VALUATION:PACKET3REALOPTIONS,ACQUISITIONVALUATIONANDVALUEENHANCEMENTAswathDamodaranUpdated:September2016

Aswath Damodaran 1

REALOPTIONS:FACTANDFANTASY

AswathDamodaran

Aswath Damodaran 2

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UnderlyingTheme:SearchingforanElusivePremium

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¨ Traditionaldiscountedcashflow modelsunderestimatethevalueofinvestments,wherethereareoptionsembeddedintheinvestmentsto¤ Delayordefermakingtheinvestment(delay)¤ Adjustoralterproductionschedulesaspricechanges(flexibility)¤ Expandintonewmarketsorproductsatlaterstagesintheprocess,baseduponobservingfavorableoutcomesattheearlystages(expansion)

¤ Stopproductionorabandoninvestmentsiftheoutcomesareunfavorableatearlystages(abandonment)

¨ Putanotherway,realoptionadvocatesbelievethatyoushouldbepayingapremiumondiscountedcashflowvalueestimates.

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Abadinvestment…

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+100

-120

1/2

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Today

Success

Failure

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Becomesagoodone…

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3/4

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+20

-20

+80

-100

2/3

1/3

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ThreeBasicQuestions

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¨ Whenistherearealoptionembeddedinadecisionoranasset?

¨ Whendoesthatrealoptionhavesignificanteconomicvalue?

¨ Canthatvaluebeestimatedusinganoptionpricingmodel?

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Whenisthereanoptionembeddedinanaction?

Aswath Damodaran

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¨ Anoptionprovidestheholderwiththerighttobuyorsellaspecifiedquantityofanunderlyingassetatafixedprice(calledastrikepriceoranexerciseprice)atorbeforetheexpirationdateoftheoption.

¨ Therehastobeaclearlydefinedunderlyingassetwhosevaluechangesovertimeinunpredictableways.

¨ Thepayoffsonthisasset(realoption)havetobecontingentonanspecifiedeventoccurringwithinafiniteperiod.

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PayoffDiagramonaCall

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Price of underlying asset

StrikePrice

Net Payoff on Call

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PayoffDiagramonPutOption

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Price of underlying asset

StrikePrice

Net PayoffOn Put

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Whendoestheoptionhavesignificanteconomicvalue?

Aswath Damodaran

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¨ Foranoptiontohavesignificanteconomicvalue,therehastobearestrictiononcompetitionintheeventofthecontingency.Inaperfectlycompetitiveproductmarket,nocontingency,nomatterhowpositive,willgeneratepositivenetpresentvalue.

¨ Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivity- youandonlyyoucantakeadvantageofthecontingency.Theybecomelessvaluableasthebarrierstocompetitionbecomelesssteep.

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Determinantsofoptionvalue

Aswath Damodaran

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¨ VariablesRelatingtoUnderlyingAsset¤ ValueofUnderlyingAsset;asthisvalueincreases,therighttobuyatafixedprice

(calls)willbecomemorevaluableandtherighttosellatafixedprice(puts)willbecomelessvaluable.

¤ Varianceinthatvalue;asthevarianceincreases,bothcallsandputswillbecomemorevaluablebecausealloptionshavelimiteddownsideanddependuponpricevolatilityforupside.

¤ Expecteddividendsontheasset,whicharelikelytoreducethepriceappreciationcomponentoftheasset,reducingthevalueofcallsandincreasingthevalueofputs.

¨ VariablesRelatingtoOption¤ StrikePriceofOptions;therighttobuy(sell)atafixedpricebecomesmore(less)

valuableatalowerprice.¤ LifeoftheOption;bothcallsandputsbenefitfromalongerlife.

¨ LevelofInterestRates;asratesincrease,therighttobuy(sell)atafixedpriceinthefuturebecomesmore(less)valuable.

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Whencanyouuseoptionpricingmodelstovaluerealoptions?

Aswath Damodaran

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¨ Thenotionofareplicatingportfoliothatdrivesoptionpricingmodelsmakesthemmostsuitedforvaluingrealoptionswhere¤ Theunderlyingassetistraded- thisyieldnotonlyobservableprices

andvolatilityasinputstooptionpricingmodelsbutallowsforthepossibilityofcreatingreplicatingportfolios

¤ Anactivemarketplaceexistsfortheoptionitself.¤ Thecostofexercisingtheoptionisknownwithsomedegreeof

certainty.¨ Whenoptionpricingmodelsareusedtovaluerealassets,we

havetoacceptthefactthat¤ Thevalueestimatesthatemergewillbefarmoreimprecise.¤ Thevaluecandeviatemuchmoredramaticallyfrommarketprice

becauseofthedifficultyofarbitrage.

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Creatingareplicatingportfolio

Aswath Damodaran

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¨ Theobjectiveincreatingareplicatingportfolioistouseacombinationofriskfreeborrowing/lendingandtheunderlyingassettocreatethesamecashflowsastheoptionbeingvalued.¤ Call=Borrowing+BuyingDoftheUnderlyingStock¤ Put=SellingShortDonUnderlyingAsset+Lending¤ Thenumberofsharesboughtorsoldiscalledtheoptiondelta.

¨ Theprinciplesofarbitragethenapply,andthevalueoftheoptionhastobeequaltothevalueofthereplicatingportfolio.

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TheBinomialOptionPricingModel

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50

70

35

100

50

25

K = $ 40t = 2r = 11%

Option Details

StockPrice Call

60

10

0

50 D - 1.11 B = 1025 D - 1.11 B = 0D = 0.4, B = 9.01Call = 0.4 * 35 - 9.01 = 4.99

Call = 4.99

100 D - 1.11 B = 6050 D - 1.11 B = 10D = 1, B = 36.04Call = 1 * 70 - 36.04 = 33.96

Call = 33.9670 D - 1.11 B = 33.9635 D - 1.11 B = 4.99D = 0.8278, B = 21.61Call = 0.8278 * 50 - 21.61 = 19.42

Call = 19.42

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TheLimitingDistributions….

Aswath Damodaran

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¨ Asthetimeintervalisshortened,thelimitingdistribution,ast->0,cantakeoneoftwoforms.¤ Ifast->0,pricechangesbecomesmaller,thelimitingdistributionisthenormaldistributionandthepriceprocessisacontinuousone.

¤ Ifast->0,pricechangesremainlarge,thelimitingdistributionisthepoisson distribution,i.e.,adistributionthatallowsforpricejumps.

¨ TheBlack-Scholesmodelapplieswhenthelimitingdistributionisthenormaldistribution,andexplicitlyassumesthatthepriceprocessiscontinuousandthattherearenojumpsinassetprices.

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BlackandScholes…

Aswath Damodaran

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¨ TheversionofthemodelpresentedbyBlackandScholeswasdesignedtovalueEuropeanoptions,whichweredividend-protected.

¨ ThevalueofacalloptionintheBlack-Scholesmodelcanbewrittenasafunctionofthefollowingvariables:¤ S=Currentvalueoftheunderlyingasset¤ K=Strikepriceoftheoption¤ t=Lifetoexpirationoftheoption¤ r=Risklessinterestratecorrespondingtothelifeoftheoption¤ s2 =Varianceintheln(value)oftheunderlyingasset

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TheBlackScholesModel

Aswath Damodaran

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Valueofcall=SN(d1)- Ke-rt N(d2)where

d2=d1-s √t

¨ ThereplicatingportfolioisembeddedintheBlack-Scholesmodel.Toreplicatethiscall,youwouldneedto¤ BuyN(d1)sharesofstock;N(d1)iscalledtheoptiondelta¤ BorrowKe-rt N(d2)

d1 = ln

SK! "

# $ + (r + σ

2

2) t

σ t

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TheNormalDistribution

Aswath Damodaran

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d N(d) d N(d) d N(d)-3.00 0.0013 -1.00 0.1587 1.05 0.8531 -2.95 0.0016 -0.95 0.1711 1.10 0.8643 -2.90 0.0019 -0.90 0.1841 1.15 0.8749 -2.85 0.0022 -0.85 0.1977 1.20 0.8849 -2.80 0.0026 -0.80 0.2119 1.25 0.8944 -2.75 0.0030 -0.75 0.2266 1.30 0.9032 -2.70 0.0035 -0.70 0.2420 1.35 0.9115 -2.65 0.0040 -0.65 0.2578 1.40 0.9192 -2.60 0.0047 -0.60 0.2743 1.45 0.9265 -2.55 0.0054 -0.55 0.2912 1.50 0.9332 -2.50 0.0062 -0.50 0.3085 1.55 0.9394 -2.45 0.0071 -0.45 0.3264 1.60 0.9452 -2.40 0.0082 -0.40 0.3446 1.65 0.9505 -2.35 0.0094 -0.35 0.3632 1.70 0.9554 -2.30 0.0107 -0.30 0.3821 1.75 0.9599 -2.25 0.0122 -0.25 0.4013 1.80 0.9641 -2.20 0.0139 -0.20 0.4207 1.85 0.9678 -2.15 0.0158 -0.15 0.4404 1.90 0.9713 -2.10 0.0179 -0.10 0.4602 1.95 0.9744 -2.05 0.0202 -0.05 0.4801 2.00 0.9772 -2.00 0.0228 0.00 0.5000 2.05 0.9798 -1.95 0.0256 0.05 0.5199 2.10 0.9821 -1.90 0.0287 0.10 0.5398 2.15 0.9842 -1.85 0.0322 0.15 0.5596 2.20 0.9861 -1.80 0.0359 0.20 0.5793 2.25 0.9878 -1.75 0.0401 0.25 0.5987 2.30 0.9893 -1.70 0.0446 0.30 0.6179 2.35 0.9906 -1.65 0.0495 0.35 0.6368 2.40 0.9918 -1.60 0.0548 0.40 0.6554 2.45 0.9929 -1.55 0.0606 0.45 0.6736 2.50 0.9938 -1.50 0.0668 0.50 0.6915 2.55 0.9946 -1.45 0.0735 0.55 0.7088 2.60 0.9953 -1.40 0.0808 0.60 0.7257 2.65 0.9960 -1.35 0.0885 0.65 0.7422 2.70 0.9965 -1.30 0.0968 0.70 0.7580 2.75 0.9970 -1.25 0.1056 0.75 0.7734 2.80 0.9974 -1.20 0.1151 0.80 0.7881 2.85 0.9978 -1.15 0.1251 0.85 0.8023 2.90 0.9981 -1.10 0.1357 0.90 0.8159 2.95 0.9984 -1.05 0.1469 0.95 0.8289 3.00 0.9987 -1.00 0.1587 1.00 0.8413

d1

N(d1)

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AdjustingforDividends

Aswath Damodaran

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¨ Ifthedividendyield(y=dividends/Currentvalueoftheasset)oftheunderlyingassetisexpectedtoremainunchangedduringthelifeoftheoption,theBlack-Scholesmodelcanbemodifiedtotakedividendsintoaccount.

¨ C=Se-yt N(d1)- Ke-rt N(d2)where,

d2=d1-s √t¨ Thevalueofaputcanalsobederived:¨ P=Ke-rt (1-N(d2))- Se-yt (1-N(d1))

d1 = ln S

K! "

# $ + (r - y + σ

2

2) t

σ t

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ChoiceofOptionPricingModels

Aswath Damodaran

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¨ MostpractitionerswhouseoptionpricingmodelstovaluerealoptionsargueforthebinomialmodelovertheBlack-Scholesandjustifythischoicebynotingthat¤ Earlyexerciseistheruleratherthantheexceptionwithrealoptions

¤ Underlyingassetvaluesaregenerallydiscontinous.¨ Ifyoucandevelopabinomialtreewithoutcomesateachnode,itlooksagreatdeallikeadecisiontreefromcapitalbudgeting.Thequestionthenbecomeswhenandwhythetwoapproachesyielddifferentestimatesofvalue.

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TheDecisionTreeAlternative

Aswath Damodaran

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¨ Traditionaldecisiontreeanalysistendstouse¤ Onecostofcapitaltodiscountcashflows ineachbranchtothepresent¤ Probabilitiestocomputeanexpectedvalue¤ Thesevalueswillgenerallybedifferentfromoptionpricingmodel

values¨ Ifyoumodifieddecisiontreeanalysisto

¤ Usedifferentdiscountratesateachnodetoreflectwhereyouareinthedecisiontree(ThisistheCopelandsolution) (or)

¤ Usetheriskfree ratetodiscountcashflows ineachbranch,estimatetheprobabilitiestoestimateanexpectedvalueandadjusttheexpectedvalueforthemarketriskintheinvestment

¨ DecisionTreescouldyieldthesamevaluesasoptionpricingmodels

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AdecisiontreevaluationofapharmaceuticalcompanywithonedrugintheFDApipeline…

Aswath Damodaran

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Test

Abandon

Succeed

70%

Fail

30%-$50

-$140.91

Types 1 & 2

Type 2

Type 1

Fail

10%

10%

30%

Develop

Abandon

Develop

Abandon

Develop

Abandon

Succeed

Succeed

Succeed

Fail

Fail

Fail

75%

25%

80%

20%

80%

20%-$328.74

-$328.74

-$328.74

$585.62

-$328.74

-$97.43-$366.30

-$366.30

$887.05

50%

$50.36

$93.37

$573.71

-$143.69

$402.75

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KeyTestsforRealOptions

Aswath Damodaran

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¨ Isthereanoptionembeddedinthisasset/decision?¤ Canyouidentifytheunderlyingasset?¤ Canyouspecifythecontingencyunderwhichyouwillgetpayoff?

¨ Isthereexclusivity?¤ Ifyes,thereisoptionvalue.¤ Ifno,thereisnone.¤ Ifinbetween,youhavetoscalevalue.

¨ Canyouuseanoptionpricingmodeltovaluetherealoption?¤ Istheunderlyingassettraded?¤ Cantheoptionbeboughtandsold?¤ Isthecostofexercisingtheoptionknownandclear?

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I.OptionsinProjects/Investments/Acquisitions

Aswath Damodaran

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¨ Oneofthelimitationsoftraditionalinvestmentanalysisisthatitisstaticanddoesnotdoagoodjobofcapturingtheoptionsembeddedininvestment.¤ Thefirstoftheseoptionsistheoptiontodelaytakingainvestment,whenafirmhasexclusiverightstoit,untilalaterdate.

¤ Thesecondoftheseoptionsistakingoneinvestmentmayallowustotakeadvantageofotheropportunities(investments)inthefuture

¤ Thelastoptionthatisembeddedinprojectsistheoptiontoabandonainvestment,ifthecashflowsdonotmeasureup.

¨ Theseoptionsalladdvaluetoprojectsandmaymakea“bad” investment(fromtraditionalanalysis)intoagoodone.

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A.TheOptiontoDelay

Aswath Damodaran

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¨ Whenafirmhasexclusiverightstoaprojectorproductforaspecificperiod,itcandelaytakingthisprojectorproductuntilalaterdate.

¨ Atraditionalinvestmentanalysisjustanswersthequestionofwhethertheprojectisa“good” oneiftakentoday.

¨ Thus,thefactthataprojectdoesnotpassmustertoday(becauseitsNPVisnegative,oritsIRRislessthanitshurdlerate)doesnotmeanthattherightstothisprojectarenotvaluable.

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ValuingtheOptiontoDelayaProject

Aswath Damodaran

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Present Value of Expected Cash Flows on Product

PV of Cash Flows from Project

Initial Investment in Project

Project has negativeNPV in this section

Project's NPV turns positive in this section

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Example1:Valuingproductpatentsasoptions

Aswath Damodaran

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¨ Aproductpatentprovidesthefirmwiththerighttodeveloptheproductandmarketit.

¨ Itwilldosoonlyifthepresentvalueoftheexpectedcashflowsfromtheproductsalesexceedthecostofdevelopment.

¨ Ifthisdoesnotoccur,thefirmcanshelvethepatentandnotincuranyfurthercosts.

¨ IfIisthepresentvalueofthecostsofdevelopingtheproduct,andVisthepresentvalueoftheexpectedcashflowsfromdevelopment,thepayoffsfromowningaproductpatentcanbewrittenas:

Payofffromowningaproductpatent =V- I ifV>I=0 ifV≤I

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PayoffonProductOption

Aswath Damodaran

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Present Value ofcashflows on product

Net Payoff tointroduction

Cost of product introduction

ObtainingInputsforPatentValuation

Input Estimation Process

1. Value of the Underlying Asset • Present Value of Cash Inflows from taking projectnow

• This will be noisy, but that adds value.2. Variance in value of underlying asset • Variance in cash flows of similar assets or firms

• Variance in present value from capital budgetingsimulation.

3. Exercise Price on Option • Option is exercised when investment is made.• Cost of making investment on the project ; assumed

to be constant in present value dollars.4. Expiration of the Option • Life of the patent

5. Dividend Yield • Cost of delay• Each year of delay translates into one less year of

value-creating cashflowsAnnual cost of delay = 1

n

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ValuingaProductPatent:Avonex

Aswath Damodaran

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¨ Biogen,abio-technologyfirm,hasapatentonAvonex,adrugtotreatmultiplesclerosis,forthenext17years,anditplanstoproduceandsellthedrugbyitself.

¨ Thekeyinputsonthedrugareasfollows:¤ PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion¤ PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion¤ PatentLife=t=17yearsRisklessRate=r=6.7%(17-yearT.Bond rate)¤ VarianceinExpectedPresentValues=s2 =0.224(Industryaveragefirmvariancefor

bio-techfirms)¤ ExpectedCostofDelay=y=1/17=5.89%

¨ Theoutputfromtheoptionpricingmodel¤ d1=1.1362 N(d1)=0.8720¤ d2=-0.8512 N(d2)=0.2076CallValue=3,422exp(-0.0589)(17)(0.8720)- 2,875exp(-0.067)(17) (0.2076)=$907million

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TheOptimalTimetoExercise

Aswath Damodaran

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0

100

200

300

400

500

600

700

800

900

1000

17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1Number of years left on patent

Val

ue

Value of patent as option Net present value of patent

Exercise the option here: Convert patent to commercial product

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Valuingafirmwithpatents

Aswath Damodaran

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¨ Thevalueofafirmwithasubstantialnumberofpatentscanbederivedusingtheoptionpricingmodel.

ValueofFirm=Valueofcommercialproducts(usingDCFvalue+Valueofexistingpatents(usingoptionpricing)+(ValueofNewpatentsthatwillbeobtainedinthe

future– Costofobtainingthesepatents)¨ Thelastinputmeasurestheefficiencyofthefirmin

convertingitsR&Dintocommercialproducts.Ifweassumethatafirmearnsitscostofcapitalfromresearch,thistermwillbecomezero.

¨ Ifweusethisapproach,weshouldbecarefulnottodoublecountandallowforahighgrowthrateincashflows(intheDCFvaluation).

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ValueofBiogen’sexistingproducts

Aswath Damodaran

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¨ Biogenhadtwocommercialproducts(adrugtotreatHepatitisBandIntron)atthetimeofthisvaluationthatithadlicensedtootherpharmaceuticalfirms.

¨ Thelicensefeesontheseproductswereexpectedtogenerate$50millioninafter-taxcashflowseachyearforthenext12years.

¨ Tovaluethesecashflows,whichwereguaranteedcontractually,the pre-taxcostofdebtoftheguarantorswasused:PresentValueofLicenseFees=$50million(1– (1.07)-12)/.07

=$397.13million

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ValueofBiogen’sFutureR&D

Aswath Damodaran

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¨ Biogencontinuedtofundresearchintonewproducts,spendingabout$100milliononR&Dinthemostrecentyear.TheseR&Dexpenseswereexpectedtogrow20%ayearforthenext10years,and5%thereafter.

¨ Itwasassumedthateverydollarinvestedinresearchwouldcreate$1.25invalueinpatents(valuedusingtheoptionpricingmodeldescribedabove)forthenext10years,andbreakevenafterthat(i.e.,generate$1inpatentvalueforevery$1investedinR&D).

¨ Therewasasignificantamountofriskassociatedwiththiscomponentandthecostofcapitalwasestimatedtobe15%.

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ValueofFutureR&D

Aswath Damodaran

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Yr ValueofPatents R&DCost ExcessValue PV(at15%)

1 $150.00 $120.00 $30.00 $26.09

2 $180.00 $144.00 $36.00 $27.22

3 $216.00 $172.80 $43.20 $28.40

4 $259.20 $207.36 $51.84 $29.64

5 $311.04 $248.83 $62.21 $30.93

6 $373.25 $298.60 $74.65 $32.27

7 $447.90 $358.32 $89.58 $33.68

8 $537.48 $429.98 $107.50 $35.14

9 $644.97 $515.98 $128.99 $36.67

10 $773.97 $619.17 $154.79 $38.26

$318.30

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ValueofBiogen

Aswath Damodaran

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¨ ThevalueofBiogenasafirmisthesumofallthreecomponents– thepresentvalueofcashflowsfromexistingproducts,thevalueofAvonex(asanoption)andthevaluecreatedbynewresearch:Value=Existingproducts+ExistingPatents+Value:FutureR&D

=$397.13million+$907million+$318.30million=$1622.43million

¨ SinceBiogenhadnodebtoutstanding,thisvaluewasdividedbythenumberofsharesoutstanding(35.50million)toarriveatavaluepershare:¤Valuepershare=$1,622.43million/35.5=$45.70

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TheRealOptionsTest:PatentsandTechnology

Aswath Damodaran

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¨ TheOptionTest:¤ UnderlyingAsset:Productthatwouldbegeneratedbythepatent¤ Contingency:

n IfPVofCFsfromdevelopment>Costofdevelopment:PV- Costn IfPVofCFsfromdevelopment<Costofdevelopment:0

¨ TheExclusivityTest:¤ Patentsrestrictcompetitorsfromdevelopingsimilarproducts¤ Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreatthesamedisease.

¨ ThePricingTest¤ UnderlyingAsset:Patentsarenottraded.Notonlydoyouthereforehavetoestimatethepresentvaluesand

volatilitiesyourself,youcannotconstructreplicatingpositionsordoarbitrage.¤ Option:Patentsareboughtandsold,thoughnotasfrequentlyasoilreservesormines.¤ CostofExercisingtheOption:Thisisthecostofconvertingthepatentforcommercialproduction.Here,

experiencedoeshelpanddrugfirmscanmakefairlypreciseestimatesofthecost.

¨ Conclusion:Youcanestimatethevalueoftherealoptionbutthequalityofyourestimatewillbeadirectfunctionofthequalityofyourcapitalbudgeting.Itworksbestifyouarevaluingapubliclytradedfirmthatgeneratesmostofitsvaluefromoneorafewpatents- youcanusethemarketvalueofthefirmandthevarianceinthatvaluetheninyouroptionpricingmodel.

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Example2:ValuingNaturalResourceOptions

Aswath Damodaran

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¨ Inanaturalresourceinvestment,theunderlyingassetistheresourceandthevalueoftheassetisbasedupontwovariables- thequantityoftheresourcethatisavailableintheinvestmentandthepriceoftheresource.

¨ Inmostsuchinvestments,thereisacostassociatedwithdevelopingtheresource,andthedifferencebetweenthevalueoftheassetextractedandthecostofthedevelopmentistheprofittotheowneroftheresource.

¨ DefiningthecostofdevelopmentasX,andtheestimatedvalueoftheresourceasV,thepotentialpayoffsonanaturalresourceoptioncanbewrittenasfollows:

Payoffonnaturalresourceinvestment =V- X ifV>X=0 ifV≤X

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PayoffDiagramonNaturalResourceFirms

Aswath Damodaran

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Value of estimated reserve of natural resource

Net Payoff onExtraction

Cost of Developing Reserve

EstimatingInputsforNaturalResourceOptions

Input Estimation Process

1. Value of Available Reserves of the Resource • Expert estimates (Geologists for oil..); Thepresent value of the after-tax cash flows fromthe resource are then estimated.

2. Cost of Developing Reserve (Str ike Price) • Past costs and the specifics of the investment

3. Time to Expiration • Relinqushment Period: if asset has to berelinquished at a point in time.

• Time to exhaust inventory - based uponinventory and capacity output.

4. Variance in value of underlying asset • based upon variability of the price of theresources and variability of available reserves.

5. Net Production Revenue (Dividend Yield) • Net production revenue every year as percentof market value.

6. Development Lag • Calculate present value of reserve based uponthe lag.

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ValuingGulfOil

Aswath Damodaran

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¨ GulfOilwasthetargetofatakeoverinearly1984at$70pershare(Ithad165.30millionsharesoutstanding,andtotaldebtof$9.9billion).¤ Ithadestimatedreservesof3038millionbarrelsofoilandtheaveragecostofdevelopingthesereserveswasestimatedtobe$10abarrelinpresentvaluedollars(Thedevelopmentlagisapproximatelytwoyears).

¤ Theaveragerelinquishmentlifeofthereservesis12years.¤ Thepriceofoilwas$22.38perbarrel,andtheproductioncost,taxesandroyaltieswereestimatedat$7perbarrel.

¤ Thebondrateatthetimeoftheanalysiswas9.00%.¤ Gulfwasexpectedtohavenetproductionrevenueseachyearofapproximately5%ofthevalueofthedevelopedreserves.Thevarianceinoilpricesis0.03.

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ValuingUndevelopedReserves

Aswath Damodaran

42

¨ Inputsforvaluingundevelopedreserves¤ Valueofunderlyingasset=Valueofestimatedreservesdiscountedbackforperiod

ofdevelopmentlag=3038*($22.38- $7)/1.052 =$42,380.44¤ Exerciseprice=Estimateddevelopmentcostofreserves=3038*$10=$30,380

million¤ Timetoexpiration=Averagelengthofrelinquishmentoption=12years¤ Varianceinvalueofasset=Varianceinoilprices=0.03¤ Risklessinterestrate=9%¤ Dividendyield=Netproductionrevenue/Valueofdevelopedreserves=5%

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.6548 N(d1)=0.9510d2=1.0548 N(d2)=0.8542CallValue=42,380.44exp(-0.05)(12)(0.9510)-30,380(exp(-0.09)(12) (0.8542)

=$13,306million

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ValuingGulfOil

Aswath Damodaran

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¨ Inaddition,GulfOilhadfreecashflows tothefirmfromitsoilandgasproductionof$915millionfromalreadydevelopedreservesandthesecashflows arelikelytocontinuefortenyears(theremaininglifetimeofdevelopedreserves).

¨ Thepresentvalueofthesedevelopedreserves,discountedattheweightedaveragecostofcapitalof12.5%,yields:¤ Valueofalreadydevelopedreserves=915(1- 1.125-10)/.125=$5065.83

¨ AddingthevalueofthedevelopedandundevelopedreservesValueofundevelopedreserves =$13,306millionValueofproductioninplace =$5,066millionTotalvalueoffirm =$18,372millionLessOutstandingDebt =$9,900millionValueofEquity =$8,472millionValuepershare =$8,472/165.3 =$51.25

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TheOptiontoExpand/TakeOtherProjects

Aswath Damodaran

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¨ Takingaprojecttodaymayallowafirmtoconsiderandtakeothervaluableprojectsinthefuture.

¨ Thus,eventhoughaprojectmayhaveanegativeNPV,itmaybeaprojectworthtakingiftheoptionitprovidesthefirm(totakeotherprojectsinthefuture)providesamore-than-compensatingvalue.

¨ Thesearetheoptionsthatfirmsoftencall“strategicoptions” anduseasarationalefortakingon“negativeNPV” oreven“negativereturn” projects.

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B.TheOptiontoExpand

Aswath Damodaran

45

Present Value of Expected Cash Flows on Expansion

PV of Cash Flows from Expansion

Additional Investment to Expand

Firm will not expand inthis section

Expansion becomes attractive in this section

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Theoptiontoexpand:Valuingayoung,start-upcompany

Aswath Damodaran

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¨ YouhavecompleteaDCFvaluationofasmallanti-virussoftwarecompany,SecureMail,andestimatedavalueof$115million.

¨ Assumethatthereisthepossibilitythatthecompanycouldusethecustomerbasethatitdevelopsfortheanti-virussoftwareandthetechnologyonwhichthesoftwareisbasedtocreateadatabasesoftwareprogramsometimeinthenext5years.¤ ItwillcostSecureMailabout$500milliontodevelopanewdatabase

program,iftheydecidedtodoittoday.¤ Basedupontheinformationyouhavenowonthepotentialforadatabase

program,thecompanycanexpecttogenerateabout$40millionayearinafter-taxcashflowsfortenyears.Thecostofcapitalforprivatecompaniesthatprovidedatabasesoftwareis12%.

¤ Theannualizedstandarddeviationinfirmvalueatpubliclytradeddatabasecompaniesis50%.

¤ Thefive-yeartreasurybondrateis3%.

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ValuingtheExpansionOption

Aswath Damodaran

47

S =Valueofenteringthedatabasesoftwaremarket=PVof$40millionfor10years@12% =$226million

K =Exerciseprice=Costofenteringthedatabasesoftwaremarket=$500million

t =Periodoverwhichyouhavetherighttoenterthemarket=5years

s =Standarddeviationofstockpricesofdatabasefirms=50%r =Risklessrate=3%¨ CallValue=$56MillionDCFvaluationofthefirm =$115millionValueofOptiontoExpandtoDatabasemarket =$56millionValueofthecompanywithoptiontoexpand =$171million

48

Anoteofcaution:Opportunitiesarenotoptions…

Aswath Damodaran

48

An Exclusive Right toSecond Investment

A Zero competitiveadvantage on Second Investment

100% of option valueNo option value

Increasing competitive advantage/ barriers to entry

Pharmaceuticalpatents

TelecomLicenses

Brand Name

TechnologicalEdge

First-Mover

Second Investment has zero excess returns

Second investmenthas large sustainableexcess return

Option has no value Option has high value

Is the first investment necessary for the second investment?

Pre-RequisitNot necessary

49

TheRealOptionsTestforExpansionOptions

Aswath Damodaran

49

¨ TheOptionsTest¤ UnderlyingAsset:ExpansionProject¤ Contingency¤ IfPVofCFfromexpansion>ExpansionCost:PV- ExpansionCost¤ IfPVofCFfromexpansion<ExpansionCost:0

¨ TheExclusivityTest¤ Barriersmayrangefromstrong(exclusivelicensesgrantedbythegovernment)toweaker

(brandname,knowledgeofthemarket)toweakest(firstmover).¨ ThePricingTest

¤ UnderlyingAsset:Aswithpatents,thereisnotradingintheunderlyingassetandyouhavetoestimatevalueandvolatility.

¤ Option:Licensesaresometimesboughtandsold,butmorediffuseexpansionoptionsarenot.¤ CostofExercisingtheOption:Notknownwithanyprecisionandmayitselfevolveovertimeas

themarketevolves.¨ Usingoptionpricingmodelstovalueexpansionoptionswillnotonlyyield

extremelynoisyestimates,butmayattachinappropriatepremiumstodiscountedcashflow estimates.

50

C.TheOptiontoAbandon

Aswath Damodaran

50

¨ Afirmmaysometimeshavetheoptiontoabandonaproject,ifthecashflowsdonotmeasureuptoexpectations.

¨ Ifabandoningtheprojectallowsthefirmtosaveitselffromfurtherlosses,thisoptioncanmakeaprojectmorevaluable.

Present Value of Expected Cash Flows on Project

PV of Cash Flows from Project

Cost of Abandonment

51

ValuingtheOptiontoAbandon

Aswath Damodaran

51

¨ AirbusisconsideringajointventurewithLearAircrafttoproduceasmallcommercialairplane(capableofcarrying40-50passengersonshorthaulflights)¤ Airbuswillhavetoinvest$500millionfora50%shareoftheventure¤ Itsshareofthepresentvalueofexpectedcashflowsis480million.

¨ LearAircraft,whichiseagertoenterintothedeal,offerstobuyAirbus’s50%shareoftheinvestmentanytimeoverthenextfiveyearsfor$400million,ifAirbusdecidestogetoutoftheventure.

¨ Asimulationofthecashflowsonthistimeshareinvestmentyieldsavarianceinthepresentvalueofthecashflowsfrombeinginthepartnershipis0.16.

¨ Theprojecthasalifeof30years.

52

ProjectwithOptiontoAbandon

Aswath Damodaran

52

¨ ValueoftheUnderlyingAsset(S)=PVofCashFlowsfromProject =$480million

¨ StrikePrice(K)=SalvageValuefromAbandonment=$400million

¨ VarianceinUnderlyingAsset’sValue=0.16¨ Timetoexpiration=LifeoftheProject=5years¨ DividendYield=1/LifeoftheProject=1/30=0.033(Weareassumingthattheproject’spresentvaluewilldropbyroughly1/neachyearintotheproject)

¨ Assumethatthefive-yearrisklessrateis6%.Thevalueoftheputoptioncanbeestimated.

53

ShouldAirbusenterintothejointventure?

Aswath Damodaran

53

ValueofPut=Ke-rt (1-N(d2))- Se-yt (1-N(d1))=400exp(-0.06)(5)(1-0.4624)- 480exp(-0.033)(5)(1-0.7882)=$73.23million

¨ Thevalueofthisabandonmentoptionhastobeaddedontothenetpresentvalueoftheprojectof-$20million,yieldingatotalnetpresentvaluewiththeabandonmentoptionof$53.23million.

54

ImplicationsforInvestmentAnalysis/Valuation

Aswath Damodaran

54

¨ Havingaoptiontoabandonaprojectcanmakeotherwiseunacceptableprojectsacceptable.

¨ Otherthingsremainingequal,youwouldattachmorevaluetocompanieswith¤ Morecostflexibility,thatis,makingmoreofthecostsoftheprojectsintovariablecostsasopposedtofixedcosts.

¤ Fewerlong-termcontracts/obligationswithemployeesandcustomers,sincetheseaddtothecostofabandoningaproject.

¨ Theseactionswillundoubtedlycostthefirmsomevalue,butthishastobeweighedoffagainsttheincreaseinthevalueoftheabandonmentoption.

55

D.OptionsinCapitalStructure

Aswath Damodaran

55

¨ Themostdirectapplicationsofoptionpricingincapitalstructuredecisionsisinthedesignofsecurities.Infact,mostcomplexfinancialinstrumentscanbebrokendownintosomecombinationofasimplebond/commonstockandavarietyofoptions.¤ Ifthesesecuritiesaretobeissuedtothepublic,andtraded,the

optionshavetobepriced.¤ Ifthesearenon-tradedinstruments(bankloans,forinstance),they

stillhavetobepricedintotheinterestrateontheinstrument.¨ Theotherapplicationofoptionpricingisinvaluingflexibility.

Often,firmspreservedebtcapacityorholdbackonissuingdebtbecausetheywanttomaintainflexibility.

56

TheValueofFlexibility

Aswath Damodaran

56

¨ Firmsmaintainexcessdebtcapacityorlargercashbalancesthanarewarrantedbycurrentneeds,tomeetunexpectedfuturerequirements.

¨ Whilemaintainingthisfinancingflexibilityhasvaluetofirms,italsohasacost;theexcessdebtcapacityimpliesthatthefirmisgivingupsomevalueandhasahighercostofcapital.

¨ Thevalueofflexibilitycanbeanalyzedusingtheoptionpricingframework;afirmmaintainslargecashbalancesandexcessdebtcapacityinordertohavetheoptiontotakeprojectsthatmightariseinthefuture.

57

TheValueofFlexibility

Aswath Damodaran

57

Actual ReinvestmentNeeds

Expected (Normal) Reinvestment Needs that can be financed without flexibility

Cost of Maintaining Financing Flexibility

Use financing flexibilityto take unanticipatedinvestments (acquisitions)

Payoff: (S-K)*Excess Return/WACC

Excess Return/WACC = PV of excess returns in perpetutity

58

Disney’sOptimalDebtRatio

Aswath Damodaran

58

DebtRatio CostofEquity CostofDebt CostofCapital0.00% 13.00% 4.61% 13.00%10.00% 13.43% 4.61% 12.55%Current:18% 13.85% 4.80% 12.22%20.00% 13.96% 4.99% 12.17%30.00% 14.65% 5.28% 11.84%40.00% 15.56% 5.76% 11.64%50.00% 16.85% 6.56% 11.70%60.00% 18.77% 7.68% 12.11%70.00% 21.97% 7.68% 11.97%80.00% 28.95% 7.97% 12.17%90.00% 52.14% 9.42% 13.69%

59

InputstoOptionValuationModel- Disney

Aswath Damodaran

59

Model input

Estimated as In general… For Disney

S Expected annual reinvestment needs (as % of firm value)

Measures magnitude of reinvestment needs

Average of Reinvestment/ Value over last 5 years = 5.3%

s2 Variance in annual reinvestment needs

Measures how much volatility there is in investment needs.

Variance over last 5 years in ln(Reinvestment/Value) =0.375

K (Internal + Normal access to external funds)/ Value

Measures the capital constraint

Average over last 5 years = 4.8%

T 1 year Measures an annual value for flexibility

T =1

60

ValuingFlexibilityatDisney

Aswath Damodaran

60

¨ Thevalueofanoptionwiththesecharacteristicsis1.6092%.Youcanconsiderthisthevalueoftheoptiontotakeaproject,buttheoverallvalueofflexibilitywillstilldependuponthequalityoftheprojectstaken.Inotherwords,thevalueoftheoptiontotakeaprojectiszeroiftheprojecthaszeronetpresentvalue.

¨ Disneyearns18.69%onitsprojectshasacostofcapitalof12.22%.Theexcessreturn(annually)is6.47%.Assumingthattheycancontinuetogeneratetheseexcessreturnsinperpetuity:ValueofFlexibility(annual)=1.6092%(.0647/.1222)=0.85%ofvalue

¨ Disney’scostofcapitalatitsoptimaldebtratiois11.64%.Thecostitincurstomaintainflexibilityistherefore0.58%annually(12.22%-11.64%).Itthereforepaystomaintainflexibility.

61

DeterminantsoftheValueofFlexibility

Aswath Damodaran

61

¨ CapitalConstraints(ExternalandInternal):Thegreaterthecapacitytoraisefunds,eitherinternallyorexternally,thelessthevalueofflexibility.¤ 1.1:Firmswithsignificantinternaloperatingcashflowsshouldvalue

flexibilitylessthanfirmswithsmallornegativeoperatingcashflows.¤ 1.2:Firmswitheasyaccesstofinancialmarketsshouldhavealower

valueforflexibilitythanfirmswithoutthataccess.¨ Unpredictabilityofreinvestmentneeds:Themore

unpredictablethereinvestmentneedsofafirm,thegreaterthevalueofflexibility.

¨ Capacitytoearnexcessreturns:Thegreaterthecapacitytoearnexcessreturns,thegreaterthevalueofflexibility.¤ 1.3:Firmsthatdonothavethecapacitytoearnorsustainexcess

returnsgetnovaluefromflexibility.

62

E.ValuingEquityasanoption

Aswath Damodaran

62

¨ Theequityinafirmisaresidualclaim,i.e.,equityholderslayclaimtoallcashflowsleftoverafterotherfinancialclaim-holders(debt,preferredstocketc.)havebeensatisfied.

¨ Ifafirmisliquidated,thesameprincipleapplies,withequityinvestorsreceivingwhateverisleftoverinthefirmafteralloutstandingdebtsandotherfinancialclaimsarepaidoff.

¨ Theprincipleoflimitedliability,however,protectsequityinvestorsinpubliclytradedfirmsifthevalueofthefirmislessthanthevalueoftheoutstandingdebt,andtheycannotlosemorethantheirinvestmentinthefirm.

63

PayoffDiagramforLiquidationOption

Aswath Damodaran

63

Value of firm

Net Payoffon Equity

Face Valueof Debt

64

Applicationtovaluation:Asimpleexample

Aswath Damodaran

64

¨ Assumethatyouhaveafirmwhoseassetsarecurrentlyvaluedat$100millionandthatthestandarddeviationinthisassetvalueis40%.

¨ Further,assumethatthefacevalueofdebtis$80million(Itiszerocoupondebtwith10yearslefttomaturity).

¨ Iftheten-yeartreasurybondrateis10%,¤ howmuchistheequityworth?¤ Whatshouldtheinterestrateondebtbe?

65

ModelParameters

Aswath Damodaran

65

¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$100million

¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million

¨ Lifeoftheoption=t¤ Lifeofzero-coupondebt=10years

¨ Varianceinthevalueoftheunderlyingasset=s2

¤ Varianceinfirmvalue=0.16¨ Risklessrate=r

¤ Treasurybondratecorrespondingtooptionlife=10%

66

ValuingEquityasaCallOption

Aswath Damodaran

66

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.5994 N(d1)=0.9451d2=0.3345 N(d2)=0.6310

¨ Valueofthecall=100(0.9451)- 80exp(-0.10)(10)(0.6310)=$75.94million

¨ Valueoftheoutstandingdebt=$100- $75.94=$24.06million

¨ Interestrateondebt=($80/$24.06)1/10-1=12.77%

67

I.TheEffectofCatastrophicDropsinValue

Aswath Damodaran

67

¨ Assumenowthatacatastrophewipesouthalfthevalueofthisfirm(thevaluedropsto$50million),whilethefacevalueofthedebtremainsat$80million.Whatwillhappentotheequityvalueofthisfirm?a. Itwilldropinvalueto$25.94million[$50million-

marketvalueofdebtfrompreviouspage]b. Itwillbeworthnothingsincedebtoutstanding>Firm

Valuec. Itwillbeworthmorethan$25.94million

68

ValuingEquityintheTroubledFirm

Aswath Damodaran

68

¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$50million

¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million

¨ Lifeoftheoption=t¤ Lifeofzero-coupondebt=10years

¨ Varianceinthevalueoftheunderlyingasset=s2

¤ Varianceinfirmvalue=0.16¨ Risklessrate=r

¤ Treasurybondratecorrespondingtooptionlife=10%

69

TheValueofEquityasanOption

Aswath Damodaran

69

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.0515 N(d1)=0.8534d2=-0.2135 N(d2)=0.4155

¨ Valueofthecall=50(0.8534)- 80exp(-0.10)(10) (0.4155)=$30.44million

¨ Valueofthebond=$50- $30.44=$19.56million¨ Theequityinthisfirmdropsby$45.50million,lessthantheoveralldropinvalueof$50million,becauseoftheoptioncharacteristicsofequity.

¨ Thismightexplainwhystockinfirms,whichareinChapter11andessentiallybankrupt,stillhasvalue.

70

Equityvaluepersists..

Aswath Damodaran

70

Value of Equity as Firm Value Changes

0

10

20

30

40

50

60

70

80

100 90 80 70 60 50 40 30 20 10Value of Firm ($ 80 Face Value of Debt)

Val

ue

of

Equi

ty

71

II.Theconflictbetweenstockholdersandbondholders

Aswath Damodaran

71

¨ Consideragainthefirmdescribedintheearlierexample,withavalueofassetsof$100million,afacevalueofzero-couponten-yeardebtof$80million,astandarddeviationinthevalueofthefirmof40%.Theequityanddebtinthisfirmwerevaluedasfollows:¤ ValueofEquity=$75.94million¤ ValueofDebt=$24.06million¤ ValueofFirm==$100million

¨ Nowassumethatthestockholdershavetheopportunitytotakeaprojectwithanegativenetpresentvalueof-$2million,butassumethatthisprojectisaveryriskyprojectthatwillpushupthestandarddeviationinfirmvalueto50%.Wouldyouinvestinthisproject?a. Yesb. No

72

ValuingEquityaftertheProject

Aswath Damodaran

72

¨ Valueoftheunderlyingasset=S¤ Valueofthefirm=$100million- $2million=$98million(Thevalueofthefirmisloweredbecauseofthenegativenetpresentvalueproject)

¨ Exerciseprice=K¤ FaceValueofoutstandingdebt=$80million

¨ Lifeoftheoption=t¨ Lifeofzero-coupondebt=10years¨ Varianceinthevalueoftheunderlyingasset=s2

¤ Varianceinfirmvalue=0.25¨ Risklessrate=r

¤ Treasurybondratecorrespondingtooptionlife=10%

73

OptionValuation

Aswath Damodaran

73

¨ OptionPricingResultsforEquityandDebtValue¤ ValueofEquity=$77.71¤ ValueofDebt=$20.29¤ ValueofFirm=$98.00

¨ Thevalueofequityrisesfrom$75.94millionto$77.71million,eventhoughthefirmvaluedeclinesby$2million.Theincreaseinequityvaluecomesattheexpenseofbondholders,whofindtheirwealthdeclinefrom$24.06millionto$20.19million.

74

EffectsofanAcquisition

Aswath Damodaran

74

¨ Assumethatyouarethemanagerofafirmandthatyoubuyanotherfirm,withafairmarketvalueof$150million,forexactly$150million.Inanefficientmarket,thestockpriceofyourfirmwilla. Increaseb. Decreasec. RemainUnchanged

75

Effectsonequityofaconglomeratemerger

Aswath Damodaran

75

¨ Youareprovidedinformationontwofirms,whichoperateinunrelatedbusinessesandhopetomerge.

FirmA FirmBValueofthefirm $100million $150millionFaceValueofDebt(10yr zeros) $80million $50millionMaturityofdebt 10years 10yearsStd.Dev.invalue 40% 50%Correlationbetweencashflows 0.4¤ Theten-yearbondrateis10%.

¨ Thevarianceinthevalueofthefirmaftertheacquisitioncanbecalculatedasfollows:Varianceincombinedfirmvalue =w1

2 s12 +w2

2 s22 +2w1 w2 r12s1s2

=(0.4)2 (0.16)+(0.6)2 (0.25)+2(0.4)(0.6)(0.4)(0.4)(0.5)=0.154

76

ValuingtheCombinedFirm

Aswath Damodaran

76

¨ Thevaluesofequityanddebtintheindividualfirmsandthecombinedfirmcanthenbeestimatedusingtheoptionpricingmodel:

FirmA FirmB CombinedfirmValueofequityinthefirm $75.94 $134.47 $207.43Valueofdebtinthefirm $24.06 $15.53 $42.57Valueofthefirm $100.00 $150.00 $250.00¨ Thecombinedvalueoftheequitypriortothemergeris$210.41million

anditdeclinesto$207.43millionafter.¨ Thewealthofthebondholdersincreasesbyanequalamount.¨ Thereisatransferofwealthfromstockholderstobondholders,asa

consequenceofthemerger.Thus,conglomeratemergersthatarenotfollowedbyincreasesinleveragearelikelytoseethisredistributionofwealthoccuracrossclaimholdersinthefirm.

77

Obtainingoptionpricinginputs- Somerealworldproblems

Aswath Damodaran

77

¨ Theexamplesthathavebeenusedtoillustratetheuseofoptionpricingtheorytovalueequityhavemadesomesimplifyingassumptions.Amongthemarethefollowing:(1)Therewereonlytwoclaimholdersinthefirm- debtandequity.(2)Thereisonlyoneissueofdebtoutstandinganditcanberetiredatfacevalue.(3)Thedebthasazerocouponandnospecialfeatures(convertibility,putclausesetc.)(4)Thevalueofthefirmandthevarianceinthatvaluecanbeestimated.

RealWorldApproachestoValuingEquityinTroubledFirms:GettingInputs

Input Estimation Process

Value of the Firm • Cumulate market values of equity and debt (or)

• Value the assets in place using FCFF and WACC (or)

• Use cumulated market value of assets, if traded.

Variance in Firm Value • If stocks and bonds are traded,

σ2firm = we2 σe2 + wd2 σd2 + 2 we wd ρed σe σd

where σe2 = variance in the stock price

we = MV weight of Equity

σd2 = the variance in the bond price wd = MV weight of

debt

• If not traded, use variances of similarly rated bonds.

• Use average firm value variance from the industry in

which company operates.

Value of the Debt • If the debt is short term, you can use only the face or book

value of the debt.

• If the debt is long term and coupon bearing, add the

cumulated nominal value of these coupons to the face

value of the debt.

Maturity of the Debt • Face value weighted duration of bonds outstanding (or)

• If not available, use weighted maturity

79

ValuingEquityasanoption- Eurotunnelinearly1998

Aswath Damodaran

79

¨ Eurotunnelhasbeenafinancialdisastersinceitsopening¤ In1997,Eurotunnelhadearningsbeforeinterestandtaxesof-£56millionandnetincomeof-£685million

¤ Attheendof1997,itsbookvalueofequitywas-£117million¨ Ithad£8,865millioninfacevalueofdebtoutstanding

¤ Theweightedaveragedurationofthisdebtwas10.93yearsDebtType FaceValue DurationShortterm 935 0.5010year 2435 6.720year 3555 12.6Longer 1940 18.2Total £8,865mil 10.93years

80

TheBasicDCFValuation

Aswath Damodaran

80

¨ Thevalueofthefirmestimatedusingprojectedcashflowstothefirm,discountedattheweightedaveragecostofcapitalwas£2,312million.

¨ Thiswasbaseduponthefollowingassumptions–¤ Revenueswillgrow5%ayearinperpetuity.¤ TheCOGSwhichiscurrently85%ofrevenueswilldropto65%of

revenuesinyr5andstayatthatlevel.¤ Capitalspendinganddepreciationwillgrow5%ayearinperpetuity.¤ Therearenoworkingcapitalrequirements.¤ Thedebtratio,whichiscurrently95.35%,willdropto70%afteryear5.

Thecostofdebtis10%inhighgrowthperiodand8%afterthat.¤ Thebetaforthestockwillbe1.10forthenextfiveyears,anddropto

0.8afterthenext5years.¤ Thelongtermbondrateis6%.

81

OtherInputs

Aswath Damodaran

81

¨ ThestockhasbeentradedontheLondonExchange,andtheannualizedstd deviationbaseduponln (prices)is41%.

¨ ThereareEurotunnelbonds,thathavebeentraded;theannualizedstd deviationinln(price)forthebondsis17%.¤ Thecorrelationbetweenstockpriceandbondpricechangeshasbeen

0.5.Theproportionofdebtinthecapitalstructureduringtheperiod(1992-1996)was85%.

¤ Annualizedvarianceinfirmvalue=(0.15)2 (0.41)2 +(0.85)2 (0.17)2 +2(0.15)(0.85)(0.5)(0.41)(0.17)=0.0335

¨ The15-yearbondrateis6%.(Iusedabondwithadurationofroughly11yearstomatchthelifeofmyoption)

82

ValuingEurotunnelEquityandDebt

Aswath Damodaran

82

¨ InputstoModel¤ Valueoftheunderlyingasset=S=Valueofthefirm=£2,312million¤ Exerciseprice=K=FaceValueofoutstandingdebt=£8,865million¤ Lifeoftheoption=t=Weightedaveragedurationofdebt=10.93years¤ Varianceinthevalueoftheunderlyingasset=s2 =Varianceinfirmvalue=

0.0335¤ Risklessrate=r=Treasurybondratecorrespondingtooptionlife=6%

¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:¤ d1=-0.8337 N(d1)=0.2023¤ d2=-1.4392 N(d2)=0.0751

¨ Valueofthecall=2312(0.2023)- 8,865exp(-0.06)(10.93) (0.0751)=£122million

¨ Appropriateinterestrateondebt=(8865/2190)(1/10.93)-1=13.65%

83

InClosing…

Aswath Damodaran

83

¨ Therearerealoptionseverywhere.¨ Mostofthemhavenosignificanteconomicvaluebecause

thereisnoexclusivityassociatedwithusingthem.¨ Whenoptionshavesignificanteconomicvalue,theinputs

neededtovaluetheminabinomialmodelcanbeusedinmoretraditionalapproaches(decisiontrees)toyieldequivalentvalue.

¨ Therealvaluefromrealoptionsliesin¤ Recognizingthatbuildinginflexibilityandescapehatchesintolarge

decisionshasvalue¤ Insightswegetonunderstandinghowandwhycompaniesbehavethe

waytheydoininvestmentanalysisandcapitalstructurechoices.

AcquirersAnonymous:SevenStepsbacktoSobriety…

AswathDamodaran

Aswath Damodaran 84

85

Acquisitionsaregreatfortargetcompaniesbutnotalwaysforacquiringcompanystockholders…

Aswath Damodaran

85

86

Andthelong-termfollowupisnotpositiveeither..

Aswath Damodaran

86

¨ Managersoftenarguethatthemarketisunabletoseethelongtermbenefitsofmergersthattheycanseeatthetimeofthedeal.Iftheyareright,mergersshouldcreatelongtermbenefitstoacquiringfirms.

¨ Theevidencedoesnotsupportthishypothesis:¤ McKinseyandCo.hasexaminedacquisitionprogramsatcompanieson

n Didthereturnoncapitalinvestedinacquisitionsexceedthecostofcapital?n Didtheacquisitionshelptheparentcompaniesoutperformthecompetition?n Halfofallprogramsfailedonetest,andaquarterfailedboth.

¤ Synergyiselusive.KPMGinamorerecentstudyofglobalacquisitionsconcludesthatmostmergers(>80%)fail- themergedcompaniesdoworsethantheirpeergroup.

¤ Alargenumberofacquisitionsthatarereversedwithinfairlyshorttimeperiods.About20%oftheacquisitionsmadebetween1982and1986weredivestedby1988.Instudiesthathavetrackedacquisitionsforlongertimeperiods(tenyearsormore)thedivestiturerateofacquisitionsrisestoalmost50%.

87

Ascarythought…Thediseaseisspreading…IndianfirmsacquiringUStargets– 1999- 2005

Aswath Damodaran

87

Months around takeover

88

Growingthroughacquisitionsseemstobea“loser’sgame”

Aswath Damodaran

88

¨ Firmsthatgrowthroughacquisitionshavegenerallyhadfarmoretroublecreatingvaluethanfirmsthatgrowthroughinternalinvestments.

¨ Ingeneral,acquiringfirmstendto¤ Paytoomuchfortargetfirms¤ Overestimatethevalueof“synergy” and“control”¤ Haveadifficulttimedeliveringthepromisedbenefits

¨ Worsestill,thereseemstobeverylittlelearningbuiltintotheprocess.Thesamemistakesaremadeoverandoveragain,oftenbythesamefirmswiththesameadvisors.

¨ Conclusion:Thereissomethingstructurallywrongwiththeprocessforacquisitionswhichisfeedingintothemistakes.

89

Thesevensinsinacquisitions…

Aswath Damodaran

89

1. RiskTransference:Attributingacquiringcompanyriskcharacteristicstothetargetfirm.

2. Debtsubsidies:Subsidingtargetfirmstockholdersforthestrengthsoftheacquiringfirm.

3. Auto-pilotControl:The“20%controlpremium” andothermyth…

4. ElusiveSynergy:Misidentifyingandmis-valuingsynergy.5. Itsallrelative:Transactionmultiples,exitmultiples…6. Verdictfirst,trialafterwards:Pricefirst,valuationtofollow7. It’snotmyfault:Holdingnooneresponsiblefordelivering

results.

90

Testingsheet

Aswath Damodaran

90

Test Passed/Failed Rationalization

Risk transference

Debt subsidies

Control premium

The value of synergy

Comparables and Exit MultiplesBias

A successful acquisition strategy

91

Letsstartwithatargetfirm

Aswath Damodaran

91

¨ Thetargetfirmhasthefollowingincomestatement:Revenues 100OperatingExpenses 80= OperatingIncome 20Taxes 8=After-taxOI 12

¨ Assumethatthisfirmwillgeneratethisoperatingincomeforever(withnogrowth)andthatthecostofequityforthisfirmis20%.Thefirmhasnodebtoutstanding.Whatisthevalueofthisfirm?

92

Test1:RiskTransference…

Aswath Damodaran

92

¨ Assumethatasanacquiringfirm,youareinamuchsaferbusinessandhaveacostofequityof10%.Whatisthevalueofthetargetfirmtoyou?

93

Lesson1:Don’ttransferyourriskcharacteristicstothetargetfirm

Aswath Damodaran

93

¨ Thecostofequityusedforaninvestmentshouldreflecttheriskoftheinvestmentandnottheriskcharacteristicsoftheinvestorwhoraisedthefunds.

¨ Riskybusinessescannotbecomesafejustbecausethebuyerofthesebusinessesisinasafebusiness.

94

Test2:Cheapdebt?

Aswath Damodaran

94

¨ Assumeasanacquirerthatyouhaveaccesstocheapdebt(at4%)andthatyouplantofundhalftheacquisitionwithdebt.Howmuchwouldyoubewillingtopayforthetargetfirm?

95

Lesson2:Renderuntothetargetfirmthatwhichisthetargetfirm’sbutnotapennymore..

Aswath Damodaran

95

¨ Asanacquiringfirm,itisentirelypossiblethatyoucanborrowmuchmorethanthetargetfirmcanonitsownandatamuchlowerrate.Ifyoubuildthesecharacteristicsintothevaluationofthetargetfirm,youareessentiallytransferringwealthfromyourfirm’sstockholdertothetargetfirm’sstockholders.

¨ Whenvaluingatargetfirm,useacostofcapitalthatreflectsthedebtcapacityandthecostofdebtthatwouldapplytothefirm.

96

Test3:ControlPremiums

Aswath Damodaran

96

¨ Assumethatyouarenowtoldthatitisconventionaltopaya20%premiumforcontrolinacquisitions(backedupbyMergerstat).Howmuchwouldyoubewillingtopayforthetargetfirm?

¨ WouldyouranswerchangeifItoldyouthatyoucanrunthetargetfirmbetterandthatifyoudo,youwillbeabletogeneratea30%pre-taxoperatingmargin(ratherthanthe20%marginthatiscurrentlybeingearned).

¨ Whatifthetargetfirmwereperfectlyrun?

97

Lesson3:Bewareofrulesofthumb…

Aswath Damodaran

97

¨ Valuationisclutteredwithrulesofthumb.Afterpainstakinglyvaluingatargetfirm,usingyourbestestimates,youwillbeoftenbetoldthat¤ Itiscommonpracticetoaddarbitrarypremiumsforbrandname,qualityofmanagement,controletc…

¤ Thesepremiumswillbeoftenbebackedupbydata,studiesandservices.Whattheywillnotrevealistheenormoussamplingbiasinthestudiesandthestandarderrorsintheestimates.

¤ Ifyouhavedoneyourvaluationright,thosepremiumsshouldalreadybeincorporatedinyourestimatedvalue.Payingapremiumwillbedoublecounting.

98

Test4:Synergy….

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¨ Assumethatyouaretoldthatthecombinedfirmwillbelessriskythanthetwoindividualfirmsandthatitshouldhavealowercostofcapital(andahighervalue).Isthislikely?

¨ Assumenowthatyouaretoldthattherearepotentialgrowthandcostsavingssynergiesintheacquisition.Wouldthatincreasethevalueofthetargetfirm?

¨ Shouldyoupaythisasapremium?

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TheValueofSynergy

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Synergy is created when two firms are combined and can be either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

Higher returns on new investments

More newInvestments

Cost Savings in current operations

Tax BenefitsAdded Debt Capacity Diversification?

Higher ROC

Higher Growth Rate

Higher Reinvestment

Higher Growth RateHigher Margin

Higher Base-year EBIT

Strategic Advantages Economies of Scale

Longer GrowthPeriod

More sustainableexcess returns

Lower taxes on earnings due to - higher depreciaiton- operating loss carryforwards

Higher debt raito and lower cost of capital

May reducecost of equity for private or closely heldfirm

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ValuingSynergy

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(1)thefirmsinvolvedinthemergerarevaluedindependently,bydiscountingexpectedcashflowstoeachfirmattheweightedaveragecostofcapitalforthatfirm.(2)thevalueofthecombinedfirm,withnosynergy,isobtainedbyaddingthevaluesobtainedforeachfirminthefirststep.(3)Theeffectsofsynergyarebuiltintoexpectedgrowthratesandcashflows,andthecombinedfirmisre-valuedwithsynergy.

ValueofSynergy=Valueofthecombinedfirm,withsynergy-Valueofthecombinedfirm,withoutsynergy

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Synergy- Example1Highergrowthandcostsavings

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P&G Gillette Piglet: No Synergy Piglet: SynergyFree Cashflow to Equity $5,864.74 $1,547.50 $7,412.24 $7,569.73 Annual operating expenses reduced by $250 millionGrowth rate for first 5 years 12% 10% 11.58% 12.50% Slighly higher growth rateGrowth rate after five years 4% 4% 4.00% 4.00%Beta 0.90 0.80 0.88 0.88Cost of Equity 7.90% 7.50% 7.81% 7.81% Value of synergyValue of Equity $221,292 $59,878 $281,170 $298,355 $17,185

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Synergy:Example3TaxBenefits?

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¨ AssumethatyouareBestBuy,theelectronicsretailer,andthatyouwouldliketoenterthehardwarecomponentofthemarket.YouhavebeenapproachedbyinvestmentbankersforZenith,whichwhilestillarecognizedbrandname,isonitslastlegsfinancially.Thefirmhasnetoperatinglossesof$2billion.Ifyourtaxrateis36%,estimatethetaxbenefitsfromthisacquisition.

¨ IfBestBuyhadonly$500millionintaxableincome,howwouldyoucomputethetaxbenefits?

¨ IfthemarketvalueofZenithis$800million,wouldyoupaythistaxbenefitasapremiumonthemarketvalue?

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Lesson4:Don’tpayforbuzzwords

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¨ Throughtime,acquirershavealwaysfoundwaysofjustifyingpayingforpremiumsoverestimatedvaluebyusingbuzzwords- synergyinthe1980s,strategicconsiderationsinthe1990sandrealoptionsinthisdecade.

¨ Whileallofthesecanhavevalue,theonusshouldbeonthosepushingfortheacquisitionstoshowthattheydoandnotonthosepushingagainstthemtoshowthattheydonot.

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Test5:ComparablesandExitMultiples

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¨ Nowassumethatyouaretoldthatananalysisofotheracquisitionsrevealsthatacquirershavebeenwillingtopay5timesEBIT..GiventhatyourtargetfirmhasEBITof$20million,wouldyoubewillingtopay$100millionfortheacquisition?

¨ WhatifIestimatetheterminalvalueusinganexitmultipleof5timesEBIT?

¨ Asanadditionalinput,yourinvestmentbankertellsyouthattheacquisitionisaccretive.(YourPEratiois20whereasthePEratioofthetargetisonly10…Therefore,youwillgetajumpinearningspershareaftertheacquisition…)

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Biasedsamples=Poorresults

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¨ Biasedsamplesyieldbiasedresults.Basingwhatyoupayonwhatotheracquirershavepaidisarecipefordisaster.Afterall,weknowthatacquirer,onaverage,paytoomuchforacquisitions.Bymatchingtheirprices,weriskreplicatingtheirmistakes.

¨ Evenwhenweusethepricingmetricsofotherfirmsinthesector,wemaybebasingthepriceswepayonfirmsthatarenottrulycomparable.

¨ Whenweuseexitmultiples,weareassumingthatwhatthemarketispayingforcomparablecompaniestodayiswhatitwillcontinuetopayinthefuture.

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Lesson5:Don’tbealemming…

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¨ Alltoooften,acquisitionsarejustifiedbyusingoneofthefollowingtwoarguments:¤ Everyoneelseinyoursectorisdoingacquisitions.Youhavetodothesametosurvive.

¤ Thevalueofatargetfirmisbaseduponwhatothershavepaidonacquisitions,whichmaybemuchhigherthanwhatyourestimateofvalueforthefirmis.

¨ Withtherightsetofcomparablefirms,youcanjustifyalmostanyprice.

¨ EPSaccretionisameaninglessmeasure.Afterall,buyingancompanywithaPElowerthanyourswillleadmathematicallytoEPSaccretion.

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Test6:TheCEOreallywantstodothis…ortherearecompetitivepressures…

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¨ NowassumethatyouknowthattheCEOoftheacquiringfirmreally,reallywantstodothisacquisitionandthattheinvestmentbankersonbothsideshaveproducedfairnessopinionsthatindicatethatthefirmisworth$100million.Wouldyoubewillingtogoalong?

¨ Nowassumethatyouaretoldthatyourcompetitorsarealldoingacquisitionsandthatifyoudon’tdothem,youwillbeatadisadvantage?Wouldyoubewillingtogoalong?

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Lesson6:Don’tletegosorinvestmentbankersgetthebetterofcommonsense…

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¨ Ifyoudefineyourobjectiveinabiddingwaraswinningtheauctionatanycost,youwillwin.Butbewarethewinner’scurse!

¨ Thepremiumspaidonacquisitionsoftenhavenothingtodowithsynergy,controlorstrategicconsiderations(thoughtheymaybeprovidedasthereasons).TheymayjustreflecttheegosoftheCEOsoftheacquiringfirms.Thereisevidencethat“overconfident”CEOsaremorelikelytomakeacquisitionsandthattheyleaveatrailacrossthefirmsthattheyrun.

¨ Pre-emptiveordefensiveacquisitions,whereyouoverpay,eitherbecauseeveryoneelseisoverpayingorbecauseyouareafraidthatyouwillbeleftbehindifyoudon’tacquirearedangerous.Iftheonlywayyoucanstaycompetitiveinabusinessisbymakingbadinvestments,itmaybebesttothinkaboutgettingoutofthebusiness.

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Toillustrate:Abaddealismade,andjustifiedbyaccountants&bankers

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TheCEOstepsin…anddigsahole…

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¨ LeoApothekerwastheCEOofHPatthetimeofthedeal,broughtintoreplaceMarkHurd,thepreviousCEOwhowasforcedtoresignbecauseofa“sex”scandal.

¨ InthefaceofalmostuniversalfeelingthatHPhadpaidtoomuchforAutonomy,Mr. Apotheker addressing a conference at the time of the deal: “We have a pretty rigorous process inside H.P. that we follow for all our acquisitions, which is a D.C.F.-based model,”he said, in a reference to discounted cash flow, a standard valuation methodology. “And we try to take a very conservative view.”

¨ Apotheker added, “Just to make sure everybody understands, Autonomy will be, on Day 1, accretive to H.P….. “Just take it from us. We did that analysis at great length, in great detail, and we feel that we paid a very fair price for Autonomy. And it will give a great return to our shareholders.

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Ayearlater…HPadmitsamistake…andexplainsit…

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Test7:Isithopeless?

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¨ Theoddsseemtobeclearlyweightedagainstsuccessinacquisitions.Ifyouweretocreateastrategytogrow,baseduponacquisitions,whichofthefollowingoffersyourbestchanceofsuccess?

This OrthisSoleBidder BiddingWarPublictarget PrivatetargetPaywithcash PaywithstockSmalltarget LargetargetCostsynergies Growthsynergies

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Bettertoloseabiddingwarthantowinone…

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Returns in the 40 months before & after bidding warSource: Malmendier, Moretti & Peters (2011)

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Youarebetteroffbuyingsmallratherthanlargetargets…withcashratherthanstock

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Andfocusingonprivatefirmsandsubsidiaries,ratherthanpublicfirms…

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GrowthvsCostSynergies

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Synergy:Oddsofsuccess

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¨ Studiesthathavefocusedonsynergieshaveconcludedthatyouarefarmorelikelytodelivercostsynergiesthangrowthsynergies.

¨ Synergiesthatareconcreteandplannedforatthetimeofthemergeraremorelikelytobedeliveredthanfuzzysynergies.

¨ Synergyismuchmorelikelytoshowupwhensomeoneisheldresponsiblefordeliveringthesynergy.

¨ Youaremorelikelytogetashareofthesynergygainsinanacquisitionwhenyouareasinglebidderthanifyouareoneofmultiplebidders.

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Lesson7:Foracquisitionstocreatevalue,youhavetostaydisciplined..

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1. Ifyouhaveasuccessfulacquisitionstrategy,stayfocusedonthatstrategy.Don’tletsizeorhubrisdriveyouto“expand” thestrategy.

2. Realisticplansfordeliveringsynergyandcontrolhavetobeputinplacebeforethemergeriscompleted.Byrealistic,wehavetomeanthatthemagnitudeofthebenefitshavetobereachableandnotpipedreamsandthatthetimeframeshouldreflecttherealitythatittakesawhilefortwoorganizationstoworkasone.

3. Thebestthingtodoinabiddingwaristodropout.4. Someone(preferablythepersonpushinghardestforthemerger)

shouldbeheldtoaccountfordeliveringthebenefits.5. Thecompensationforinvestmentbankersandothersinvolvedin

thedealshouldbetiedtohowwellthedealworksratherthanforgettingthedealdone.

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AReallyBigDeal!

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TheAcquirer(ABInBev)

LatinAmerica42%

Africa0%

AsiaPacific11%

Europe11%

NorthAmerica36%

RevenueBreakdown(2014)

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TheTarget(SABMiller)

CapitalMix Operating MetricsInterest-bearingDebt $12,550 Revenues $22,130.00LeaseDebt $368 OperatingIncome(EBIT) $4,420.00MarketCapitalization $75,116 OperatingMargin 19.97%DebttoEquityratio 17.20% Effectivetaxrate 26.40%DebttoCapitalratio 14.67% After-taxreturnoncapital 10.32%BondRating A3 ReinvestmentRate= 16.02%

LatinAmerica35%

Africa31%

AsiaPacific14%

Europe19%

NorthAmerica

1%

RevenueBreakdown(2015)

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Settingupthechallenge

¨ SABMiller’smarketcapitalizationwas$75billiononSeptember15,2015,thedayABInBev announceditsintenttoacquireSABMiller.

¨ Thedealwascompleted(pendingregulatoryapproval)amonthlater,withABInBev agreeingtopay$104billionforSABMiller.

¨ CanABInBev create$29billioninadditionalvaluefromthisacquisitionandifsowherewillitfindthevalue?¤ Themarketseemstothinkso,adding$33billioninmarketvaluetothecombinedcompany.

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TheThree(Value)ReasonsforAcquisitions

¨ Undervaluation:Youbuyatargetcompanybecauseyoubelievethatthemarketismispricingthecompanyandthatyoucanbuyitforlessthanits"fair"value.

¨ Control:Youbuyacompanythatyoubelieveisbadlymanaged,withtheintentofchangingthewayitisrun.Ifyouarerightonthefirstcountandcanmakethenecessarychanges,thevalueofthefirmshouldincreaseunderyourmanagement

¨ Synergy:Youbuyacompanythatyoubelieve,whencombinedwithabusiness(orresource)thatyoualreadyown,willbeabletodothingsthatyoucouldnothavedoneasseparateentities.Thissynergycanbe¤ Offensivesynergy:Highergrowthandincreasedpricingpower¤ Defensivesynergy:Costcutting,consolidation&preemptingcompetitors.¤ Taxsynergy:Directlyfromtaxclausesorindirectlythroughdent

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Fournumberstowatch

1. AcquisitionPrice:Thisisthepriceatwhichyoucanacquirethetargetcompany.Ifitisaprivatebusiness,itwillbenegotiatedandprobablybasedonwhatothersarepayingforsimilarbusinesses.Ifitisapubliccompany,itwillbeatapremiumoverthemarketprice.

2. StatusQuoValue:Valueofthetargetcompany,runbyexistingmanagement.

3. RestructuredValue:Valueofthetargetcompany,withchangestoinvesting,financinganddividendpolicies.

4. Synergyvalue:Valueofthecombinedcompany(withthesynergybenefitsbuiltin)– (Valueoftheacquiringcompany,asastandaloneentity,andtherestructuredvalueofthetargetcompany)

¨ TheAcidTest¤ Undervaluation:Pricefortargetcompany<StatusQuoValue¤ Control:Pricefortargetcompany<RestructuredValue¤ Synergy:Pricefortargetcompany<RestructuredValue+ValueofSynergy

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SABMillerStatusQuoValue

SABMiller +CoorsJV +ShareofAssociates SABMillerConsolidatedRevenues $22,130.00 $5,201.00 $6,099.00OperatingMargin 19.97% 15.38% 10.72%OperatingIncome(EBIT) $4,420.00 $800.00 $654.00InvestedCapital $31,526.00 $5,428.00 $4,459.00Beta 0.7977 0.6872 0.6872ERP 8.90% 6.00% 7.90%CostofEquity= 9.10% 6.12% 7.43%After-taxcostofdebt= 2.24% 2.08% 2.24%DebttoCapitalRatio 14.67% 0.00% 0.00%Costofcapital= 8.09% 6.12% 7.43%

After-taxreturnoncapital= 10.33% 11.05% 11.00%ReinvestmentRate= 16.02% 40.00% 40.00%Expectedgrowthrate= 1.65% 4.42% 4.40%Numberofyearsofgrowth 5 5 5ValueoffirmPVofFCFFinhighgrowth= $11,411.72 $1,715.25 $1,351.68Terminalvalue= $47,711.04 $15,094.36 $9,354.28Valueofoperatingassetstoday= $43,747.24 $12,929.46 $7,889.56 $64,566.26+Cash $1,027.00- Debt $12,918.00- MinorityInterests $1,183.00Valueofequity $51,492.26

Price on September 15, 2015: $75 billion > $51.5 billion

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SABMiller:PotentialforControl

SABMiller ABInBevGlobal Alcoholic Beverage Sector

Pre-taxOperatingMargin 19.97% 32.28% 19.23%

EffectiveTaxRate 26.36% 18.00% 22.00%

Pre-taxROIC 14.02% 14.76% 17.16%

ROIC 10.33% 12.10% 13.38%

ReinvestmentRate 16.02% 50.99% 33.29%

DebttoCapital 14.67% 23.38% 18.82%

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SABMiller:ValueofControl

Status Quo Value Optimal valueCost of Equity = 9.10% 9.37%After-tax cost of debt = 2.24% 2.24%Cost of capital = 8.09% 8.03%

After-tax return on capital = 10.33% 12.64%Reinvestment Rate = 16.02% 33.29%Expected growth rate= 1.65% 4.21%

Value of firmPV of FCFF in high growth = $11,411.72 $9,757.08Terminal value = $47,711.04 $56,935.06Value of operating assets today = $43,747.24 $48,449.42+ Cash $1,027.00 $1,027.00+ Minority Holdings $20,819.02 $20,819.02- Debt $12,918.00 $12,918.00- Minority Interests $1,183.00 $1,183.00 Value of Control

Value of equity $51,492.26 $56,194.44 $4,702.17Price on September 15, 2015: $75 billion > $51.5 + $4.7 billion

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TheSynergies?

Inbev SABMiller

Combined firm (status

quo)Combined firm

(synergy)LeveredBeta 0.85 0.8289 0.84641 0.84641Pre-taxcostofdebt 3.0000% 3.2000% 3.00% 3.00%Effectivetaxrate 18.00% 26.36% 19.92% 19.92%DebttoEquityRatio 30.51% 23.18% 29.71% 29.71%

Revenues $45,762.00 $22,130.00 $67,892.00 $67,892.00

OperatingMargin 32.28% 19.97% 28.27% 30.00%OperatingIncome(EBIT) $14,771.97 $4,419.36 $19,191.33 $20.368

After-taxreturnoncapital 12.10% 12.64% 11.68% 12.00%ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%ExpectedGrowthRate 6.17% 4.21% 5.09% 6.00%

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Thevalueofsynergy

Inbev SABMiller

Combined firm (status

quo)Combined firm

(synergy)CostofEquity= 8.93% 9.37% 9.12% 9.12%After-taxcostofdebt= 2.10% 2.24% 2.10% 2.10%Costofcapital= 7.33% 8.03% 7.51% 7.51%

After-taxreturnoncapital= 12.10% 12.64% 11.68% 12.00%

ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%

Expectedgrowthrate= 6.17% 4.21% 5.09% 6.00%

Value of firmPVofFCFFinhighgrowth= $28,733 $9,806 $38,539 $39,151Terminalvalue= $260,982 $58,736 $319,717 $340,175Valueofoperatingassets= $211,953 $50,065 $262,018 $276,610

Value of synergy = 276,610 – 262,018 = 14,592 million

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PassingJudgment

¨ Ifyouadduptherestructuredfirmvalueof$56.2billiontothesynergyvalueof$14.6billion,yougetavalueofabout$70.8billion.

¨ Thatiswellbelowthe$104billionthatABInBev isplanningtopayforSABMiller.

¨ Oneofthefollowinghastobetrue:¤ Ihavemassivelyunderestimatedthepotentialforsynergyinthismerger(eitherintermsofhighermarginsorhighergrowth).

¤ ABInBev hasoverpaidsignificantlyonthisdeal.Thatwouldgoagainsttheirhistoryasagoodacquirerandagainstthehistoryof3GCapitalasagoodstewardofcapital.

VALUEENHANCEMENTANDTHEEXPECTEDVALUEOFCONTROL:BACKTOBASICS

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PriceEnhancementversusValueEnhancement

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Themarketgives… Andtakesaway….

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ThePathstoValueCreation

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¨ UsingtheDCFframework,therearefourbasicwaysinwhichthevalueofafirmcanbeenhanced:¤ Thecashflowsfromexistingassetstothefirmcanbeincreased,byeither

n increasingafter-taxearningsfromassetsinplaceorn reducingreinvestmentneeds(netcapitalexpendituresorworkingcapital)

¤ Theexpectedgrowthrateinthesecashflowscanbeincreasedbyeithern Increasingtherateofreinvestmentinthefirmn Improvingthereturnoncapitalonthosereinvestments

¤ Thelengthofthehighgrowthperiodcanbeextendedtoallowformoreyearsofhighgrowth.

¤ Thecostofcapitalcanbereducedbyn Reducingtheoperatingriskininvestments/assetsn Changingthefinancialmixn Changingthefinancingcomposition

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ValueCreation1:IncreaseCashFlowsfromAssetsinPlace

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Revenues

* Operating Margin

= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

+ Depreciation- Capital Expenditures- Chg in Working Capital= FCFF

Divest assets thathave negative EBIT

More efficient operations and cost cuttting: Higher Margins

Reduce tax rate- moving income to lower tax locales- transfer pricing- risk management

Live off past over- investment

Better inventory management and tighter credit policies

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ValueCreation2:IncreaseExpectedGrowth

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Reinvestment Rate

* Return on Capital

= Expected Growth Rate

Reinvest more inprojects

Do acquisitions

Increase operatingmargins

Increase capital turnover ratio

PricingStrategiesPriceLeaderversusVolumeLeaderStrategiesReturnonCapital=OperatingMargin*CapitalTurnoverRatio

GametheoryHowwillyourcompetitorsreacttoyourmoves?Howwillyoureacttoyourcompetitors’moves?

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ValueCreatingGrowth…EvaluatingtheAlternatives..

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III.BuildingCompetitiveAdvantages:Increaselengthofthegrowthperiod

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Increase length of growth period

Build on existing competitive advantages

Find new competitive advantages

Brand name

Legal Protection

Switching Costs

Cost advantages

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ValueCreation4:ReduceCostofCapital

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Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Change financing mix

Make product or service less discretionary to customers

Reduce operating leverage

Match debt to assets, reducing default risk

Changing product characteristics

More effective advertising

Outsourcing Flexible wage contracts &cost structure

Swaps Derivatives Hybrids

Current Cashflow to FirmEBIT(1-t) : 1414- Nt CpX 831 - Chg WC - 19= FCFF 602Reinvestment Rate = 812/1414

=57.42%

Expected Growth in EBIT (1-t).5742*.1993=.114411.44%

Stable Growthg = 3.41%; Beta = 1.00;Debt Ratio= 20%Cost of capital = 6.62% ROC= 6.62%; Tax rate=35%Reinvestment Rate=51.54%

Terminal Value10= 1717/(.0662-.0341) = 53546

Cost of Equity8.77%

Cost of Debt(3.41%+..35%)(1-.3654)= 2.39%

WeightsE = 98.6% D = 1.4%

Cost of Capital (WACC) = 8.77% (0.986) + 2.39% (0.014) = 8.68%

Op. Assets 31,615+ Cash: 3,018- Debt 558- Pension Lian 305- Minor. Int. 55=Equity 34,656-Options 180Value/Share106.12

Riskfree Rate:Euro riskfree rate = 3.41% +

Beta 1.26 X

Risk Premium4.25%

Unlevered Beta for Sectors: 1.25

Mature riskpremium4%

Country Equity Prem0.25%

SAP: Status Quo Reinvestment Rate 57.42%

Return on Capital19.93%

Term Yr5451354318261717

Avg Reinvestment rate = 36.94%

On May 5, 2005, SAP was trading at 122 Euros/share

First 5 yearsGrowth decreases gradually to 3.41%

Debt ratio increases to 20%Beta decreases to 1.00

Year 1 2 3 4 5 6 7 8 9 10EBIT 2,483 2,767 3,083 3,436 3,829 4,206 4,552 4,854 5,097 5,271EBIT(1-t) 1,576 1,756 1,957 2,181 2,430 2,669 2,889 3,080 3,235 3,345 - Reinvestm 905 1,008 1,124 1,252 1,395 1,501 1,591 1,660 1,705 1,724 = FCFF 671 748 833 929 1,035 1,168 1,298 1,420 1,530 1,621

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SAP:OptimalCapitalStructure

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Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 1.25 8.72% AAA 3.76% 36.54% 2.39% 8.72% $39,08810% 1.34 9.09% AAA 3.76% 36.54% 2.39% 8.42% $41,48020% 1.45 9.56% A 4.26% 36.54% 2.70% 8.19% $43,56730% 1.59 10.16% A- 4.41% 36.54% 2.80% 7.95% $45,90040% 1.78 10.96% CCC 11.41% 36.54% 7.24% 9.47% $34,04350% 2.22 12.85% C 15.41% 22.08% 12.01% 12.43% $22,44460% 2.78 15.21% C 15.41% 18.40% 12.58% 13.63% $19,65070% 3.70 19.15% C 15.41% 15.77% 12.98% 14.83% $17,44480% 5.55 27.01% C 15.41% 13.80% 13.28% 16.03% $15,65890% 11.11 50.62% C 15.41% 12.26% 13.52% 17.23% $14,181

Current Cashflow to FirmEBIT(1-t) : 1414- Nt CpX 831 - Chg WC - 19= FCFF 602Reinvestment Rate = 812/1414

=57.42%

Expected Growth in EBIT (1-t).70*.1993=.114413.99%

Stable Growthg = 3.41%; Beta = 1.00;Debt Ratio= 30%Cost of capital = 6.27% ROC= 6.27%; Tax rate=35%Reinvestment Rate=54.38%

Terminal Value10= 1898/(.0627-.0341) = 66367

Cost of Equity10.57%

Cost of Debt(3.41%+1.00%)(1-.3654)= 2.80%

WeightsE = 70% D = 30%

Cost of Capital (WACC) = 10.57% (0.70) + 2.80% (0.30) = 8.24%

Op. Assets 38045+ Cash: 3,018- Debt 558- Pension Lian 305- Minor. Int. 55=Equity 40157-Options 180Value/Share 126.51

Riskfree Rate:Euro riskfree rate = 3.41% +

Beta 1.59 X

Risk Premium4.50%

Unlevered Beta for Sectors: 1.25

Mature riskpremium4%

Country Equity Prem0.5%

SAP: Restructured Reinvestment Rate70%

Return on Capital19.93%

Term Yr6402416122631898

Avg Reinvestment rate = 36.94%

On May 5, 2005, SAP was trading at 122 Euros/share

First 5 yearsGrowth decreases gradually to 3.41%

Year 1 2 3 4 5 6 7 8 9 10EBIT 2,543 2,898 3,304 3,766 4,293 4,802 5,271 5,673 5,987 6,191EBIT(1-t) 1,614 1,839 2,097 2,390 2,724 3,047 3,345 3,600 3,799 3,929 - Reinvest 1,130 1,288 1,468 1,673 1,907 2,011 2,074 2,089 2,052 1,965 = FCFF 484 552 629 717 817 1,036 1,271 1,512 1,747 1,963

Reinvest more in Reinvest more in emerging marketsemerging markets

Use more debt financing.Use more debt financing.

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Current Cashflow to FirmEBIT(1-t) : 163- Nt CpX 39 - Chg WC 4= FCFF 120Reinvestment Rate = 43/163

=26.46%

Expected Growth in EBIT (1-t).2645*.0406=.01071.07%

Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%

Terminal Value5= 104/(.0676-.03) = 2714

Cost of Equity8.50%

Cost of Debt(4.10%+2%)(1-.35)= 3.97%

WeightsE = 48.6% D = 51.4%

Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%

Op. Assets 2,472+ Cash: 330- Debt 1847=Equity 955-Options 0Value/Share $ 5.13

Riskfree Rate:Riskfree rate = 4.10% +

Beta 1.10 X

Risk Premium4%

Unlevered Beta for Sectors: 0.80

Firmʼs D/ERatio: 21.35%

Mature riskpremium4%

Country Equity Prem0%

Blockbuster: Status Quo Reinvestment Rate 26.46%

Return on Capital4.06%

Term Yr184 82102

1 2 3 4 5EBIT (1-t) $165 $167 $169 $173 $178 - Reinvestment $44 $44 $51 $64 $79 FCFF $121 $123 $118 $109 $99

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Current Cashflow to FirmEBIT(1-t) : 249- Nt CpX 39 - Chg WC 4= FCFF 206Reinvestment Rate = 43/249

=17.32%

Expected Growth in EBIT (1-t).1732*.0620=.01071.07%

Stable Growthg = 3%; Beta = 1.00;Cost of capital = 6.76% ROC= 6.76%; Tax rate=35%Reinvestment Rate=44.37%

Terminal Value5= 156/(.0676-.03) = 4145

Cost of Equity8.50%

Cost of Debt(4.10%+2%)(1-.35)= 3.97%

WeightsE = 48.6% D = 51.4%

Discount at Cost of Capital (WACC) = 8.50% (.486) + 3.97% (0.514) = 6.17%

Op. Assets 3,840+ Cash: 330- Debt 1847=Equity 2323-Options 0Value/Share $ 12.47

Riskfree Rate:Riskfree rate = 4.10% +

Beta 1.10 X

Risk Premium4%

Unlevered Beta for Sectors: 0.80

Firmʼs D/ERatio: 21.35%

Mature riskpremium4%

Country Equity Prem0%

Blockbuster: Restructured Reinvestment Rate 17.32%

Return on Capital6.20%

Term Yr280124156

1 2 3 4 5EBIT (1-t) $252 $255 $258 $264 $272 - Reinvestment $44 $44 $59 $89 $121 FCFF $208 $211 $200 $176 $151

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TheExpectedValueofControl

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The Value of ControlProbability that you can change the management of the firm

Change in firm value from changingmanagementX

Takeover Restrictions

Voting Rules & Rights

Access to Funds

Size of company

Value of the firm run optimally

Value of the firm run status quo-

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Whytheprobabilityofmanagementchangingshiftsovertime….

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¨ Corporategovernancerulescanchangeovertime,asnewlawsarepassed.Ifthechangegivesstockholdersmorepower,thelikelihoodofmanagementchangingwillincrease.

¨ Activistinvestingebbsandflowswithmarketmovements(activistinvestorsaremorevisibleindownmarkets)andofteninresponsetoscandals.

¨ Eventssuchashostileacquisitionscanmakeinvestorsreassessthelikelihoodofchangebyremindingthemofthepowerthattheydopossess.

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EstimatingtheProbabilityofChange

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¨ Youcanestimatetheprobabilityofmanagementchangesbyusinghistoricaldata(oncompanieswherechangehasoccurred)andstatisticaltechniquessuchasprobits orlogits.

¨ Empirically,thefollowingseemtoberelatedtotheprobabilityofmanagementchange:¤ Stockpriceandearningsperformance,withforcedturnovermorelikelyinfirms

thathaveperformedpoorlyrelativetotheirpeergroupandtoexpectations.¤ Structureoftheboard,withforcedCEOchangesmorelikelytooccurwhenthe

boardissmall,iscomposedofoutsidersandwhentheCEOisnotalsothechairmanoftheboardofdirectors.

¤ Ownershipstructure,sinceforcedCEOchangesaremorecommonincompanieswithhighinstitutionalandlowinsiderholdings.Theyalsoseemtooccurmorefrequentlyinfirmsthataremoredependentuponequitymarketsfornewcapital.

¤ Industrystructure,withCEOsmorelikelytobereplacedincompetitiveindustries.

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ManifestationsoftheValueofControl

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¨ Hostileacquisitions:Inhostileacquisitionswhicharemotivatedbycontrol,thecontrolpremiumshouldreflectthechangeinvaluethatwillcomefromchangingmanagement.

¨ Valuingpubliclytradedfirms:Themarketpriceforeverypubliclytradedfirmshouldincorporateanexpectedvalueofcontrol,asafunctionofthevalueofcontrolandtheprobabilityofcontrolchanging.¤ Marketvalue=Statusquovalue+(Optimalvalue– Statusquovalue)*

Probabilityofmanagementchanging¨ Votingandnon-votingshares:Thepremium(ifany)thatyouwould

payforavotingshareshouldincreasewiththeexpectedvalueofcontrol.

¨ MinorityDiscountsinprivatecompanies:Theminoritydiscount(attachedtobuyinglessthanacontrollingstake)inaprivatebusinessshouldbeincreasewiththeexpectedvalueofcontrol.

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1.HostileAcquisition:Example

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¨ Inahostileacquisition,youcanensuremanagementchangeafteryoutakeoverthefirm.Consequently,youwouldbewillingtopayuptotheoptimalvalue.

¨ Asanexample,Blockbusterwastradingat$9.50pershareinJuly2005.Theoptimalvaluepersharethatweestimatedas$12.47pershare.Assumingthatthisisareasonableestimate,youwouldbewillingtopayupto$2.97asapremiuminacquiringtheshares.

¨ Issuestoponder:¤ Wouldyouautomaticallypay$2.97asapremiumpershare?Whyorwhynot?

¤ Whatwouldyourpremiumpersharebeifchangewilltakethreeyearstoimplement?

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2.MarketpricesofPubliclyTradedCompanies:Anexample

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¨ Themarketpricepershareatthetimeofthevaluation(May2005)wasroughly$9.50.¤ Expectedvaluepershare=StatusQuoValue+Probabilityofcontrol

changing*(OptimalValue– StatusQuoValue)¤ $9.50=$5.13+Probabilityofcontrolchanging($12.47- $5.13)

¨ Themarketisattachingaprobabilityof59.5%thatmanagementpoliciescanbechanged.ThiswasafterIcahn’ssuccessfulchallengeofmanagement.Priortohisarriving,themarketpricepersharewas$8.20,yieldingaprobabilityofonly41.8%ofmanagementchanging.

Value of Equity Value per s hare

Status Quo $ 955 million $ 5.13 per share

Optimally mana ged $2,323 million $12.47 per share

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Valueofstockinapubliclytradedfirm

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¨ Whenafirmisbadlymanaged,themarketstillassessestheprobabilitythatitwillberunbetterinthefutureandattachesavalueofcontroltothestockpricetoday:

¨ Withvotingsharesandnon-votingshares,adisproportionateshareofthevalueofcontrolwillgotothevotingshares.Intheextremescenariowherenon-votingsharesarecompletelyunprotected:€

Value per share = Status Quo Value + Probability of control change (Optimal - Status Quo Value)Number of shares outstanding

€

Value per non - voting share = Status Quo Value # Voting Shares + # Non - voting shares

€

Value per voting share = Value of non - voting share + Probability of control change (Optimal - Status Quo Value)# Voting Shares

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3.VotingandNon-votingShares:AnExample

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¨ Tovaluevotingandnon-votingshares,wewillconsiderEmbraer,theBrazilianaerospacecompany.AsistypicalofmostBraziliancompanies,thecompanyhascommon(voting)sharesandpreferred(non-votingshares).¤ StatusQuoValue=12.5billion$Rfortheequity;¤ OptimalValue=14.7billion$R,assumingthatthefirmwouldbemoreaggressivebothinits

useofdebtandinitsreinvestmentpolicy.

¨ Thereare242.5millionvotingsharesand476.7non-votingsharesinthecompanyandtheprobabilityofmanagementchangeisrelativelylow.Assumingaprobabilityof20%thatmanagementwillchange,weestimatedthevaluepernon-votingandvotingshare:¤ Valuepernon-votingshare=StatusQuoValue/(#votingshares+#non-votingshares)=

12,500/(242.5+476.7)=17.38$R/share¤ Valuepervotingshare=StatusQuovalue/sh+Probabilityofmanagementchange*(Optimal

value– StatusQuoValue)=17.38+0.2*(14,700-12,500)/242.5=19.19$R/share

¨ Withourassumptions,thevotingsharesshouldtradeatapremiumof10.4%overthenon-votingshares.

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4.MinorityDiscount:Anexample

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¨ AssumethatyouarevaluingKristinKandy,aprivatelyownedcandybusinessforsaleinaprivatetransaction.Youhaveestimatedavalueof$1.6millionfortheequityinthisfirm,assumingthattheexistingmanagementofthefirmcontinuesintothefutureandavalueof$2millionfortheequitywithnewandmorecreativemanagementinplace.¤ Valueof51%ofthefirm=51%ofoptimalvalue=0.51*$2million=

$1.02million¤ Valueof49%ofthefirm=49%ofstatusquovalue=0.49*$1.6million

=$784,000¨ Notethata2%differenceinownershiptranslatesintoalarge

differenceinvaluebecauseonestakeensurescontrolandtheotherdoesnot.

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AlternativeApproachestoValueEnhancement

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¨ Maximizeavariablethatiscorrelatedwiththevalueofthefirm.Thereareseveralchoicesforsuchavariable.Itcouldbe¤ anaccountingvariable,suchasearningsorreturnoninvestment¤ amarketingvariable,suchasmarketshare¤ acashflowvariable,suchascashflowreturnoninvestment(CFROI)¤ arisk-adjustedcashflowvariable,suchasEconomicValueAdded(EVA)

¨ Theadvantagesofusingthesevariablesarethatthey¤ AreoftensimplerandeasiertousethanDCFvalue.

¨ Thedisadvantageisthatthe¤ Simplicitycomesatacost;thesevariablesarenotperfectlycorrelated

withDCFvalue.

154

EconomicValueAdded(EVA)andCFROI

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¨ TheEconomicValueAdded(EVA)isameasureofsurplusvaluecreatedonaninvestment.¤ Definethereturnoncapital(ROC)tobethe“true” cashflowreturnoncapitalearnedonaninvestment.

¤ Definethecostofcapitalastheweightedaverageofthecostsofthedifferentfinancinginstrumentsusedtofinancetheinvestment.

¤ EVA=(ReturnonCapital- CostofCapital)(CapitalInvestedinProject)

¨ TheCFROIisameasureofthecashflowreturnmadeoncapital¤ ItiscomputedasanIRR,baseduponabasevalueofcapitalinvestedandthecashflowonthatcapital.

155

Thebottomline…

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¨ Thevalueofafirmisnotgoingtochangejustbecauseyouuseadifferentmetricforvalue.Allapproachesthatarediscountedcashflowapproachesshouldyieldthesamevalueforabusiness,iftheymakeconsistentassumptions.

¨ Iftherearedifferencesinvaluefromusingdifferentapproaches,theymustbeattributabletodifferencesinassumptions,eitherexplicitorimplicit,behindthevaluation.

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ASimpleIllustration

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¨ Assumethatyouhaveafirmwithabookvaluevalueofcapitalof$100million,onwhichitexpectstogenerateareturnoncapitalof15%inperpetuitywithacostofcapitalof10%.

¨ Thisfirmisexpectedtomakeadditionalinvestmentsof$10millionatthebeginningofeachyearforthenext5years.Theseinvestmentsarealsoexpectedtogenerate15%asreturnoncapitalinperpetuity,withacostofcapitalof10%.

¨ Afteryear5,assumethat¤ Theearningswillgrow5%ayearinperpetuity.¤ Thefirmwillkeepreinvestingbackintothebusinessbutthereturnon

capitalonthesenewinvestmentswillbeequaltothecostofcapital(10%).

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FirmValueusingEVAApproach

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CapitalInvestedinAssetsinPlace = $100EVAfromAssetsinPlace=(.15– .10)(100)/.10 = $50

+PVofEVAfromNewInvestmentsinYear1=[(.15-– .10)(10)/.10] = $5

+PVofEVAfromNewInvestmentsinYear2=[(.15-– .10)(10)/.10]/1.1= $4.55+PVofEVAfromNewInvestmentsinYear3=[(.15-– .10)(10)/.10]/1.12= $4.13

+PVofEVAfromNewInvestmentsinYear4=[(.15-– .10)(10)/.10]/1.13= $3.76+PVofEVAfromNewInvestmentsinYear5=[(.15-– .10)(10)/.10]/1.14= $3.42

ValueofFirm = $170.85

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FirmValueusingDCFValuation:EstimatingFCFF

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BaseY ear

1 2 3 4 5 Term.Y ear

EBIT (1-t) : Assets in Place $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00

EBIT(1-t) :Investments- Yr 1 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t) :Investments- Yr 2 $ 1.50 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t): Investments -Yr 3 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t): Investments -Yr 4 $ 1.50 $ 1.50

EBIT(1-t): Investments- Yr 5 $ 1.50

Total EBIT(1-t) $ 16.50 $ 18.00 $ 19.50 $ 21.00 $ 22.50 $ 23.63

- Net Capital Expenditures $10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 11.25 $ 11.81

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

After year 5, the reinvestment rate is 50% = g/ ROC

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FirmValue:PresentValueofFCFF

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Year 0 1 2 3 4 5 Term Year

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

PV of FCFF ($10) $ 5.91 $ 6.61 $ 7.14 $ 7.51 $ 6.99

Terminal Value $ 236.25

PV of Terminal Value $ 146.69

Value of Firm $170.85

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Implications

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¨ Growth,byitself,doesnotcreatevalue.Itisgrowth,withinvestmentinexcessreturnprojects,thatcreatesvalue.¤ Thegrowthof5%ayearafteryear5createsnoadditionalvalue.

¨ The“marketvalueadded” (MVA),whichisdefinedtobetheexcessofmarketvalueovercapitalinvestedisafunctionofttheexcessvaluecreated.¤ Intheexampleabove,themarketvalueof$170.85millionexceedsthebookvalueof$100million,becausethereturnoncapitalis5%higherthanthecostofcapital.

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Year-by-yearEVAChanges

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¨ Firmsareoftenevaluatedbaseduponyear-to-yearchangesinEVAratherthanthepresentvalueofEVAovertime.

¨ Theadvantageofthiscomparisonisthatitissimpleanddoesnotrequirethemakingofforecastsaboutfutureearningspotential.

¨ Anotheradvantageisthatitcanbebrokendownbyanyunit-person,divisionetc.,aslongasoneiswillingtoassigncapitalandallocateearningsacrossthesesameunits.

¨ WhileitissimplerthanDCFvaluation,usingyear-by-yearEVAchangescomesatacost.Inparticular,itisentirelypossiblethatafirmwhichfocusesonincreasingEVAonayear-to-yearbasismayendupbeinglessvaluable.

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Gamingthesystem:DeliveringhighcurrentEVAwhiledestroyingvalue…

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¨ TheGrowthtradeoffgame:ManagersmaygiveupvaluablegrowthopportunitiesinthefuturetodeliverhigherEVAinthecurrentyear.

¨ TheRiskgame:ManagersmaybeabletodeliverahigherdollarEVAbutinriskierbusinesses.ThevalueofthebusinessisthepresentvalueofEVAovertimeandtheriskeffectmaydominatetheincreasedEVA.

¨ TheCapitalInvestedgame:ThekeytodeliveringpositiveEVAistomakeinvestmentsthatdonotshowupaspartofcapitalinvested.Thatway,youroperatingincomewillincreasewhilecapitalinvestedwilldecrease.

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DeliveringahighEVAmaynottranslateintohigherstockprices…

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¨ TherelationshipbetweenEVAandMarketValueChangesismorecomplicatedthantheonebetweenEVAandFirmValue.

¨ ThemarketvalueofafirmreflectsnotonlytheExpectedEVAofAssetsinPlacebutalsotheExpectedEVAfromFutureProjects

¨ TotheextentthattheactualeconomicvalueaddedissmallerthantheexpectedEVAthemarketvaluecandecreaseeventhoughtheEVAishigher.

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Whenfocusingonyear-to-yearEVAchangeshasleastsideeffects

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¨ 1.Mostoralloftheassetsofthefirmarealreadyinplace;i.e,verylittleornoneofthevalueofthefirmisexpectedtocomefromfuturegrowth.¤ ThisminimizestheriskthatincreasesincurrentEVAcomeatthe

expenseoffutureEVA¨ 2.Theleverageisstableandthecostofcapitalcannotbe

alteredeasilybytheinvestmentdecisionsmadebythefirm.¤ ThisminimizestheriskthatthehigherEVAisaccompaniedbyan

increaseinthecostofcapital¨ 3.Thefirmisinasectorwhereinvestorsanticipatelittleor

notsurplusreturns;i.e.,firmsinthissectorareexpectedtoearntheircostofcapital.¤ ThisminimizestheriskthattheincreaseinEVAislessthanwhatthe

marketexpectedittobe,leadingtoadropinthemarketprice.

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TheBottomline…

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¨ Valuecreationishardwork.Therearenoshortcuts.¨ Investmentbanks/Consultants/Expertswhoclaimtohaveshortcutsandmetricsthatallowforeasyvaluecreationareholdingbackonhardtruths.

¨ Valuecreationdoesnothappeninfinancedepartmentsofbusinesses.Everyemployeehasaroletoplay.