DAY
1 - THURSDAY, JULY 10
12:00 - 1:00 Registration
1:00 - 2:30 Valuing Acquistions
Chairperson: Alexander Triantis, University
of Maryland
A Real Options Approach to
Tender Offers and Acquisitions
Jose Pablo Dapena, Universidad del CEMA
Santiago Fidalgo, Repsol
YPF, Argentina
Abstract
Corporate control has added value for an investor since it gives degrees
of freedom about the use of assets, sources of finance, salaries, etc. On the
other hand, real options create value through the flexibility associated to
the ability to react to some relevant
uncertainty. The process of acquisition of corporate control can have two
real options associated, a waiting option and a growth option. In the waiting
option value is created through sequential investment instead of investing at
once, while the growth option carries all the private benefits the investor
can seize from control by making follow up investments, which can also
justify premiums paid above the former market price. A relevant
proposition of our paper is that the exercise price of the growth option (and
hence the amount to be paid as the control premium) can be affected by the
release of information. We develop a model for these two theoretical
extremes: One where the exercise price fully reacts to events, and one where
the exercise price does not react at all, and we obtain that the timing of
the process of acquiring control would depend on the reaction of the price to
be paid to obtain control, so would the size of the control premium over the
former price.
Equity Carve-outs as Acquisitions
of Strategic Real Options
Silvia Rossetto, Université de Toulouse
Enrico Perotti, University of Amsterdam
Marc Kranenburg, University of Amsterdam
Abstract
Equity carve-outs, the listing of a stake in a subsidiary on the stock
market, are empirically transitory arrangements. This paper studies decisions
aimed to gaining access to the choice over a "second stage" event,
namely either a sell-off or a buy-back decision. Hence, an equity carve out
can be seen as a compound option. The decision is driven by learning over
strategic synergies between the parent firm and the subsidiary, which evolves
stochastically over time. We find that the decisions to carve-out, to
buy-back and to sell off are critically influenced by uncertainty over future
synergies. We also find that there is an optimal amount of shares sold, which
is positively related to uncertainty over future synergies.
A Dynamic Model of Corporate
Acquisitions
Sandra Betton, Concordia University, Canada
Pablo Morán, Universidad de Talca, Chile
Abstract
Using a game-theoretic real option approach, this paper presents a model
of corporate acquisitions. We incorporate imperfect information about synergy
gains, strategic interaction among competing bidders, and between the
successful bidder and the target firm. Assuming the absence of managerial
motives, the model is able to explain some empirical regularities that have
only been explained under the agency and hubris hypotheses. Under valuation,
asymmetric distribution of gains, and divestitures are a natural output in
our model. This theoretical model suggests that controlling for industry
characteristics is an important element in empirical research.
2:30 - 3:00
Afternoon Coffee Break
3:00 - 5:00
Empirical Evidence
Chairperson: Laarni Bulan, Brandeis University
A Cross-sectional Analysis of Firm
Growth Options
Michael Long, Rutgers Business School
John Wald, Rutgers Business School
Jingfeng Zhang, Rutgers Business School
Abstract
We estimate the present value of growth options (PVGO) for a sample of
manufacturing firms. We find that a firm's PVGO is positively related to the
firm's R&D, past sales growth, and cash flow volatility. We also find
that firms with higher PVGO, and therefore higher irreversible investment
opportunities, invest less. This suggests that on average delaying investment
maximizes the value of a firm's real options. We also examine the
relationship between a firm's PVGO and market structure. We find that firms
in more concentrated industries with above median Q are more likely to have
higher PVGO. Additionally, more diversified firms have lower PVGO. These
results appear to be robust to a number of definitions and controls.
Real Options, Corporate
Performance, and Shareholder Value Creation
Cyrus Ramezani, California Polytechnic
Abstract
Real Options have proved to be a very useful framework for analyzing
corporate investment decisions. While significant progress has been made in
identifying and valuing Real Options, two important questions have not been
addressed in a systematic manner. First, how does the existence and optimal
exercise of Real Options affect managerial performance metrics such Return on
Investment (ROI), Return on Assets (ROA), Economic and Market Value Added
(EVA and MVA), and other measures of operational efficiency of the firm?
Second, do security prices and risk adjusted returns (as measured by Jensen's
Alpha) reflect the value of the portfolio of Real Options the firm owns? The
purpose of this study is to address these questions. We use cross sectional
data for over 3000 firms (Sources: Compustat and CRSP) covering the period
1990-2002 to provide answers to these questions.
Two key ingredients that enhance the value of Real Options are managerial
flexibility and the volatility (risk) of the underlying value driver(s). One
can then think in terms of a two by tow matrix with four quadrants, with low
option values corresponding to low volatility and limited managerial
flexibility and high option values corresponding to high volatility coupled
with high level of managerial flexibility. The value of Real Options for the
other two quadrants lie within these two extremes. We use this scheme to
assign firms into the four Real Option value quadrants and compare the
performance of firms in each quadrant from the perspective of both the firm's
mangers and its shareholders.
We identify several variables as proxies for managerial flexibility and
volatility of the underlying risk. For measures of managerial flexibility we
use items from the firms' statement of cash flows, including expenditures on
investment activity and R&D, and the level of managerial ownership of the
firm. When appropriate, we normalize these measures by sales or the market
(or book) value of assets to control for firm size. For measures of
underlying risk we use volatility of quarterly sale growth, quarterly cash
flow growth, and monthly return on the firm's stock. We further decompose the
total monthly return volatility into systematic and idiosyncratic components
using the standard CAPM framework. This decomposition enables us to access
the impact of firm specific risk on the value of its Real Options.
We use the median value of volatility and managerial flexibility measures
to assign firms to the four quadrants. The industries in each quadrant are
identified from their four digit SIC code. The main industries in the high
flexibility-high volatility (HH) quadrant are mining and oil and gas
extraction, pharmaceuticals, semiconductor equipment, electronic computers,
communications, and computer software. The main industries in low
flexibility-low volatility (LL) quadrant are construction, food, newspapers
and periodicals, plastic materials and synthetic resins, primary metals,
transportation equipment, and general merchandize stores. The main industries
in low flexibility- high volatility (LH) quadrant are chemicals,
communications equipment, semiconductors, apparel, miscellaneous retail, and
direct mail advertising. Finally, the main industries in high flexibility-low
volatility (HL) quadrant are oil extraction and refining, food, paper, motor
vehicles, and air transpartation.
The impact of Real Options on a number of traditional and value-based
corporate performance measures are studies. These include Return on
Investment (ROI), Return on Assets (ROA), Economic and Market Value Added
(EVA and MVA), Tobin's Q, Price-Earnings ratio, and several measures of
corporate profitability. To study the influence of Real Options on stock
returns we use Jensen's Alpha for firms in each quadrant. We also calculate
the rate of return to an actively managed portfolio (equally weighted) that
invests and annually rebalances a portfolio composed of firms in each
quadrant (monthly returns for January 1990 through December 2002). We show
that performance measures for firms with valuable Real Options are
significantly higher than firms without such options. Moreover, we find that
risk adjusted and total returns to a portfolio of firms with valuable Real
Options are consistently higher than firms without such options or a broad
index that represents a passive trading strategy.
Financial and Real Option Hedges
Implemented by U.S. Multinational Corporations
David Carter, Oklahoma State University
Christos Pantzalis, University of South Florida
Betty Simkins, Oklahoma State University
Abstract
This study investigates the influence of both financial and operational
hedges on the foreign-exchange exposure of U.S. multinational corporations.
Three important contributions of our research are: (1) we provide evidence
that exposure of U.S. MNCs to foreign-exchange risk is asymmetric; (2) our
results demonstrate that both operational and financial hedges can
effectively reduce foreign-currency exposure; and (3) we find evidence
suggesting that operational hedges serve as real options in that exposure
varies not only as to whether the firm is a 'net importer' or 'net exporter'
but also across weak and strong dollar states. Prior research assuming
symmetric exposure to foreign-exchange risk may be need to be re-evaluated in
light of our finding that many MNCs have asymmetric foreign-exchange
exposures.
JEL Classification: F30, F31, G15 Key words: Multinational finance,
Foreign exchange risk, Operational hedges, Real options, Currency derivatives
Irreversible Investment, Real Options and Competition: Evidence
from Real Estate Development
Laarni Bulan, Brandeis University
Christopher Mayer, University of Pennsylvania
Tsur Somerville, University of British Columbia
Abstract
We examine 1,214 condominium developments in Vancouver, Canada between
1979-1998 to identify the extent to which uncertainty delays investment. We
find that increases in both idiosyncratic and systematic risk lead developers
to delay new real estate investments. Empirically, a one-standard deviation
increase in the return volatility reduces the hazard rate of investment by 13
percent, equivalent to a 9 percent decline in real prices. Increases in the
number of potential competitors located near a project negates the negative
relationship between idiosyncratic risk and development. These results
support the argument that competition erodes option values and provide clear
evidence for the real options model of investment under uncertainty over
alternatives such as simple risk aversion.
Financial Innovation, Strategic
Real Options and Endogenous Competition in Internet Banking
David Nickerson, Colorado State University and Freddie Mac
Richard Sullivan, Federal Reserve Bank of Kansas
City
Abstract
Innovations in financial services continuously influence the scope of
financial intermediation and the nature of competition between
intermediaries. This paper examines the optimal exercise of strategic real
options to invest in such an innovation, Internet banking technology, within
a two-stage game, parameterized by the distribution of bank size and
uncertainty over the profitability of investment, and empirically tests the
results on a novel data set. Unlike traditional options, in which the
distribution of the future value of the underlying asset is exogenous and the
timing of exercise affects only the return to the option holder, the timing
of the exercise of real options in a strategic context allows the option
holder to manipulate the distribution of returns to all players. The value of
the strategic investment option in our model, as a consequence, depends on
both expected future profits as well as the variance of those profits.
Expected profits to an entrant depend, in equilibrium, on its size, as
measured by existing market share (concentration) or total assets, relative
to its rivals. Conditional on the degree of uncertainty, larger banks should,
as a consequence, exercise their options earlier than smaller banks, for
purely strategic advantages, and act as market leaders in the provision of
Internet banking services. Like ordinary options, however, the value of the
strategic investment option to both large and small banks increases in
uncertainty, implying that early exercise will be more likely the more
information is available about potential demand. We test these hypotheses on
investment in Internet banking services with data from a sample of 1,618
commercial banks in the tenth Federal Reserve District during 1999. Evidence
indicates that relative bank size, as measured by either market share or
asset size, positively influences the likelihood of entry into Internet
banking, and trend-adjusted variation in income per person (a proxy for
uncertainty of demand) negatively influences the likelihood of entry into
Internet banking. In addition, market concentration of a bank's competitive
rivals has a negative relationship with the likelihood of entering the market
for Internet banking services. These relations are evident in both bivariate
analysis and in multivariate logit regression analysis.
5:00 - 6:00
Panel Discussion
Valuation, Technology and Corporate Strategy: Current Status, Challenges and
Prospects
Moderator: Tom Copeland, Monitor
Panelists Include:
John McCormack (Stern Stewart & Co.)
Ghene Faulcon (BP Oil)
Kryzysztof Wolyniec (Mirant Corp.)
Gill Eapen (Decision Optics LLC)
Onno Lint (U. Leuven, Belgium)
Dwight Allen (Deloitte Consulting)
Soussan Faiz (ex Texaco)
Peter Damisch (Boston Consulting Group)
6:30 - 8:00
Networking Reception
DAY
2 - FRIDAY, JULY 11
7:00 - 7:45
Registration and Continental Breakfast
7:45 - 8:20
Chairperson's Welcome & Address
Real Options and Investment
Under Uncertainty
Lenos Trigeorgis, University of Cyprus and President, Real
Options Group
Track I
8:30 - 10:00
Conceptual
Chairperson: Adam Borison, Stanford University
Option Pricing in the Real
World: A Generalized Binomial Model with Applications to Real Options
Tom Arnold, University of Richmond
Timothy Crack, Barclays Global Investors Ltd.
Abstract
We extend a popular binomial model to allow for option pricing using
real-world rather than risk neutral world probabilities. There are three
benefits. First, our model allows direct inference about relevant real-world
probabilities (e.g., of success in a real-option project, of default on a
corporate bond, or of an American-style option finishing in the money).
Second, practitioners using our model for corporate real option applications
completely avoid the managerial anxiety that competing risk-neutral models
generate when they use risk-free discount rates for risky cash flows. Third,
our model simplifies option pricing when higher moments (e.g. skewness and
kurtosis) appear in asset pricing models.
Uncertainty as a Key Value
Driver of Real Options
Johannes Braeutigam, European Business School, Germany
Anett Mehler-Bicher, University of Applied Science, Mainz
Christoph Esche, European Business School
Abstract
Real option valuation can be difficult and time consuming. Therefore, we
propose a framework which is aimed at facilitating the process of real option
valuation and to make it more time efficient. The framework covers not only
the valuation of real options but also the organizational- , strategic-, and
controlling aspects necessary to apply real option valuation accurately. In particular
this paper focuses on uncertainties underlying any real option. Uncertainties
will be used not only to identify options but also to link the interaction of
uncertainties with the interaction of options. Finally, we will demonstrate
the applicability of the framework with a real life e-commerce case study.
Coordination of Investment in
Systems of Complementary Assets: A Clinical Study
Peter Miller, London School of Economics
Ted O'Leary, University of Manchester and University of
Michigan
Abstract
This paper reports the results of a 4-year longitudinal clinical study
conducted at executive office levels in Intel Corporation. It seeks to remedy
the neglect of firm-level empirical analyses of capital budgeting, and in
particular to address the mechanisms used to coordinate investment decisions
and associated expectations. The aim is to provide an empirical illustration
of recent work that has modelled formally the benefits available when capital
spending decisions are structured as complementary investments at both
intra-firm and inter-firm levels. Within Intel’s capital budgeting
process, we focus on a hitherto neglected mechanism termed a technology
roadmap – a mechanism used to ensure that large-scale capital
investments made by sub-units of the firm are coordinated with one another,
and that they are aligned also with investments made by a wide range of
complementor firms, such as OEM customers and developers of operating
systems. We describe the technology roadmap mechanism, and examine how it
integrates with DCF analyses to permit an individual capital spending
proposal to be valued within the system of complementary investments of which
it is a part. The contributions of the paper are threefold. First, our
findings provide strong, firm-level evidence supporting the arguments of
Milgrom and Roberts (1995a, b) and Trigeorgis (1995, 1996) that the system of
assets, rather than the individual investment decision, may often be the
critical unit of analysis and decision for managers. Second, we find that
value-maximising investments in systems of complementary assets require
coordination mechanisms that are largely overlooked in recent theoretical
literature. Third, we identify issues for investigation in future
large-sample surveys and clinical analyses of the capital budgeting process.
In particular, we suggest investigating whether there are systematic
differences between industries in the effectiveness with which interdependent
investments are planned and coordinated across firm boundaries.
Real Options Analysis: Where are the
Emperor's Clothes?
Adam Borison, Stanford University
Abstract
In the more than 25 years since the term 'real options' was coined by
Stewart Myers, several approaches have been proposed for calculating the
real-option value of a potential corporate investment. Unfortunately, the
assumptions underlying these various approaches and the conditions that are
appropriate for their application are often not spelled out. Where they are
spelled out or can be inferred, they differ widely from approach to approach
and are even contradictory. Furthermore, the difficulties in implementing the
different approaches are rarely discussed, and the pros and cons of
alternative approaches are not explained. This paper attempts to help remedy
this situation by describing, contrasting, and, yes, critiquing the major
proposed analytic approaches for applying real options, typically termed
"real options analysis" or "real option valuation." The
emphasis is on three fundamental issues surrounding each proposed approach:
1. Applicability: what does the calculated real-option value represent, and
where is it appropriate to use this calculation? Assumptions: what are the
notable assumptions underlying the approach, and what is the evidence
regarding the validity of these assumptions? 2. Mechanics: what steps are
involved in applying the approach, and what are the associated difficulties?
3. The paper concludes with observations about the relative strengths and
weaknesses of the proposed approaches, and specific recommendations on which
ones to use in what circumstances.
10:00 - 10:30
Morning Coffee Break
10:30 - 12:00
Valuing Natural Resource Investments
Chairperson: David Laughton, University of Alberta
Evaluating Natural Resource
Investments Using Monte Carlo Simulation
Andrianos Tsekrekos, University of Durham
Mark Shackleton, Lancaster University
Rafal Wojakowski, Lancaster University
Abstract
The idea that Monte Carlo simulation can not be applied to the pricing of
options (real or financial) with early exercise features has been overridden
in the light of new research results in the last decade. This paper attempts
to contribute to this revived interest on Monte Carlo simulation valuation,
by applying the proposed least--squares simulation method to the valuation of
a hypothetical natural resource investment. Results seem to suggest that the
Monte Carlo framework might be a natural way forward in the valuation of
investments under multiple uncertainties and project--specific complexities.
Real Option Decision Rules for Oil Field
Development under Market Uncertainty
Juan G. Lazo, Pontifical Catholic University of Rio de Janeiro
Marco Aurélio Pacheco, Pontifical Catholic University of Rio
de Janeiro
Marley M. Vellasco, Pontifical Catholic University of Rio de
Janeiro
Marco Antonio Guimarães Dias, PUC-Rio and Petrobras
Abstract
A decision to invest in the development of an oil reserve requires an
in-depth analysis of several uncertainty factors. Such factors may involve
either technical uncertainties related to the size and economic quality of
the reserve, or market uncertainties. When a great number of investment
alternatives are involved, the task of selecting the best alternative or a
decision rule is very important and also quite complicated due to the
considerable number of possibilities and parameters that must be taken into
account. This work proposes a model based on Genetic Algorithms and on Monte
Carlo simulation which has been designed to find an optimal decision rule for
oil field development alternatives, under market uncertainty, that may help
decision-making with regard to: developing a field immediately or waiting
until market conditions are more favorable. This optimal decision rule is
formed by three mutually exclusive alternatives which describe three exercise
regions along time, up to the expiration of the concession of the field. The
Monte Carlo simulation is employed within the genetic algorithm for the
purpose of simulating the possible paths of oil prices up to the expiration
date, and it is assumed that oil prices follow a Geometric Brownian Motion.
Keywords: Real Options, Genetic Algorithms, Monte Carlo Simulation
Valuation of an Oil Field Using Real Options
and the Information Provided by Term Structures of Commodity Prices
Delphine Lautier, Cereg, University Paris IX Dauphine
Abstract
This article emphasises that the information provided by term structures
of commodity prices has an influence on the real option value and on the
investment decision. We exhibit first of all the analysis framework: the
evaluation of an oil field. We suppose that a single source of uncertainty -
the crude oil price - affects the investment decision. We also present the
two term structure models used to represent the dynamic behaviour of this
price and to evaluate the net cash flows of the field. Then we present the
real options valuation method. Lastly, simulations illustrate the sensibility
of the real options to the term structure of commodity prices, and we analyse
the investment signals given by the optional method. Our principal
conclusions are twofold. Firstly, to understand the behaviour of the real
option, it is essential to take into account the information given by the
term structure of prices. Secondly, for some specific price curves, the investment
signal associated with the optional method does not differ from the one given
by the net present value.
KEYWORDS: convenience yield - stochastic models - real option to delay -
crude oil - term structure - net present value.
Using Real Options to Analyze the Effect of
Contractual Investment Restrictions: The Case of Construction Guarantees
Michael Samis, Kuiseb Minerals Consulting
Richard Poulin, Université Laval
Vincent Blais, Université Laval
Abstract
Non-equity project participants, such as creditors and the host
government, have an important effect on the attractiveness of investing in
natural resource projects. An obvious cause of this effect is through
the distribution of a portion of project cash flows as taxes, mineral
royalties, and interest payments. Non-equity participants also
influence project value in a less direct manner through non-monetary contract
terms that are intended to protect their interests. Unfortunately, it
is difficult to quantitatively assess the impact of such terms on the
distribution of project value so that equity owners, government officials,
and project financiers are left with qualitative or even rhetorical analysis
to negotiate the terms of their participation.
In this paper, we use the real option valuation method to look at the
effect of construction (completion) guarantees on project attractiveness when
there is mineral price and foreign exchange rate uncertainty.
Construction guarantees are used by project financiers and some host
countries as one method of ensuring that project development is completed
instead of being suspended in the event of downside outcomes such as low
mineral prices or extreme foreign exchange rate movements. We show that
these guarantees can result in a direct reduction of value in the equity
owner’s claim to project cash flows that is not accounted for by
conventional discounted cash flow valuation methods. There are good
reasons for project creditors and host governments to desire construction
guarantees such as protecting downside risk exposure and ensuring economic
development. However, it is equally important for the mining company,
project financiers, and the host country to understand the full implications
that non-monetary contractual terms have on mining investment.
12:00 - 1:30
Luncheon
Keynote
Address
Alexander Triantis, University of Maryland
Dr. Triantis is Associate Professor of Finance at the Robert H. Smith
School of Business at the University of Maryland. Previously he was a member
of the finance faculties at the MIT Sloan School of Management (as a visiting
scholar) and the University of Wisconsin. He received his Ph.D. from Stanford
University in 1988. He is currently an Editor of Financial Management,
an Associate Editor of Management Science, and an Advisory Board
member of the Journal of Applied Corporate Finance.
Professor Triantis has published numerous articles on the topic of real
options in the areas of finance, economics, law, management science and real
estate. He has made important contributions on a range of topics, including
the value of flexibility, the design of sequential and parallel investment
strategies, the interaction between dynamic financing and investment
policies, and the design of securities and contracts.
On the practitioner side, Dr. Triantis has been an advisor to several
multinational corporations and consulting firms, as well as to U.S.
Government departments and multilateral agencies. His role in helping
companies adopt real options valuation tools has been cited in business
publications such as Business Week, Business Finance Magazine and CFO
Europe.
1:30 - 3:00
Valuing Power and Energy
Chairperson: Stathis Tompaidis, University of Texas, Austin
and ITAM, Mexico
Gas Fired Power Plants:
Investment Timing, Operating Flexibility and Abandonment
Stein-Erik Fleten, Norwegian University of Science and
Technology
Erkka Näsäkkälä, Helsinki University of Technology
Abstract
Many firms are considering investment in gas fired power plants. We
consider a firm holding a license, i.e. an option, to build a gas fired power
plant. The operating cash flows from the plant depend on the spark spread,
defined as the difference between the unit price of electricity and cost of
gas. The plant produces electricity when the spark spread exceeds emission
costs. Otherwise the plant is ramped down and held idle. The owner has also
an option to abandon the plant and realize the salvage value of the
equipment. We compute optimal entry and exit threshold values for the spark
spread. Also the effects of emission costs on the value of installing CO2
capture technology are analyzed.
Valuation and Optimal
Interruption for Interruptible Electricity Contracts
Ross Baldick, University of Texas at Austin
Sergey Kolos, University of Texas at Austin
Stathis Tompaidis, University of Texas at Austin and ITAM,
Mexico
Abstract
We consider interruptible electricity contracts issued by a distributor of
electricity, that allow for interruptions to electric service in exchange for
either an overall reduction in the price of electricity delivered, or for
financial compensation at the time of interruption. We introduce an
equilibrium model to determine electricity prices, based on stochastic models
of supply and demand. In the context of this model we quantify the value of
interruptible contracts and describe the optimal interruption strategy. Our
numerical results indicate that, in a competitive market, interruptible
contracts can alleviate supply problems associated with spikes of demand.
Fuel Cell Power Production in
Shipping
Sigbjørn Sødal, Agder University College, Norway
Abstract
The paper discusses some main economic characteristics of fuel cell power
production technology applied to shipping. Whenever competitive fuel cell
systems enter the market, they are likely to have higher capital costs and
lower operating costs than systems based on traditional combustion
technology. Implications of the difference are investigated with respect to
investment flexibility by the use of a real options model of ship investment,
lay-up and scrapping decisions under freight rate uncertainty. A higher
capital share of total expected costs can represent a significant opportunity
cost in uncertain markets. The paper highlights the significance of
accounting properly for value of flexibility prior to investment in new
technology.
3:00 - 3:30
Afternoon Coffee Break
3:30 - 5:00
Valuing Infrastructure and Network Investments
Chairperson: Mark Jeffery, Northwestern University
Real Options and Enterprise
Technology Project Selection and Deployment Strategies
Mark Jeffery, Northwestern University
Sandeep Shah, Northwestern University
Robert Sweeney, Wright State University
Abstract
The reality of most IT departments is that capital is limited, or rationed,
so that positive net present value (NPV) projects are not always funded. In
the present work we examine enterprise technology projects that have a
positive traditional NPV. Incorporating real option value enables management
to more objectively compare and rank projects in a capital rationed
information technology portfolio management process, and decide upon the
optimal deployment strategy for the project. The present work examines
different phase-wise deployment strategies for large enterprise technology
projects and incorporates real options into the decision making framework. We
focus specifically on multi-stage options embedded in enterprise data
warehousing (EDW) projects. We also examine the lattice granularity necessary
so that discrete time option valuation models more accurately describe large
enterprise projects. We show that the single-step binomial lattice model
significantly undervalues real options in large enterprise wide technology
projects, and that a multi-step binomial model more accurately calculates the
option value. We compare different deployment strategies with different
underlying NPVs and volatilities. The results show that the traditional NPV
of a project combined with additional real option premiums can provide
important insight into the selection and deployment strategy for a project.
Our results are generalizable to a large class of IT investment decisions
where managers may consider single-phase versus multi-phase deployment in the
presence of project risk.
Government Supports as Bundle
of Real Options in Build-Operate-Transfer Highways Projects
Santi Charoenpornpattana, University of Tokyo
Takayuki Minato, University of Tokyo
Shunsuke Nakahama, University of Tokyo
Abstract
Recently government of many countries have adopted plan to encourage
private investment on infrastructure undertaken normally by public sector.
These infrastructures include highway, expressway, airport, power generation,
water supply, and so on. Build-Operate-Transfer (BOT) scheme is widely
employed in private financing of public infrastructure. BOT project normally
involves dealing with many parties, huge amount of budget, long period of
time, and many uncontrollable factors. These features make the BOT project
very risky. Important risks include development risk, completion risk, cost
increase risk, performance risk, operation risk, political risk,
environmental risk, credit risk, and market risk. As a private financing
scheme, BOT does not imply that private sector undertaking project must
assume all the project risks. On the contrary, success of this scheme depends
very much on reasonable supports or risk sharing from the government side.
The main focus of this paper is government supports in highway BOT
project. In BOT highway project, government normally provides supports which
mitigating financial-related risks such as market risk, because this kind of
support has direct impact on project. Examples of such supports are direct
financial subsidy, demand guarantee, revenue sharing, extension of concession
period, and shadow tolls. However, the designs of such supports are somehow
subjective, and irrational. Subjectivity is the result of lacking of
quantitative method for evaluation. Irrationality comes from shortfalls of
the current evaluation method.
The Real Options approach is proposed as a method for design and
formulation of government supports. The main point is that government support
can be taken as "Bundle of Options" from government given to
private investor. In this paper, design and formulation of the Options-like
government supports in BOT projects based on Real Options theory are explored.
Keywords: Real Options,
Bundle of Options, Build-Operate-Transfer, Highway, Risks, Government
supports, Minimum traffic guarantee, Shadow tolls system
Wireless Network Capacity
Investment
Yann d'Halluin, University of Waterloo
Peter Forsyth, University of Waterloo
Kenneth Vetzal, University of Waterloo
Abstract
This paper applies modern financial option valuation methods to the
problem of new wireless network capacity investment decision timing. In
particular, given a cluster of base stations (with a certain traffic capacity
per base station), we determine when it is optimal to increase capacity for
each of the base stations contained in the cluster. We express this in terms
of the fraction of total cluster capacity in use, i.e. we calculate the
optimal time to upgrade in terms of the ratio of observed usage to existing
capacity. We study the optimal decision problem of adding new capacity in the
presence of stochasticwireless traffic for services. We develop a four factor
algorithm that captures all of the constraints of wireless network
management, based on a real options formulation. We study the upgrade
decision for different upgrade decision intervals (e.g. monthly, quarterly,
etc.), and we investigate the effect of a safety level (i.e. the maximum
allowed capacity used in practice on a daily basis---which differs from the
theoretical maximum).
Using Real Options to Determine Optimal
Network Access Price
Ephraim Clark, Middlesex University
Joshi Easaw, University of Bath, UK
Abstract
As final goods markets have increasingly been liberalised, regulators have
focused on network provision. Facilitating a liberalised final goods market
with intense competition essentially requires an adequate and efficient
network provision. Using standard techniques borrowed from the literature on
option pricing and investment under uncertainty, the present paper introduces
the role of dynamic network investment decisions with uncertainty and
competition in the final goods market in the determination of the optimal
access price. We show that the optimal access price can be evaluated as the
certainty equivalent of the risky cash flows given up by the incumbent. This
price also accounts for the entrant's option to time his entry and, thereby,
does not give him undue advantage with respect to the incumbent and other
entrants operating the final goods market. JEL Classification: L51, D81
Keywords: Network Access Pricing, Real Options, Investment under Uncertainty.
Track II
8:30 - 10:00
Competition and Strategy
Chairperson: Helen Weeds, Lexecon Ltd. and University
of Cambridge
Real Options and Strategy
Helen Weeds, Lexecon Ltd. and University of Cambridge
Onno Lint, University of Leuven
This paper is still in progress, so the above link directs you to a
related paper by Robin Mason and Helen Weeds.
Optimal Project Rejection and New
Firm Start-ups
Bruno Cassiman, IESE Business School, Spain
Masako Ueda, Universitiy of Wisconsin-Madison
Abstract
Entrants typically appear to be more innovative than incumbent firms.
Furthermore, these innovative ideas often originate with established firms in
the industry. Therefore, the established firm and the start-up firm seem to
select different types of projects. We claim that this is the consequence of
their optimal project allocation mechanism which depends on their comparative
advantage. The start-up firm may seem more "innovative" than the
established firm because the comparative advantage of the start-up firm is to
commercialize "innovative" projects, i.e. projects that do not fit
with the established firms' existing assets. Our model integrates various
facts found in the industrial organization literature about the entry rate,
firm focus, firm growth, industry growth and innovation. We also obtain some
counter intuitive results such that a reduction in the cost of start-ups may
actually slow down start-ups and that the firm may voluntarily give away the
property rights to the inventions discovered within the firm.
The Value and Timing of Shared Real
Options with Random Maturity
P.J. Pereira, University of Minho, Portugal
M.R. Armada, University of Minho, Portugal
Abstract
In this paper we present an original model, with the purpose of
determining the value and timing of an investment opportunity (IO) that is
shared by several companies, in a competitive environment.
We assume that the market can accommodate a finite number of firms (N),
which are assumed to enter the market stochastically. Accordingly, the IO
matures with the last "admitted" company's entrance and, after that
moment, the option to invest disappears. Since companies can invest anytime up
to, but not including, the random maturity date, it's important to determine
the optimal timing to invest, in this context.
We provide an example that shows the value and the optimal timing for
investing for several situations. As expected, the value of the IO, and its
trigger value for investing, decreases as the available "places" in
the market decreases, or (and) as the probability of a competitor entrance
increases.
The example also shows that the IO's value and the optimal timing tend to the
value and to the optimal timing of a perpetual American option as N assumes
higher values or (and) when the probability of a competitor entrance tends to
zero.
Preemptive Patenting under Uncertainty and
Asymmetric Information
Yaowen Hsu, National Taiwan University
Bart Lambrecht, University of Cambridge
Abstract
This paper examines the investment behaviour of an incumbent and a
potential entrant that are competing for a patent with a stochastic payoff.
We incorporate asymmetric information into the model by assuming that the
challenger has complete information about the incumbent whereas the latter
does not know the precise value of its opponent's investment costs. We find
that even a small probability of being preempted gives the informationally
disadvantaged firm an incentive to invest at the breakeven point where it is
indifferent between investing and being preempted. By investing inefficiently
early to protect its market share, the incumbent gives up not only its option
to delay the investment, but also reduces the value of the firm by an amount
that increases with the investment cost incurred and the potential loss of
market share. The investment behaviour of the challenger is the same as under
complete information, namely the challenger 'epsilon preempts' the incumbent,
if optimal to do so.
10:00 - 10:30
Morning Coffee Break
10:30 - 12:00
Competition and Games
Chairperson: Marcel Boyer, Université de Montréal and
CIRANO
Continuous-Time Option
Games: Review of Models and Extensions
Marco Antonio Guimarães Dias, PUC-Rio and Petrobras
José Paulo Teixeira, PUC-Rio
Abstract
The theory of option-games being the combination of two successful, namely
real options and game theory, has a great potential to applications in many
real situations. Although the option games literature is very recent, it has
been experimenting a fast growth in the last five years. It considers besides
the key factors for investment decisions, such as the uncertainties,
flexibility, and timing, the effect of competition with the possible
strategies for each firm, in the same model. This paper reviews a selected
literature on continuous-time models of option games and provides some new
insights and extensions. Among others, we analyze models of duopoly under
uncertainty - both symmetrical and asymmetrical, oligopoly under uncertainty,
war of attrition and other models of positive externalities, and models with
either incomplete or asymmetric information. We discuss concepts like the
preemption, non-binding collusion, situations that mixed strategies are
necessary, secondary equilibrium, etc. We summarize solution methods using
concepts like the optimality of myopic behavior, and change in demand in
order to solve oligopoly as an artificial perfect competitive market. In
addition, we show that there are two equivalent ways to calculate both leader
and follower values in duopoly under uncertainty models. We also extend the
Joaquin & Buttler model by considering mixed strategies in asymmetric
duopoly and the value of option to become leader. Three differen! t demand
functions are considered. The paper also discusses the current option-games
models limitations and suggestions for future research.
Competition Games in Duopoly
Settings
Dean Paxson, Manchester Business School
Helena Pinto, Manchester Business School
Abstract
This paper presents two different real options models, with two stochastic
factors considering strategic interactions. In the first model the profits
per unit and the number of units follow two different stochastic paths and,
in the second model the returns and the investment cost pursue different
paths. For both models we analyse dissimilar games considering that the roles
of the players are pre-assigned and also exogenous to the models, always
assuming that the first mover has a competitive advantage over the second
mover. Closed form solutions are obtained for the value functions of the
first and second mover and for its trigger functions, except for the trigger
of the first mover in pre-emptive environments. The paper analyses the effect
of returns, investment cost and uncertainty on the models. Standard results
do not always hold: uncertainty can delay the adoption of the first mover.
Although pre-emption affects the leader's trigger it does not seem to
influence the entry point of the follower.
Real Options, Preemption, and the
Dynamics of Industry Investments
Marcel Boyer, CIRANO, Université de Montreal
Pierre Lasserre, CIRANO, Université du Québec à Montréal
Thomas Mariotti, Université de Toulouse
Abstract
Although most analyses of the preemption phenomenon have focused on
environments in which each firm can make at most one indivisible investment,
long-term competition per se does not rule out rent dissipation on new
investments. In this paper, in order to assess the robustness of this result,
and more generally to assess strategic behavior in long-run imperfect
competition, we study the development of a duopoly industry in a
continuous-time real-options model of capacity investment. Our methodology
allows the evaluation of investment options and exercise rules in a strategic
setup. We consider two alternative short-run competitive setups: Cournot
competition and Bertrand competition. Under short run Cournot competition,
firms choose output subject to their capacity. In the long run, they must
decide what capacity to hold, given that demand can change unpredictably
because of random aggregate shocks. In the initial industry development
phase, firms attempt to preempt each other, so that the first industry
investment occurs earlier than socially optimal and the first entrant takes
more risk than socially optimal. While capacity units are costly,
indivisible, durable, and big relative to market size, early entry cannot
secure a first-mover advantage, so that both firms are active beyond some
level of market development. Once both firms hold capacity, tacit collusion,
taking the form of postponed capacity investment, may occur in Markov Perfect
Equilibrium. Volatility and the expected speed of market development play a
crucial role in the determination of competitive behavior: we show that a
tacit-collusion equilibrium is certain to exist when market growth is highly
volatile and/or very fast.
Bertrand competition reflects more adequately situations where the market
is of finite size, and the willingness to pay is driven by stochastic taste
shocks. In the short run, firms compete in prices given their existing
capacity. In the long run, firms make irreversible acquisitions of
indivisible units of capacity at a constant fixed cost. Our focus is again
the timing of investments in a Markov perfect equilibrium of the game.
Different patterns of equilibria may arise, depending on the importance of
the real option effect. If the average growth rate of the market is close to
the risk free rate, or if the volatility of demand shocks is high, no
dissipation of rents occurs in equilibrium, despite instantaneous Bertrand
competition. If these conditions do not hold, the equilibrium investment
timing is suboptimal, and the firms' long-run capacities may depend on the
initial market conditions. Our conclusions contrast sharply with standard
rent dissipation results.
Key words: Real options; Option value; Duopoly; Preemption; Cournot;
Bertrand; Collusion; Capacity; Industry growth; Volatility; Risk.
J.E.L. classification: C73, D43, D92; L13.
12:00 - 1:30
Luncheon
Keynote Address
Alexander Triantis, University of Maryland
Dr. Triantis is Associate Professor of Finance at the Robert H. Smith
School of Business at the University of Maryland. Previously he was a member
of the finance faculties at the MIT Sloan School of Management (as a visiting
scholar) and the University of Wisconsin. He received his Ph.D. from Stanford
University in 1988. He is currently an Editor of Financial Management,
an Associate Editor of Management Science, and an Advisory Board
member of the Journal of Applied Corporate Finance.
Professor Triantis has published numerous articles on the topic of real options
in the areas of finance, economics, law, management science and real estate.
He has made important contributions on a range of topics, including the value
of flexibility, the design of sequential and parallel investment strategies,
the interaction between dynamic financing and investment policies, and the
design of securities and contracts.
On the practitioner side, Dr. Triantis has been an advisor to several
multinational corporations and consulting firms, as well as to U.S.
Government departments and multilateral agencies. His role in helping
companies adopt real options valuation tools has been cited in business
publications such as Business Week, Business Finance Magazine and CFO
Europe.
1:30 - 3:00
Buyer-Seller Relationships and Supply Contracts
Chairperson: Bardia Kamrad, Georgetown University
Asymmetric Buyer-Seller
Relationships and Real Switching Options
Ellen Römer, University of Paderborn, Germany
Abstract
Industrial buyer-seller relationships are frequently characterized by the
fact that the seller and/or the buyer have to dedicate specific up-front
investments to the relationship. Marketing research analyzes these
relationships on the basis of Transaction Cost Economics (TCE). TCE
highlights the risk of hold-up which arises after specific investments are
dedicated. However, exogenous uncertainties are largely neglected in TCE.
Therefore, the aim of this paper is to analyze the effects of both hold-up
and exogenous uncertainty on the value of customers in buyer-seller
relationships. From the perspective of a supplier, the value of her customers
is modeled by a dynamic programming approach. It is shown how different
contracting scenarios affect hold-up and the value of an option to switch
customers. A numerical analysis illustrates the analytical findings.
Strategic Relationships
between Buyers and Sellers under Uncertainty
Milind Shrikhande, Georgia State University
Ajay Subramanian, Georgia Tech
Nagesh Murthy, Georgia Tech
Abstract
This paper proposes and investigates a theoretical model to analyze the
real switching options that a firm with multiple economic agents holds and
the corresponding implications for competitive equilibria between the firm
and the agents. Although our model is generally applicable in several
different economic scenarios, for expositional simplicity we consider the
specific situation where the economic agents are suppliers of the firm. We
begin by considering the optimal policy problem for the firm where it may
face different exogenously specified relationship specific fixed costs and
random variable costs vis-à-vis each supplier and its goal is to dynamically
choose a supplier over time so as to maximize its expected discounted cash
flows. At any instant of time, the firm therefore holds compound real options
of either entering the market with a particular supplier, switching to
another supplier or exiting the market. In the process of deriving the
optimal dynamic policies for the firm,the paper specifically investigates the
switching option of the firm, i.e. the option of the firm to switch between
suppliers. In the case where the firm has two suppliers, we derive necessary
and sufficient conditions on the fixed and variable cost structures of the
firm vis-à-vis the suppliers for the switching option of the firm to have
strictly positive value. These conditions have important implications for the
firm's suppliers since either one of the two suppliers captures the market if
these conditions do not hold. In other words, they represent necessary and
sufficient conditions for each supplier to have positive expected revenue in
any competitive equilibrium between the suppliers and the firm. We illustrate
our analytical results through several numerical simulations.
Next, we investigate the general competitive equilibrium problem between
the firm and its suppliers when both suppliers are in the same foreign
country (or, more generally, in two countries with perfectly correlated or
pegged currencies). The prices quoted by the suppliers and, therefore, the
variable costs of the firm are now determined endogenously in equilibrium
where the suppliers and the firm respond rationally and optimally to each
other's policies. We use the insights from the firm's optimal policy problem
to develop and implement a numerical procedure to solve the competitive
equilibrium problem. We derive competitive equilibria between the firm and
its suppliers for several different values of underlying parameters that
illustrate the impact of competition in global markets.
Profit Sharing and
Adjustment Options in Supply Contracts
Bardia Kamrad, Georgetown University, McDonough School of
Business
Akhtar Siddique, Office of the Comptroller of the Currency
Abstract
A common theme in the studies of flexible supply contracts has been the
producer's profit maximization problem without regard for the suppliers';
reactions to the producer's operating policies. However, suppliers do react
and protect their downside against producer's operating policies by revising
their strategies in a manner consistent with their profit maximization
objectives. This fact motivates our work. Using a real options (contingent
claims) approach, we analyze and value supply contracts in a setting
characterized by exchange rate uncertainty, supplier-switching options, order
quantity flexibility, profit sharing, and supplier reaction-options. We also
use basic diversification concepts, from portfolio theory, to provide a
unique framework for risk reduction. Given this set up, we explicitly model
how flexibility can be mutually beneficial to the producer and his suppliers.
We also analyze what induces the producer and the suppliers to accept
flexibility in their contracts.
3:00 - 3:30
Afternoon Coffee Break
3:30 - 5:00
Valuing Manufacturing & Production Options
Chairperson: Apostolos Burnetas, Case Western
Reserve University
Effects of Correlated
Defaults in Supply Chains
Volodymyr Babich, Case Western Reserve University
Apostolos Burnetas, Case Western Reserve University
Peter Ritchken, Case Western Reserve University
Abstract
We study the effects of credit risk in a supply chain where one retailer
deals with competing risky suppliers who may default during their production
lead-times. The suppliers, who compete for business with the retailer by
establishing wholesale prices, are leaders in a Stackelberg game with the
retailer. The retailer, facing uncertain future demand, chooses order
quantities while weighing the benefits of procuring from the cheapest
supplier against the advantages of reducing credit risk through diversification.
Although, in general, the timing of the retailer-to-suppliers payments is
important, we identify a family of wholesale pricing policies for which, in
equilibrium, the suppliers and the retailer are indifferent between up-front
and on-delivery payment schedules. Our analysis reveals that the equilibrium
firms' profits decline as default risk increases. Furthermore, the decline
rates for firms in different echelons of the supply chain depend on the shape
of the demand distribution. If the wholesale prices were fixed, the retailer
would benefit from the decreasing correlation of the defaults. However, if
prices are endogenous to the model, the decreasing defaults' correlation
alters the nature of the competition among the suppliers and lowers the
equilibrium wholesale prices. We show that, in equilibrium, the retailer
prefers suppliers with positively correlated default events. In contrast, the
suppliers and the supply chain prefer defaults that are negatively
correlated.
Market and Process Risks in
Production Opportunities: Demand and Yield Uncertainty
Bardia Kamrad, Georgetown University
Keith Ord, Georgetown University
Abstract
By adopting a real options framework, we develop and analyze a production
based valuation model that jointly incorporates process and market risks.
Given this setting, techniques of contingent claims analysis and stochastic
control theory are employed to obtain value maximizing operating policies in
a constrained capacity environment. In our analysis, adjustments to operating
policies are analogously modeled as a sequence of complex (real) options
whose optimal exercise maximizes their inherent flexibility value.
A Real Option Valuation of Delivery Time
Uncertainty
N. Takezawa, International University of Japan
Abstract
We attempt to value the delivery time uncertainty related to the
disruption of the production line due to breakdowns in a consumer electronic
production line. In this type of manufacturing environment, the steady state
production activity will have little option value attached to the delivery
time, but the major source of uncertainty often originates from machine
breakdowns. In this paper, we decompose the delivery time uncertainty into
two parts, the direct impact from the breakdown and the secondary effect due
to the recovery process. The second factor is examined and interpreted as the
workforces’ effort to recover from a machine breakdown.
Key Words: Real Option, Outsourcing, Production, Delivery Time, Mean
Reversion
DAY
3 - SATURDAY, JULY 12
7:30 - 8:30
Continental Breakfast
Track I
8:30 - 10:00
Optimal Investment
Chairperson: Jean-Daniel Saphores, University of
California Irvine
The Optimal Value of Waiting to Invest with
Learning
Herve Roche, Instituto Tecnologico Autonomo de Mexico
Abstract
The goal of this paper is to study irreversible investment decisions under
incomplete information when the investor has an active role and can increase
her knowledge about the type of the project she wants to undertake. In their
seminal article ''The Value of Waiting to Invest'', McDonald and Siegel
(1986) highlight the option value of waiting in the case of an irreversible
investment. In their paper, uncertainty is modeled by (and reduced to) a
shock affecting the future benefits of investing. Irreversibility and the
possibility of delay generate a range of inaction and the investment decision
does not occur as soon as the NPV of the project is positive but instead, the
investor requires a wedge between the value of the project that triggers
investment and the cost of investing. In this article, we incorporate some
incomplete information about the characteristics of the project into the
classical real option framework. Applications include investments in new and
unfamiliar markets (joint ventures), research and development, and new
start-up companies. Typically, the expected growth rate of the project is
known to be either low or high. Waiting and observing the realizations of the
value of the project provide information to the investor who can update her
beliefs about the true value of the expected return. Moreover, the investor
can purchase some additional information, which allows her to control the
learning speed of her beliefs. We prove the existence of a solution to the
optimal control program and derive analytical properties for the option value
and the optimal trigger investment frontier. Investor's beliefs follow a
martingale and the optimal investment trigger depends on the degree of
optimism. We propose an original algorithm to solve the ! non-linear Bellman
equation with a free boundary to be determined. The optimal amount of
information purchased is found to be increasing in the project payoffs and
the variance of beliefs, but decreasing in the project volatility. Overall,
the opportunity to purchase information enhances the option value of waiting
to invest, thus delays investment.
Barriers and Optimal Investment
Rules
Jean-Daniel Saphores, University of California Irvine
Abstract
This paper revisits the simplest stochastic investment decision: when to
incur a sunk cost in exchange for a random payoff. It shows that the standard
real options approach typically yields incorrect decision rules except for
reflecting or unattracting barriers. Optimal investment rules are derived for
different barriers and illustrated for common stochastic processes. An
explicit solution for the perpetual call option with a lower absorbing
barrier is also obtained; it shows that the standard perpetual call option
overestimates the corresponding investment threshold when uncertainty is high
enough. These results have implications for stochastic investment problems in
continuous time.
Is the Myopic Investor Right? Numerical
Evidence for Systematic Overestimation of Investment Reluctance for Real
Options
Oliver Musshoff, Humboldt University Berlin
Norbert Hirschauer, Humboldt University Berlin
Alfons Balmann, Institute of Agricultural Development in
Central and Eastern Europe (IAMO)
Martin Odening, Humboldt University Berlin
Abstract
Empirical applications of real options models in competitive environments
implicitly exploit the optimality of myopic planning. In a seminal paper
Leahy (1993) shows that the optimal investment strategy of a myopic planner,
who ignores market entries and exits of competitors as well as the resulting
price effects, also constitutes a market equilibrium under rather general
conditions. As a result, the calculation of optimal investment strategies is
simplified considerably because competition does not have to be taken into
account. In this paper, however, we demonstrate that myopic planning may lead
to non-optimal investment strategies. This is due to the fact that it is
difficult, or even impossible, to specify the correct or equivalent price
process for the myopic investor using real world data. The myopic investor
acts on the assumption of an unregulated (exogenous) price process. But what
we observe in the real (competitive) world is indeed the outcome of a
regulated (endogenous) price process. Hence, an estimation of parameters which
is based on the unregulated form of stochastic process is inconsistent. This
misconception, whose outcome we call 'competitive bias', has been widely
ignored in the literature. Our paper quantifies this bias, analyses its
determinants and shows the outcome of alternative estimation procedures which
could be used to get around it. It turns out that due to the 'competitive
bias' the widely acknowledged 'reluctance to invest' is over-estimated. The
suitability of alternative estimation methods depends on their respective
specifications.
Keywords: investment, uncertainty, competition, myopic planning
10:00 - 10:30
Morning Coffee Break
10:30 - 12:00
Valuing Levered Equity, Debt and Capital Structure Interactions
Chairperson: Grzegorz Pawlina, Tillburg University
Real Options, Capital
Structure, and Taxes
Andrea Gamba, University of Verona, Italy
Carmen Aranda Leon, University of Navarra, Spain
Gordon A. Sick, University of Calgary, Canada
Abstract
This paper presents a valuation approach for real options when the capital
structure of the underlying project/firm is levered, assuming that the goal
is the maximization of total firm/project value (i.e., under a first-best
investment policy). We analyze also the effect of different financing schemes
on the value of the real option and on the exercise policy. The main finding
of this work is that a higher leverage reduce the time-value of the option to
delay investment and increases the probability of exercising the options.
Underinvestment, Capital Structure and
Strategic Debt Restructuring
Grzegorz Pawlina, Tilburg University, The Netherlands
Abstract
In this paper the investment and liquidation policy of a levered firm is
analyzed. The possibility of renegotiating the original debt contract is
included. It is shown that the shareholders' option to restructure the
outstanding debt exacerbates Myers' (1977) underinvestment problem. This
result is due to a higher wealth transfer from the shareholders to the
creditors occurring upon investment when the option to renegotiate is
present. The problem can be eliminated only when all the bargaining power is
given to the creditors. In such a case, the renegotiation commences at the
shareholders' bankruptcy trigger and no additional wealth transfer occurs.
Moreover, it is shown the liquidation policy under partial debt financing
differs from the optimal policy when the firm is all-equity financed. Even
after removing the effects of the tax shield by excluding taxes, it holds
that the liquidation policy is affected by the second-best investment policy,
thus it occurs inefficiently early. Finally, it is shown that the presence of
a positive NPV investment opportunity increases the likelihood of a strategic
default when the bargaining power of shareholders is high.
The Valuation of Corporate Debt with
Default Risk
Hassan Naqvi, London School of Economics
Abstract
This article values equity and corporate debt by taking into account the
fact that in practice the default point differs from the liquidation point
and that it might be in the creditors' interest to delay liquidation. The
article develops a continuous time asset pricing model of debt restructuring
which explicitly considers the inalienability of human capital. The study
finds that even though in general the creditors will not liquidate the firm
on the incidence of default, but nevertheless would liquidate the firm prematurely
relative to the first best threshold. This agency problem leads to the
breakdown of the capital structure irrelevance result. Abstract:
Carrots or Sticks? Optimal Compensation
for Firm Managers
Ajay Subramanian, Georgia Institute of Technology
Abstract
We investigate the existence of and explicitly characterize compensation
structures that eliminate agency conflicts between a leveraged firm (or its
shareholders) and the manager due to managerial asset substitution within a
continuous time framework. The manager may dynamically switch between two
strategies with different risks and expected returns after debt is in place.
We show that when the strategies satisfy a specific condition that (roughly)
ensures that the difference in their drifts is not large compared with the
difference in their volatilities, a periodic compensation structure that
completely aligns the manager’s interests with those of the firm (or its
shareholders) is one where the manager’s payoff is proportional to the
firm’s operating cash flows, but subject to a floor and a ceiling. This
result explains the prevalence of compensation schemes where firm managers
obtain shares of firm profits subject to floors and ceilings apart from the
usual components of cash,stock, and options. We also investigate conditions
under which convex and concave compensation structures are optimal. We show
that a concave compensation structure where the manager obtains a proportion
of firm cash flows subject to a ceiling is optimal when the higher volatility
strategy also has a higher expected return. On the other hand, a convex
compensation structure where the manager obtains a proportion of firm cash
flows subject to a floor is optimal when the higher volatility strategy has a
lower expected return. Our theoretical analysis therefore offers insights
into features of compensation contracts that mitigate agency conflicts due to
managerial asset substitution.
Key Words: Optimal Compensation, Asset Substitution, Agency Costs
Track II
8:30 - 10:00
Economic Models of Real Options Valuation
Chairperson: Hassan Naqvi, London School of Economics
Investment and Value of a Firm Facing
Uncertainty, Adjustment Cost, Information Costs and Irreversibility
Mondher Bellalah, University of Cergy and Paris-Dauphine
Abstract
Following the analysis in Abel and Eberly (1997), I derive closed-form
solutions for the investment and value of a competitive firm with a constan
treturns- to-scale production function and convex costs of adjustment. The
analysis concerns reversible and irreversible investments under incomplete
information. Optimal investment seems to be a non-decreasing function of q,
the shadow value of capital. This depends also on the magnitude of shadow
costs of incomplete information.
On the Real Option Value of
Scientific Uncertainty for Public Policies
Justus Wesseler, Wageningen University, Netherlands
Abstract
In this paper scientific uncertainty is defined as the impossibility to
choose the correct stochastic process for the value of a public policy. The
real option value of waiting under scientific uncertainty is derived using
the difference between the geometric Brownian motion and the mean reverting
process by applying contingent claim analysis. The results are compared with
those generated by either using a geometric Brownian motion or a
mean-reverting process only. The results show that scientific uncertainty is
less important than one would expect at first hand. The small effect of
scientific uncertainty adds confidence to the use of a geometric Brownian
motion for the kind of public policy decisions discussed in this paper. The
paper contributes to the suggestion made by scientists to analyze the
sensitivity public policy valuations, provides insights about the magnitude
of error that can be made by choosing the wrong process, provides a solution
to the problem and highlights the implication for public policy decision
making.
Real Options Effects on
Employment: Does Exchange Rate Uncertainty Matter for Aggregation?
Ansgar Belke, University of Hohenheim, Germany
Matthias Göcke, University of Münster, Germany
Abstract
In a baseline micro model a band of inaction due to hiring- and
firing-costs is widened by option value effects of exchange rate uncertainty.
Based on this micro foundation an aggregation approach is presented. Under
uncertainty, intervals of weak response to exchange rate reversals are
introduced on the macro-level. 'Spurts' in new employment or firing may occur
after an initially weak response. Since these mechanisms may apply to other
investment cases where the aggregation of microeconomic real options effects
under uncertainty are relevant, they may even be of a more general interest.
Quota Utilization under
Voluntary Export Restraints: The Case of Textile and Clothing
Jihe Song, University of Wales, Aberystwyth, UK
Shumei Gao, Heriot-Watt University, UK
Abstract
A large part of international trade today is governed by quantitative
restrictions. In this paper, we apply the real options framework to the
analysis of trade policy instruments. The partocular instrument studied in
this paper is the so-called "Voluntary Export Restraints" (VERs).
We extend the early analysis of Anderson (1986), Eldor and Marcus (1988) to
the valuation and exercise of export quotas under VERs. Of particular
interest is quota utilisation, which is modeled as an option exercise
problem. We also present extensive evidence on quota utilisation rates for
textile and clothing export from East Asian countries to the European markets
in the 1980s. While the evidence in general supports the model, the data
presents more challenges for real options modeling.
10:00 - 10:30
Morning Coffee Break
10:30 - 12:00
Theoretical Issues
Chairperson: Ajay Subramanian, Georgia Institute of
Technology
Market Entry, Pricing Decisions and
Options Contracts
Alison Dean, University of Kent, UK
Charles Baden-Fuller, City University, UK
Abstract
This paper bridges the literature on real options in strategy with that on
financial options. It uses insights from both literatures to show how the use
of options contracts can encourage innovators to enter markets by mitigating
the effects of uncertainty and permitting the capture of greater value from
innovation. The dilemma facing a firm trying to secure the successful launch
of its innovation is how to set price to achieve market penetration yet still
receive an adequate return. The traditional view is that the low price
necessary for penetration may yield such poor returns that the innovator is
dissuaded from launch. This problem is exacerbated when the innovator is an
entrant and faces retaliatory reactions from incumbents. We explore how
financial options can mitigate these effects and recapture the
"lost" added value. Using financial options can encourage
commitment, overcome delay in launch and allow innovators to capture value
quickly. Finally, we explore s! ome of the impediments to executing our
ideas, discuss when they might be useful to managers and suggest ways in
which they can be tested empirically.
Controlling Cash Flow at Risk
with Real Options with Applications in Shipping
Giuseppe Alesii, Universita' de L'Aquila, Italy
Abstract
Cash flow at risk (CFaR) can be controlled using real options. In this
normative paper, we derive numerically in a univariate discrete time model,
extension of (Kulatilaka, 1988), the expanded NPV of an industrial investment
and, simultaneously, state variable thresholds to optimally exercise real
options for the whole life of the project. In this framework, we model total
variability in expanded NPV using a Markov chain Montecarlo method. A number
of original results are derived for an all equity financed firm. Cash Flow
distribution and CFaR is derived for each epoch in the life of the project. A
VaR for the expanded NPV at time 0 is derived. These new methods have been
applied to two case studies in shipping finance, namely a very large crude
carrier and a Panamax.
Real Options Lesson: Learn Before
You Act
Spiros Martzoukos, University of Cyprus
Nicos Kousis, University of Cyprus
Lenos Trigeorgis, University of Cyprus
Abstract
We develop a model of strategic interactions that incorporates the ability
of the firm to actively enhance the value of a new technology or product
before final development through R&D actions that improve quality or add
new features. We encompass optional, costly, and interacting (impulse type
control) actions with random outcome in a semi-American real options
investment problem. Before though the firm commits to such costly actions, it
engages in acts of (filtering like) learning about the quality or attributes
of products or technologies, the potential market share of products, the
quantity of natural reserves, etc. This sequence of actions can be
interpreted as similar to investment in marketing research, before the firms
commits to an expensive advertising campaign; and to exploration about the
existing standing of a product or process before commitment to enhance
attributes and improve qualitative and quantitative characteristics. We
numerically analyse optimal activation rules and calculate project values for
the case of single or sequential actions. We allow the distributional
characteristics of R&D (or marketing) actions and their cost structure to
be affected by their sequence (path). This feature adds considerable
complexity and computational difficulty, but it also allows the study of
optimal timing of such actions, time to learn effects (lag in the impact of
control), abandonment decisions for partial recovery of invested capital, and
learning by doing effects (reduction in cost, enhancement of impact, etc.).
Our results demonstrate the importance of active management and optimal
R&D choice.
Return Characteristics of Strategic
Options
Hans Haanappel, Erasmus University, Netherlands
Abstract
In this study we develop implications for the return distribution of firms
with embedded strategic growth options. In our model we integrate real option
theory with a Cournot-Nash framework where two firms choose output levels
endogenously and may have investment-timing differences. Simulations of the
returns of the strategic growth option show that traditional option
variables, such as the value of the project relative to the investment (i.e.,
moneyness of the growth option), the return interval relative to the period
the project can be deferred (i.e., maturity), and uncertainty in demand for
the product are significant determinants for the moments of the distribution
of the option returns. In addition to these option variables, uncertain
preemption may introduce discontinuities in the payoff of our model and
consequently further enhance skewness and kurtosis. Investment-timing
differences between competitors may even lead to bimodal return
distributions, where the firm with a first-mover advantage has a high
probability to generate high returns.
12:00 - 1:00
Panel Discussion: Current State, Challenges and Future Prospects
Moderator: Alex Triantis, University of Maryland
Panelists Include:
Adam Borison (Sanford University)
Marcel Boyer (Université de Montréal and CIRANO)
Bardia Kamrad (Georgetown University)
Ted O'Leary (University of Manchester and University of Michigan)
Ajay Subramanian (Georgia Institute of Technology)
Lenos Trigeorgis (University of Cyprus and ROG)
Helen Weeds (Lexecon Ltd and University of Cambridge)
1:00 Closing
Remarks: Conference Concludes
Thursday | Friday Track I
| Friday Track II
Keynote Address | Saturday
Track I | Saturday Track II
