includes, and not limited to, making, abandoning, expanding, delaying, extending, shortening, or contracting a capital investment. These options are the real options in that they exhibit a claim on real assets.
Real options help in decision-making process under uncertainty and in adopting the financial option techniques to the real-life decisions. Real options make the decision makers to be keen on the assumptions that underlie the projections. In any capital budgeting decision, including a multi-million pound capital budgeting, the real options include the assumption that the management is active and able to modify the project as possibly necessary. This factors in the Flexibility options, expansion options for both the product volume and geographical area, Abandonment options, addition options for both complementary products and successive generations of the same product, options to temporarily suspend or contract operations, and the delay options. Real option implication is that, since the management responds to every outcome, each option is exercised. This reduces, or completely eliminates, the possibility of having a large negative outcome. The end result is that the profit is increased as the risk is reduced.
Despite the popularity of financial option, it fails to capture the important feature of investment decision: the managerial flexibility in uncertain and dynamic environment. Real option solves this problem. The real option maximizes the value of the investment opportunity.
When the future is uncertain and the investment is irreversible, the ability to delay the investment is valuable. When managers wait for the resolution of the uncertainties before they decide to pursue the investment, large losses can potentially be avoided if the investment is foregone when the outcome is unfavorable. It is important to note that the greater the investment’s uncertainty in the expected future cash flow, the more important and valuable it is to delay the investment.
For huge capital budgeting decision, uncertainty normally depress the investment due to the delay option. More so, firms always reduce their investments whenever the industry uncertainty rises and the investments irreversible as a result of capital specificity in the industry level. During the uncertainty period, increased competition is found to substantially diminish the value of the option to delay investment.
Managers and decision makers are normally faced with capital-budgeting decisions in their day-to-day operation. Whether to accept or not to accept the investment project, as the one proposed herein, depends on a number of factors as highlighted hereunder.
i. The cash flow: the centre of focus should be the cash flows and not the profits. It is always better to get as close as possible to the economic reality of the project. The cash flows are the economic facts. On the other hand, accounting profits contain various kinds of economic fiction.
ii. The incremental cash flows: in every decision, the main idea is to judge whether the project to be undertaken would put the firm in a better or worse position. The focus should therefore be on the changes in the cash flows that are affected by the project. If the project is aimed at buying a machine, the questions that need to be considered include: will it expand the capacity (which enables the firm to exploit its demands beyond the current limit)? Will it reduce the costs (which enables the firm to operate more efficiently that previously)? Or will it create other benefits like increased quality, flexibility, etc? The question that the managers need to ask is: How will things change? If the change is positive then the project should be undertaken.
iii. Time: time is a very important factor in investment. The sooner the cash is received, the better. Net Present Value should be used to evaluate the quantitative attractiveness of the project.
iv. Risks: Risks should be accounted for. It should be noted that not all projects have same level of risks. When more risks are taken, the returns are most likely to be high. A discount rate should be used to value the flow of cash which is consistent with the risk.
Differences between real options and financial options
i. Real options normally take longer times to expire as compared to financial options
ii. In some of the real option applications, building of the underlying assets takes time. This delay is called the production lag.
iii. In real options, the issue of when to exercise the option is very fundamental.
iv. In real options, unsystematic uncertainties contribute greatly in the models.
Merger and Acquisition is an overall term commonly used to mean a consolidation of companies or firms. A merger is the coming together of two companies to establish a new company. Acquisition on the other hand is the total purchase of one firm or company by another and in which no new company is established. Acquisition starts with an offer from an acquiring firm which the shareholder has liberty to accept or refuse. Acceptance of offer initiates exchange of shareholders shares for either cash or securities.
a) Based on the forms of integration and types of mergers, merger and acquisition activities can be categorized as horizontal, vertical or conglomerate. This is explained as under.
In horizontal merger, the two firms operate in the same or similar product lines and activities. Besides, they operate in similar markets because of their similar activities. This type of merger is common with companies in direct competition.
It is the merger between firms or companies that provide similar products and/or services. It allows the surviving firm to have control of greater share of the market. This makes the firm enjoy economies of scale. Horizontal merger frequently occurs as a result of the desire for large companies to create more effective economies of scale. It involves two or more firms, which operate within the same industry and are at the same stage in the production cycle. Horizontally merging firms are direct competitors, and this acts as a market consolidation process, which results into the creation of more competitive companies.
In a vertical merger, the acquiring firm seeks out to consolidate with the one at a higher or lower product supply chain in the industry. The firm merges with another firm with better product supply chain than its current supply chain. Such a merger exists between, say, a firm and its supplier or distributor. The merging firms have buyer-seller relationship.
In other words, a vertical merger can be described as a union between a customer and its vendor. Firms involved in the merger produce different but complementary products and services. Such a merger results when the firms want to combine their assets so that they can capture a market sector, which neither of the individual firms would manage on its own. Vertical mergers normally take place voluntarily as the joining firms believe that such an arrangement would strengthen their current position and at the same time give them the room for expansion in other areas.
The main purpose of vertical merger is to maximize on the strengths of the merging companies, and to give room for future growth. Besides exploring new ways of using the existing product lines for the creation of new products for a wider market, vertical merger involves the consideration of the assets of the merging companies.
Conglomerate merger is a type of merger where two firms operate entirely in different markets and have no common business areas. They operate in different industries. The two merging firms entirely operate in totally unrelated business activities. Such a merger results when the two firms have the desire to expand in new markets so as to increase the market share, the synergy and cross selling. Conglomerate merge also results into diversification and reduction of risk exposure. When the merging parties have completely nothing in common, the resulting conglomerate merger is referred to as pure. However, if the parties desire to extend their products or markets, the merger is referred to as mixed. One potential drawback of such a merger is that a firm may be too big and too complex to operate, thus results in inefficiency.
Common motivation behind Merger and Acquisition
Merger and Acquisition activity is habitually perceived as a method of creating superior stockholder value. The most universal motive is however that of profitable investment. Firms consolidate to enhance profitability in terms of capacity, new knowledge, entering new products or all together reallocating assets to the management and control of successful owners. Common motivation is discussed as under.
i. Increased market power
Merger and Acquisition is recognized as an attempt to secure market power. For instance, when a horizontal merger takes place in an industry with fewer competitors, a newly consolidated and established company will definitely emerge with an improved market share. With larger market share, the new company can easily influence market prices. Therefore the motive behind horizontal merger may be that of market power effects. As well, vertical mergers also increase market power by minimizing dependence on outside suppliers. Their powers are however limited by regulators to avoid consumer exploitation.
ii. Faster and rapid growth
Merger and Acquisition is a form of external growth. Growth via merger and acquisition activities is a quicker way for the company owners to boost revenue as compared to internal investments. This is common with mature industries where the possibilities of organic growth opportunities are very small. With the consolidation of assets, newly established company is assured of faster growth emanating externally.
A synergy is a great force that boosts cost efficiencies of a new company established under merger and acquisition. This kind of motivation is common with mergers. It is due to the notion that the newly established company will establish synergies in which the consolidated firm will be worth more than the two firm’s costs or as well as increasing revenue. Horizontal mergers basically merge for cost synergies. Revenue synergies on the other hand come into effect as a result of cross selling products. This essentially leads to a capture of a larger market share. With improved market power, the firm is likely to control the market prices and hence takes advantage of reduced competition. Besides, motivation emanates from operational efficiencies and economies of scale.
iv. Improved operational and managerial efficiencies
This is the motive of efficiency. Horizontal mergers for instance involve the acquisition of firm’s assets. This move essentially reduces costs associated with production, increases output, improve product quality or may create completely new products. Operational efficiencies associated with horizontal mergers basically emanate from economies of scale as well as improved resource allocation. Therefore, the motive behind the merger and acquisition may be to reap the operational and managerial efficiencies emanating from the economies of scale.
v. Financial and tax benefits
There is a motive of firms being able to diversify their earnings for example in case of a vertical merger. Earnings diversification within the newly established firm is believed to lessen the profitability variation thereby escaping risk of attendant costs or bankruptcy.
Other motives behind merger acquisition include: obtaining a good buy; stakeholder expropriation and unused debt capacity.
b) Horizontal merger exist between two firms operate in the same or similar product lines and activities (same industry). Besides, the companies are in direct competition as they operate in similar markets because of their similar activities. Both Popular Press limited and Storytime limited operate in the same industry, i.e. publishing business thus this merger is a horizontal merger.
In addition, a statutory merger is also presented in the above transaction. A statutory merger is where one of the merging companies continues to exist as a legal entity while the other companies are absorbed and operate under the name of the existing company. Based on this premise, this transaction is statutory merger in that the Storytime limited’s assets and liabilities will be absorbed by Popular Press limited as Storytime limited ceases to exist and operates under the name “Popular Press limited.”
c) The amount of the gain for Storytime Limited shareholders, if the deal is completed as a cash transaction, is calculated as shown hereunder.
Gain = (PVAB) - (PVA + PVB) = cost savings
Agreed transactional value per share - £56
Number of shares outstanding - £20 million
Pre merger market value - £960 million
Gain = 56 X 20 – 960
Therefore, total premium takeover in the transaction is £160 million.
d) The amount of gain if the deal is completed as a stock transaction with an exchange ratio of 0.7
Post merger value of the combined firm
= VA + VB + S
VA is the Popular Press ltd’s pre merger value; VA = £2,400 million
VB is the Storytime Ltd’s pre merger value; VB = £960 million
S is the Cost reduction synergy; S = £180 million
=£ (2400 + 960 + 180)
Price per share for Popular Press Ltd shareholders
= (Post merger value / post merger outstanding shares)
=3540/ 50 = £70.8
Maximum price that Popular Press ltd should pay before EPS are diluted
= 0.7 / £70.8
= £49.56 per share
Shares to be issued by popular press ltd
Transaction value £56 per share
Pre merger stock price for Popular Press Ltd £80
Number of Storytimes shares outstanding £20
Shares to be issued = 56/ 80 X 20 = 14 shares
Amount of gain
= 14 X £49.56 per share
=£ 693.84 million
a) Initial investment outlay
Acquisition costs £24,000
Installation costs 16,000
Increase in working capital 12,000
Proceeds from sale 80,000
Less: taxes @40% (32,000)
Less: variable cost (48,000)
Net proceed from sale 0
Net investment outlay 52,000
c) Terminal year cash flow
Estimated salvage amount in 4 years 21,816
Less: 40% taxes (8726.4)
Terminal cash flow 13,089.6
d) Whether the project should be accepted using NPV and IRR analysis and the underlying assumptions made
The Internal rate of return analysis
The underlying assumption made in IRR is the reinvestment assumption. It is assumed that all cash flows generated by the investment project will be instantly reinvested at the same rate of 22.42% (of the discount rate). Unless this condition is met, the internal rate of return computed for the project will not be accurate. There is the assumption of no interim cash flow. Lastly, the cost of capital is not considered.
Net present value analysis
The NPV calculated can be used to determine whether the project’s cash flow is in excess or deficit. It presents the CEO with the amount in excess or in deficit with regards to the present value of the project. Its analysis is powerful as it provides valuable information for capital budgeting decisions. Basically, it is the present value of the net cash flow. Positive NPV implies that the projects return exceeds the discount rate and therefore should be considered for investment. The CEO should be aware that the NPV of 13977.23888 is acceptable since it promises a return greater than the required rate of return. This value is far much greater than zero and thus implies that the discounted value of future cash flow is greater than the initial investment. This therefore promises higher returns.
The NPV analysis assumes that all the cash flows apart from the initial investment take place at the end of the period. This is simply to make computations easier. However, it is unrealistic since cash flows occur throughout a period and not at its end. This is an assumption made in the computation. Also, the computation assumes that all cash flows generated by the project are immediately reinvested at rate of return equal to the discounted rate. Deviation from these assumptions makes the NPV computation of the project inaccurate.
In conclusion, the CEO should accept the project using NPV and IRR analysis sine both present positive returns. Besides, NPV and IRR always give same go/no-go decision as well as using same time value of money formula.