Real Options and Mergers

1
Real Options and Mergers

• P.V. Viswanath

Class Notes for FIN 648 Mergers and Acquisitions
2
Stock Options

• A call option on a stock is the right to buy a
  share of stock at a pre-specified price (exercise
  price) within a specified time period (time to
  maturity).
• Thus, a call on Sprint with an exercise price of
  22.50 and an expiration date of May 19, 2006
  traded at a price of 2.15 at close on Feb. 22,
  2006.
• The closing price of the stock on that day was
  23.80, so if the call had been exercised right
  away, it would have resulted in a loss. Still the
  option has value because the stock price might
  well go up before May 19, 2006.

3
Call option
4
Real options

• A real option is similar to a stock option. The
  primary difference is that the real option is not
  traded on a market and, often,
• The underlying asset may not be traded on a
  market, either.
• Thus, a patent grants the owner an option because
  s/he has the sole right for a certain amount of
  time (time to maturity) to develop a product
  based on the patented idea by investing the
  necessary capital (exercise price).
• The patent may or may not be traded
• The underlying asset in this case, is the product
  based on the patent. In this case, the
  underlying asset is not traded, either.

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Importance of Real Options

• Real options are pervasive for example,
  flexibility usually implies a real option.
• Real options have a big effect on firm value
  where the firm is growing and/or has unique
  assets.
• Real options capture effects that DCF doesnt.
  DCF analysis alone misestimates the value of an
  asset.

6
Using real options in MA

• Estimate the value of optionality.
• The right to take action, the triggering of which
  is contingent on some other event.
• Structure critical thinking about company values
  and/or deal design.
• Even if valuing the options is difficult,
  thinking of the transaction in terms of real
  options can help qualitatively.
• Guide negotiation and problem-solving.
• Helps in deal negotiation and in coming up with
  solutions to impasses.

7
How to identify an option

• An option is a right regarding some other asset
  or good can you identify it?
• Options give the owner a special right that
  others do not have. Is this right exclusive to
  you?
• The value of an option derives from the value of
  an uncertain underlying asset. What is the
  contingency or uncertainty in this case?
• Options are valuable, and are costly to acquire.
  Was the right costly to acquire?
• An option has a finite life.

8
Options and opportunities
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Example of option

• Right to start up a business under an exclusive
  fast-food franchise that you purchased, that
  expires within three years unless you own one or
  more outlets and that requires further spending
  to exercise. You are the exclusive franchisee in
  your territory. Whether and where you exercise
  the right is contingent on the results of a
  market survey, on zoning rulings by government,
  and on actions by competitors.
• Needs to be valued using real option analysis.

10
Example of opportunity

• Opportunity to open a restaurant in your
  community under a generic name, Downtown
  Grille. You didnt pay to acquire this
  opportunity. There is not much uncertainty you
  can rent the perfect location that will deliver a
  steady clientele. It looks like a good deal
  already.
• Can be valued using DCF analysis.

11
Decision Tree Option to Delay

• You must decide whether to invest now in new
  manufacturing capacity, for an outlay of 20
  million, or wait a year. If you delay, you must
  engage a contract manufacturer that will cost
  your firm 1m. More to produce goods than if they
  were produced at the new plant. Demand for the
  product is uncertain. There is a 50-50 chance of
  the demand generating a new business with either
  a present value of 100 million or a present
  value of zero. If you delay, the new plant will
  cost 25m. next year.

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Decision Tree Option to Delay
13
The Option to Delay Deciding

• Value of Wait -1 0.5x(100-25)(0.5x0)
  36.50
• Value of Invest -20 (0.5x100) (0.5x0)
  30m.
• It pays to wait because of the high uncertainty
  regarding the value of the underlying asset,
  i.e.new demand.
• How to take time value of money into account.
• How to adjust for risk riskiness of the option
  is not the same as the riskiness of the
  underlying asset.

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Option Valuation Binomial Method

• http//webpage.pace.edu/pviswanath/class/648/notes
  /options.htmdcfvaluation
• http//webpage.pace.edu/pviswanath/class/648/notes
  /options.htmarbitrage

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Option Valuation Black-Scholes

• http//webpage.pace.edu/pviswanath/class/648/notes
  /options.htmblackscholes

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Lucent Assessing Latent Optionality

• Why is the actual market value different from
  intrinsic value (break-up value of assets)?
• The reason might be real options.
• Shortly after Lucent was spun off from ATT in
  1996, the firm traded at 60, but assets-in-place
  were worth 11.
• If the difference is due to a real option, what
  do the option characteristics have to be?

17
Lucent Assessing Latent Optionality

• Assumptions
• Current Value of underlying asset 60
• Life of option 3 years
• Exercise price 15/share/yr. for the next 3
  years (PV 34.24)
• Project volatility 75 per annum.
• Risk-free rate of return 3
• Estimated Option Value 38.70
• See spreadsheet from Blackboard Class Documents

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EM.TV

• In March 2000, EM.TV bought 50 of SLEC for
  1.88b.
• At the same time, EM.TV also got a call to buy
  another 25 of SLEC for 1.16b by Feb. 28, 2001
  (in 4 quarters).
• Ecclestone got a put option to sell 25 of SLEC
  to EM.TV for 1.16b by May 2001 (in 5 quarters).
• When the original acquisition was announced in
  March 2000, EM.TV fell by 2b.
• When news of the put option came out somewhat
  later, EM.TV dropped in value by 2.2b.
• Is the market reaction due only to the put grant?

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EM.TV

• Assumptions
• Value today of 25 of SLEC today is 0.97b.
• Exercise price 1.16b.
• Volatility 25 per yr quarterly volatility is
  0.25(1/5)0.5
• Quarterly euro risk free rate is 0.985 per year.
• The sum of the values of the long call and short
  put works out to -0.138b.
• Modifying the initial values changes the values
  of the options, but cannot explain the price
  changes.
• What amount of the price drop is due to a
  negative signal?
• Look at spreadsheet on Blackboard under Class
  Documents.

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Binomial Method

• Grow the tree
• Up value u exp(??t) down value d exp(-??t)
• PseudoProbmove up (1rf)-d/(u-d)
• PseudoProbmove down u-(1rf)/(u-d)
• This achieves two things
• i) the volatility per period is exactly ?
• ii) the price in any period can be obtained by
  using the pseudoprobabilities and discounting the
  values next period by the riskfree rate.
• We have changed the probabilities in such a way
  that discounting can now be done using the
  riskfree rate, instead of the actual required
  rate of return.
• Since the option value is conditional on the true
  value, we can value the option also similarly.

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Value options on SLEC

• What is the value of the call that EM.TV got, and
  what is the value of the put that EM.TV gave?
• We don't really have enough information here to
  estimate these values precisely since along with
  the actual transfers of money and options, there
  is also updating by the market on the value of
  the other assets that EM.TV has
• However, we can evaluate certain hypotheses --
  for example, did the change in value reflect on
  the value of the options or was there an
  information component, as well?

22
Valuing options on SLEC

• Suppose the original price that EM.TV paid for
  the options and the 50 share of SLEC was fair,
  and the entire reduction in the value of EM.TV.
• Then we can compute the value of the put option
  and ask if the change in value at the later date
  was due to the markets reevaluation of EM.TVs
  worth in November 2001 or not.

23
MW Petroleum Structuring the Deal

• In 1991, Amoco wanted to sell its subsidiary MW
  Petroleum. Apache was the intended buyer.
• The initial asking price of 1 billion was beyond
  Apaches ability to finance.
• Even after negotiations, the gap between asking
  price and offered price was more than 10 of the
  transaction value.
• Amoco, as the seller, was naturally more
  optimistic about future pricing trends than
  Apache.
• How to structure the deal so that both parties
  would be willing to proceed?

24
MW Petroleum Structuring the Deal

• The two sides negotiated a price support
  agreement that protected Apache on the downside
  in return for guaranteeing Amoco a portion of the
  upside.
• Under the terms of this agreement, Apache would
  receive support payments if oil prices fell below
  specified reference prices for any year during
  the two-year period ended June 30, 1993, and
  Amoco would receive payments if oil prices rose
  above specified reference prices for any year
  during the eight-year period ending June 30,
  1999, or in the event gas prices exceeded
  specified reference prices for any year during
  the five-year period ending June 30, 1996.

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Some details of the price-sharing deal

• Oil price sharing payments due Amoco for contract
  years ending 6/30/1994 to 6/30/1999, would be
  based on per barrel oil prices starting at 24.75
  and increasing to 33.13.
• Annual oil volumes would decline from approx 3.3
  million barrels to 1.4 million barrels over the
  remaining term.
• Gas price sharing payments would be based on gas
  volumes starting from approximately 13.4 Bcf for
  the year ending 6/30/1994, and declining to 10.5
  Bcf in 1996.
• The referenced gas price would increase from
  2.18 per Mcf in 1994 to 2.68 per Mcf in the
  final year.
• If price sharing payments are due to Amoco, the
  volumes listed above would be doubled until Amoco
  recovers its net payments to Apache (5.8 million
  through the contract year ended June 30, 1993)
  plus interest.

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Interpreting the deal

• Apache, which believes that oil prices are not
  likely to increase will arrive at a lower
  estimate of the PV of the payments to be made to
  Amoco and at a higher estimate of the PV of the
  payments that Amoco has to pay to Apache.
• Amocos estimates are the opposite.
• Hence, the price sharing agreements constitute a
  price reduction for Apache and a price increase
  for Amoco.
• Alternatively, we could say that Amoco is selling
  Apache price-protection in case oil prices
  dont stay high.
• Apache is able to pay for this insurance in the
  form of cheap securities an agreement to pay
  Amoco if oil prices increase.