Topic 5: Strategic Flexibility

Question 1

Comments on DCF and strategic flexibility

Answer 1

1. DCF values a given stream of cash flows
2. Underlying assumption is passivity.
3. DCF implicitly assumes that each scenario is included in the valuation weighted by its probability
4. DCF assumes that management does not have the flexibility to avoid bad circumstances in CF projections
5. Traditional DCF can be described as PASSIVE; scenarios are expected to continue without intervention by management

Question 2

Methods for option style pay offs

Answer 2

1. decision trees
2. options
   Both include conditional values in valuation

Question 3

Real options are..

Answer 3

real options are options over real assets (as opposed to financial options)

Question 4

Real options include:

Answer 4

1. the option to defer
2. the option to abandon a business
3. the option to expand production capacity
4. options to make an investment in a new follow on project

Question 5

Decision Trees

Answer 5

1. Use objective probabilities, and discount the cash flows by the cost of capital
2. Calculate the probability. Work backwards through the sequence (ie start with the value of future decisions, and roll back to time = 0.

Question 6

Chance Node = ?

Decision Node = ?

Answer 6

Chance Node = calculate expected value of each branch emanating from that node (represented by a circle)
Decision Node = choose the branch with the maximum value, (represented by a square)

Question 7

Timing Option
Define:
Example: (2)
Decision tree

Answer 7

Timing Option
Define: time value of an option. By waiting, can realise more value or abandon / wait longer
Example: Land. Developers buy vacant land. Land has timing option. NPV now may be negative based on current rents; but value may increase with rezoning / higher rents. In which casen - building would be built.
Example 2: Mining.
Decision tree: start = do not build, rents too low.
Positive branch = rents rise; build building
Negative branch = rents stay same or fall; do not build

Question 8

Diversification and mergers

• why is pure financial merger with no synergies, bad
• coinsurance effect = ?

Answer 8

• Valuable in investor’s own portfolios because of elimination of unsystematic risk
• Combined company may have more stable cash flows if seasonal variation is reduced; and bankruptcy less likely
• A purely financial merger with no synergies can be good for creditors, bad for shareholders. Consider separate values for equity holders vs when merged together. Value may be transferred to bond holders.
• diversification reduces volatility of ROA. Benefits bond holders by making default less likely.
• Co-insurance: effectively the merged firms insure each other’s bonds