L10 - Option to Expand and Abandon

L10 - Option to Expand and Abandon - FINS3641 SAV Week 11:...

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FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 1 FINS3641 SECURITY ANALYSIS AND VALUATION PART 4 CONTINGENCY CLAIM VALUATION MODELS Week 11 Valuing Options to Expand and to Abandon Valuing Equity in Distressed Firms Application of option pricing models to the valuation of the option to abandon, the option to expand firms in distress Reading: Damodaran Chapters 29, 30
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FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 2 Valuation Implication of the Option to Expand/Take Other Projects i) often used by management as a rationale to accept a project, despite its “negative NPV”, because the proposed project has an embedded option to expand the investment further in new markets (from one state to another) to new products (multiple applications based on the same platform or technologies) the value of the embedded option to expand more than offsets the –ve NPV of the seed investment ii) the reason for seeing the significantly larger value of young start up firms than the PV of their expected cash flows
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FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 3 An Valuation Example of the Option to Expand Background Information: i) Ambev is considering introducing a soft drink to the U.S. market. ii) The drink will initially be introduced only in the metro areas of the U.S. iii) The cost of this “limited introduction” is $ 500 million . iv) Capital budgeting suggests that the PV of the cash flows from this investment will be only $ 400 million . v) Hence, this new investment has a negative NPV of $ 100 million . vi) If the initial introduction works out well, Ambev could go ahead with a full scale introduction to the entire market with an additional investment of $ 1 billion (exercise price) any time over the next 5 years. vii) The expected PV of cash flows from this subsequent investment is $ 750 million (underlying asset value) Valuation of the Option to Expand the Investment to the Rest of the U.S. i) Volatility of the value of the underlying asset = the average annualized standard deviation in firm value of small and publicly traded beverage firms in the U.S. = 34.25%. ii) Time to expiration = 5 years. Though set arbitrary by management, before committing itself to expand the investment, this time is needed to Monitor the viability of the pilot investment (Is the investment paying off and self sufficient?) Collect customers’ response to the product or concept (like a concept car or store to gather feedback) determine if there are better projects to spend the exercise price to get prepared for the expansion (e.g., personnel, sites, equipment orders) iii) Using a r f of 5%, the BSOPM returns a call value on the option to expand of $ 234 Million Valuation of the Initial Investment with the Option to Expand = NPV of the initial project + value to expand = $100 + $234 million = $134 million (INVEST)
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This note was uploaded on 03/01/2012 for the course FINS 3641 taught by Professor Hyip during the Three '11 term at University of New South Wales.

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L10 - Option to Expand and Abandon - FINS3641 SAV Week 11:...

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