L10 - Option to Expand and Abandon

# D is the face value of debt the exercise price x i

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D is the face value of debt (the exercise price X) i) Add up the face values of all the o/s debts (but this will ignore other liabilities and underestimate the amount of X) ii) Add accrued interests and the liabilities owed to the suppliers, employees and other o/s claims ahead of the S/Hs to (i) (but the amounts are not due at the same time) iii) Keep (i) as the face value of debt, estimate the annual amount of (ii) as a percentage of firm value and treat it as a dividend yield in the option pricing model The maturity of the debt (time to the expiration date of the option t) Best to compute the face value weighted duration of the existing debts/claims. In case of no information on yields to compute duration, use face value weighted maturity Volatility of the underlying assets of the firm 2 firm = w e 2 e 2 + w d 2 d 2 + 2 w e w d ed e d ? No, too high as e and d are inflated during distress Use average variance in firm value for other firms in the same industry instead.

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FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 13 Valuing Eurotunnel Equity and Debt in 1997 (Compare this to our infamous Lane Cove Tunnel) Background: Eurotunnel has been a financial disaster since its opening In 1997, Eurotunnel had earnings before interest and taxes of £56 million and net income of £685 million At the end of 1997, its book value of equity was £117 million It had £8,865 million in face value of debt outstanding The weighted average duration of this debt was 10.93 years Debt Type Face Value Duration Short term 935 0.50 10 year 2435 6.7 (note the error in the book) 20 year 3555 12.6 Longer 1940 18.2 Total £8,865 mil 10.93 years
FINS3641 SAV Week 11: Valuation of the Option to Expand, the Option to Abandon, and Firms in Distress 14 Valuing Eurotunnel Equity and Debt in 1997 (Cont’d) The Basic DCF Valuation : The value of the firm estimated using projected cash flows to the firm, discounted at the weighted average cost of capital was £2,278 million on the basis of the following assumptions – Revenues will grow 10% a year for the next 5 years and 3% a year in perpetuity after that. The cost of goods sold which was 72% of revenues in 1997 will drop to 60% of revenues by 2002 in linear increments and stay at that level. Capital spending and depreciation will grow 3% a year for the next 5 years. Note that the net capital expenditure is negative for each of these years – we are assuming that the firm will be able to not make significant reinvestments for the next 5 years. Beyond year 5, capital expenditures will offset depreciation. There are no working capital requirements. The debt ratio , which was 95.35% at the end of 1997, will drop to 70% by 2002. The cost of debt is 10% for the next 5 years and 8% after that.

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