Valuation of the Liability Structure by Real Options E-Book

David Heller

• Herausgeber: John Wiley & Sons
• Kategorie: Wissenschaft und neue Technologien
• Sprache: Englisch
• Veröffentlichungsjahr: 2022

Seitenzahl: 194

Beschreibung

The valuation of the liability structure can be determined by real options because the shares of a company can be regarded as similar to the purchase of a financial call option. Therefore, from this perspective, debt can be viewed as the sale of a financial put option. As a result, financial analysts are able to establish different valuations of a company, according to these two financing methods. Valuation of the Liability Structure by Real Options explains how the real options method works in conjunction with traditional methods. This innovative approach is particularly suited to the valuation of companies in industries where an underlying asset has high volatility (such as the mining or oil industries) or where research and development costs are high (for example, the pharmaceutical industry). Integration of the economic value of net debt (rather than the accounting value) and integration of the asset volatility are the main advantages of this approach.

Leseprobe

Table of Contents

Cover

Title Page

Copyright

Introduction

1 The Utility of Real Options in the Valuation of Liabilities

1.1. Introduction

1.2. Real options: a mitigating alternative to the deficiency of traditional valuation methods

1.3. Intersections between approaches to assets valuation

1.4. Valuation of liabilities structures with real options

1.5. Conclusion

2 The New Allocation of Company Value Using the Optional Approach

2.1. Introduction

2.2. Economic value of debt and systematic risk adjustment of equity

2.3. Integration of organizational problems between shareholders and debtors

2.4. Mechanisms of refinancing debt and the impact on the value of equity

2.5. Conclusion

3 Applications of Real Options on Financial Structure Valuation

3.1. Introduction

3.2. Application to the stock market index of a country: the CAC 40

3.3. Application to a business sector: the cinema industry

Conclusion

Appendices

Appendix 1: Partial Derivatives in the Option Price Equation by Galaï and Masulis (1976)

Appendix 2: Partial Derivatives for Systematic Risk of Company Debt by Galaï and Masulis (1976)

Appendix 3: Partial Derivatives for Systematic Risk of Company Equity by Galaï and Masulis (1976)

Appendix 4: Proof of Inequalities by Galaï and Masulis (1976)

Appendix 5: Partial Derivatives in the Option Price Equation by Bellalah and Jacquillat (1995)

Appendix 6: Characteristics of Companies in the CAC 40

Appendix 7: Valuation of Companies in the CAC 40 Using the Black–Scholes–Merton Method

Appendix 8: Distribution of Debt Relative to the Rate of Recovery (CAC 40)

Appendix 9: F-Equality Test of Variances for Asset and Equity Volatility (CAC 40)

Appendix 10: Equality Test for Projected Asset and Equity Volatility (CAC 40): Two Observations with Equal Variations

Appendix 11: F-Equality Test of Variances for the Growth Potential of Stock Prices Using the DCF and Real Options Methods (CAC 40)

Appendix 12: Equality Test for Projected Potential Growth of Stock Prices Using the DCF and Real Options Methods (CAC 40): Two Observations with Equal Variances

Appendix 13: F-Equality Test of Variances for Debt Ratios Based on an Accounting and Economic Net Debt (CAC 40)

Appendix 14: Equality Test of Projected Debt Ratios Based on an Accounting and Economic Net Debt (CAC 40): Two Observations with Different Variances

Appendix 15: Characteristics of Companies in the Cinema Industry

Appendix 16: Valuation of Companies in the Cinema Industry Using the Black–Scholes–Merton Method

Appendix 17: F-Equality Test of Variances for Asset and Equity Volatility (Cinema)

Appendix 18: Equality Test for Projected Asset and Equity Volatility (Cinema): Two Observations with Equal Variances

Appendix 19: F-Equality Test for Potential Growth of Stock Prices Using the DCF and Real Options Methods (Cinema)

Appendix 20: Equality Test for Projected Potential Growth of Stock Prices Using the DCF and Real Options Methods (Cinema):Two Observations with Different Variances

Appendix 21: F-Equality Test of Variances for Debt Ratios Based on an Accounting and Economic Net Debt (Cinema)

Appendix 22: Equality Test for Projected Debt Ratios Based on an Account and Economic Net Debt (Cinema): Two Observations with Equal Variances

Appendix 23: Significance Test for the Difference Between Two Standard Deviations

Bibliography

Index

End User License Agreement

List of Illustrations

Chapter 1

Figure 1.1.

Purchase of a call

Figure 1.2.

Purchase of a put

Figure 1.3.

Sale of a call

Figure 1.4.

Sale of a put

Chapter 2

Figure 2.1.

Breakdown of a loan payment installment at an intermediary date

Tables

Chapter 1

Table 1.1 Transfer of risk between shareholders and investors without impacting ...

Table 1.2 Analogy between the parameters of real options with reference to liabi...

Table 1.3 Mechanisms impacting the value of financial structure via the real opt...

Table 1.4

Valuation of equity and debt using real options

Chapter 2

Table 2.1

Variables for companies A and B for Galaï and Masulis (1976) analysis

Table 2.2

Value of the company on the maturity date of the financial debt

Chapter 3

Table 3.1

Economic valuation of equity debt using real options

Table 3.2

Sensitivity of the economic value of equity

Table 3.3

Differences between the mean asset and equity volatilities (CAC 40)

Table 3.4 Difference between the mean growth potentials of stock prices using th...

Table 3.5 Difference between the mean debt ratios based on accounting and econom...

Table 3.6

Analysis of the variance (CAC 40)

Table 3.7

Regression coefficient (CAC 40)

Table 3.8

Differences between mean asset and equity volatilities (cinema)

Table 3.9 Difference between the mean growth potentials of stock prices using th...

Table 3.10 Difference between the mean debt ratios based on accounting net and e...

Appendix 6

Table A6.1

Appendix 7

Table A7.1

Appendix 8

Table A8.1

Appendix 9

Table A9.1

Appendix 10

Table A10.1

Appendix 11

Table A11.1

Appendix 12

Table A12.1

Appendix 13

Table A13.1

Appendix 14

Table A14.1

Appendix 15

Table A15.1

Table A15.2

Appendix 16

Table A16.1

Appendix 17

Table A17.1

Appendix 18

Table A18.1

Appendix 19

Table A19.1

Appendix 20

Table A20.1

Appendix 21

Table A21.1

Appendix 22

Table A22.1

Guide

Cover

Contents

Introduction

Begin Reading

Conclusion

Bibliography

Index

End User License Agreement

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Modern Finance, Management Innovation and Economic Growth Set

coordinated by Faten Ben Bouheni

Volume 5

Valuation of the Liability Structure by Real Options

David Heller

First published 2022 in Great Britain and the United States by ISTE Ltd and John Wiley & Sons, Inc.

Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licenses issued by the CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the undermentioned address:

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John Wiley & Sons, Inc.

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© ISTE Ltd 2022

The rights of David Heller to be identified as the author of this work have been asserted by him in accordance with the Copyright, Designs and Patents Act 1988.

Any opinions, findings, and conclusions or recommendations expressed in this material are those of the author(s), contributor(s) or editor(s) and do not necessarily reflect the views of ISTE Group.

Library of Congress Control Number: 2021950761

British Library Cataloguing-in-Publication Data

A CIP record for this book is available from the British Library

ISBN 978-1-78630-734-7

Introduction

The traditional approaches to valuating companies are currently grouped into three categories: the patrimonial method is based on the value of company assets, the multiples method consists of determining a value using similar companies as a reference or transactions that took place in the same sector, and the method of discounted cash flows tries to consider the development potential of the company. These different methods are used by those who think the value obtained by one of them should not be the focus, but rather an approach that seeks to link them. This recommendation is justified given that the practice is not an exact science.

Nevertheless, these different approaches have specific and common limits. Indeed, the multiples method can lead the analyst to false sector-specific multiples when the company reference contains large disparities in terms of financial structure or investment policy. The DCF method depends on hypotheses, which in turn depend on the analyst’s subjectivity. In this way, each one can justify a level of provisional cash flow and weighted mean cost of capital by justifying the pertinence of the established business plan. The patrimonial approach counts on the value of assets in the current portfolio and excludes, as such, any potential for growth.

Otherwise, they have the common disadvantage of considering an accounting net debt rather than an economic net debt1, and omitting the notion of flexibility with respect to investment decisions. In practice, indeterminate elements can lead a company to account for unforeseen cash flow at the moment of investment. In order to obtain the economic value of personal equity, we subtract the value of net debt from the value of the company. But to be completely methodologically coherent, in each approach, we would have to take the economic value of the net debt into account instead.

Furthermore, these methods do not include the notion of flexibility, which is essential for any investment decision. Indeed, the unforeseen cash flows of model creation can appear while devising an investment plan. In this case, considering the total risk through the volatility of assets is something that would allow us to reach a better value.

Real options give us solutions with respect to this lack of flexibility. They are based on the concept of traditional financial options and by extension, have their utility. Thus, if real options are used for the study and valuation of an investment project (just like an NPV, or Net Present Value), we can suppose that there is a possible extension for the structure of liabilities and shareholders’ equity2.

In the case of real options, the implication is a “real” asset that has not been assessed. Because of this, the potential investment of a company can be seen as an entrance fee that allows us to access future opportunities. Thus, the value of a project is not limited to the present value of anticipated cash flow, but must capture all of the opportunities for growth that will present themselves in the future. Real options will then offer the advantage of incorporating the possibility of an increase, as well as a decrease in future cash flows through the parameter of volatility. Indeed, the incertitude is the reflection of the volatility of assets and the prospects of evolution in the project that would result in strategic decisions. The company can, for example, make the choice to abandon its project, follow through with it or extend it… This concept of flexibility is not taken into account in the NPV criteria and, thus, in the DCF method.

From this perspective, since liabilities are the mirror of company assets, its economic value and the value of its debts can also be studied with respect to options. By adopting a logic based on the sale of a company, shareholders, who have a limited responsibility with respect to creditors in a capital company, can recover assets from the company, as long as they pay back the nominal value of the debt. And, as in a capital company, the shareholders have a limited responsibility with regard to creditors, the economic value, which corresponds to their wealth, and is analogous to the value of the purchasing option of assets. In other words, shareholders have a claim over the assets. They can buy them as long as they reimburse the creditors. The optional references (notably Black and Scholes (1973)3 and Merton (1974)4) thus propose a new company value taken from the sum of the economic value and the net debt.

The theoretical comparison between traditional methods and the real options method must extend to practical use. Whether a company’s investment plan is more or less risky, and as a consequence, if the asset portfolio – and thus the liabilities structure – is more or less volatile whether the value of the net debt is bigger or smaller and whether its maturity is longer or shorter, the results from different valuation methods could very well vary and become more or less pertinent and reliable within a particular sector. Indeed, by trying to consider the economic value of net debt from an optional perspective, the analyst evaluating the economic value of a company using the Black–Scholes–Merton method could detect a potential for growth, meaning that stock prices are somewhat underestimated. In other words, in this case, the valuation of economic value results in the following estimation:

Since a company’s investment portfolio value, that is, its assets, is equal to the value of its liabilities, to what extent can the approach using real options be applied to the valuation of a company’s liabilities structure?

The first section will focus on the application of real options to the liabilities structure. The limits of traditional valuation methods, which the approach using options is aiming to resolve, will first be presented. Then, the optional valuation models in discrete time and continuous time will be developed, in order to locate their convergence. This theoretical framework will end in a valuation of economic value and debt using an optional approach. The second section will be dedicated to the study of the financial literature, which will specify the aspects and the stakes of economic debt and examine the adjustment of systematic risk in economic value. Then, the scientific articles that have been studied will elucidate the impact of the agency conflicts that exist between shareholders and creditors on the optional approach to the issue. Finally, debt refinancing mechanisms and their impact on economic value will be addressed. A third part will deal with two studies carried out on different dates, including statistical tests of the traditional valuation methods and following the real options approach. The first study concentrates on companies in the CAC 40 index. The second study examines companies in the cinema industry.

1

The net debt is the difference between the financial debt on the one hand, and the cash flow and equivalent of cash flows, on the other.

2

To the extent that the economic value of assets is equal to the economic value of liabilities and shareholders’ equity.

3

Black, F. and Scholes, M. (1973). The pricing of options and corporate liabilities.

Journal of Political Economy

, 81(3), 637–654.

4

Merton, R.C. (1974). On the pricing of corporate debt: The risk structure of interest rates.

Journal of Finance

, 29(2), 449–470.