L10 - Option to Expand and Abandon

# Completing the projects in stages rather than a full

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Completing the projects in stages rather than a full scale investment at the outset b) their day to day business to boost sales and revenue by offering their customers the option to terminate rather than being locked in a contract (prepaid in contrast to your planned mobile contract) return the product within a specified period (Woolworth’s fresh produce commitment)

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FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 11 Valuing the Option to Abandon Airbus is considering a joint venture with Lear Aircraft to produce a small commercial airplane Airbus will have to invest \$ 500 million (P) for a 50% share of the venture Its share of the present value of expected cash flows is\$ 480 million (S) . Lear Aircraft, which is eager to enter into the deal, offers to buy Airbus’s 50% share of the investment anytime over the next five years ( t ) for \$ 400 million (X) , if Airbus decides to get out of the venture. A simulation of the cash flows on this investment yields a variance in the present value of the cash flows of 0.16 ( ). The project has a limited life of 30 years (y = dividend yield = 1/30) Using 5 year risk free rate of 6%, Value of Put = Xe rt (1 N(d2)) Se yt (1 N(d1)) =400 (exp ( 0.06*5) (1 0.4624) 480 exp ( 0.033*5) (1 0.7882) = \$ 73.23 million Summary : From Airbus’s point of view: i) The NPV of the current project is –\$ 20 million before considering the value of the option to abandon ii) Once we add the option value to the NPV of the project, the revised NPV is= \$ 53.23 million iii) The joint venture is worth taking From Lear Aircraft’s point of view: i) Lear has bought Airbus’s participation at a cost \$73.23 million. ii) Lear will have to earn a NPV larger than this amount, if it wants to come out ahead in this transaction.
FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 12 The Intuition behind the Valuation of Equity (of a Distressed Firm) as a Call Option When a distressed firm (with high leverage, ve book value of equity, ve earnings and a significant chance of default) is liquidated, its equity has call option like payoffs: i) V – D if V > D since S/Hs have the residual claim ii) 0 if V D since S/Hs are protected by limited liability Hence the equity value of a firm in distress is no different from a call option written on the value of the firm V is the liquidation value of the firm (S) i) Market value of listed equity + debt (but aren’t we supposed to value equity by an option pricing model?) ii) Value the firm’s assets in place given by the stable growth FCFF discounted valuation model that uses a reinvestment rate to preserve existing assets less the expected cost of liquidation (but the depressed current OI used by the DCF model may bias the value of the firm downwards) iii) Apply the industry average revenue multiple to the current revenue of the distressed firm (but we need a potential buyer willing to pay this value in the event of liquidation)

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