1. Lecture 12 Allocating Capital and Corporate Strategy

2. The LG Group Financial Markets and Corporate Strategy, David Hillier Started a cosmetic cream factory in the late 1940s Start a plastic business to produce plastic caps combs, toothbrushes, and soap boxes Manufacture electrical and electronic products and telecommunication equipment A tanker-shipping company Largest insurance company in Korea Lucky- Goldstar group

3. Advanced valuation techniques Financial Markets and Corporate Strategy, David Hillier Refers to the application of the derivatives valuation methodology introduced in Chapters 7 and 8 to value real assets. Real options approach Values an investment at approximately the same ratio of value to a salient economic variable as an existing comparable investment for which the same ratio is observable. Ratio comparison approach Attributes positive net present value to any project of a firm that can identify its competitive advantages and a negative NPV to any project where competitors have the advantages. Competitive analysis approach

4. Sources of positive net present value Financial Markets and Corporate Strategy, David Hillier Competitive advantage Barriers to entry Economies of scale Economies of scope Economies of Scope, Discounted Cash Flow, and Options Option Pricing Theory as a Tool for Quantifying Economies of Scope Result 12.1 New opportunities for a firm often arise as a result of information and relationships developed in its past investment projects. Therefore, firms should evaluate investment projects on the basis of their potential to generate valuable information and to develop important relationships, as well as on the basis of the direct cash flows they generate.

5. Valuing Strategic Options with the Real Options Methodology Financial Markets and Corporate Strategy, David Hillier Exhibit 12.1 Cash Flows of Forward Contracts to Exchange Q t Units of Copper for Cash at Future Date t

6. Example 12.1: Valuing a Gold Mine Financial Markets and Corporate Strategy, David Hillier AngloGold Ashanti, a South African mining firm, own the Geita Gold Mine in the North of Tanzania. The mine, which was commissioned in 2000, has a total 8.474 million ounces of gold (source: AngloGold Ashanti Tanzania report). Although in a normal year between 300,000 and 600,000 ounces are extracted, for the purposes of this example assume that all the gold will be extracted in year 1 (2.474 million ounces) and year 2 (6 million ounces). The most recent year’s extraction costs were $497/oz, however this is exceptionally high because of an unusual combination of drought followed by extremely heavy rains in the Mwanza region of Tanzania where the Geita Gold Mine is situated. A more appropriate estimate of extraction costs is $275/oz which is roughly equal to the average costs in 2004 and 2005. The current forward prices are $851 per ounce for a one-year contract and $900 per ounce for a two-year contract. The annually compounded risk-free rates are 3.75 percent for one-year zero-coupon bonds and 4 percent for two-year zero-coupon bonds. What is the present value of the cash flows from the mine, assuming that payments for the mined gold are received at the end of each year? Answer:

7. Exhibit 12.2 Future Cash Flows and Current Costs of Geita Gold Mine versus Portfolio of Forward Contracts and Zero-Coupon Bonds Financial Markets and Corporate Strategy, David Hillier F 1 = Year 1 forward price $851 per ounce F 2 = Year 2 forward price $900 per ounce Investment Cost Beginning of First Year Cash Flow End of First Year Cash Flow End of Second Year Geita Gold MinePV Unknown 2.474 (p 1  $275)6 (p 2  $275) a.Forward contract to buy 2.474 million ounces of gold at beginning of year 1 $0 2.474 (p 1  $851) $0 b.Forward contract to buy 6 million ounces of gold at beginning of year 2 $0 6(p 2  $900) c.Buy zero-coupon bonds; Maturity  year 1 Face amount = $2.474 (851  275) $2.474(851  275) $0 d.Buy zero-coupon bonds; Maturity = year 2 Face amount = $6(900  275) $0 $6 (900  275) Total: a + b + c + d$4.841 billion $2.474 (p 1  $275)$6 (p 2  $275)

8. Valuing a Mine with an Abandonment Option- A Binomial Illustration of the Brennan-Schwartz Method Financial Markets and Corporate Strategy, David Hillier Exhibit 12.3 Payoffs of a Gold Mine with a Shutdown Option The equation that the same tracking portfolio also yields $5.296 billion if gold prices are high is x($900  $851) + y (1.0375) = $5.296 billion Simultaneously solving the equations for scenarios 1 and 2 gives the tracking portfolio x = 15,175,501 ounces of gold received from a one-year forward contract y = $4.388 billion invested in zero-coupon bonds The value of this tracking portfolio is $4.388 billion. Therefore, the gold mine must also have a value of $4.388 billion. The equation that the same tracking portfolio also yields $5.296 billion if gold prices are high is x($900  $851) + y (1.0375) = $5.296 billion Simultaneously solving the equations for scenarios 1 and 2 gives the tracking portfolio x = 15,175,501 ounces of gold received from a one-year forward contract y = $4.388 billion invested in zero-coupon bonds The value of this tracking portfolio is $4.388 billion. Therefore, the gold mine must also have a value of $4.388 billion.

9. Valuing a Mine with an Abandonment Option - continue Financial Markets and Corporate Strategy, David Hillier Practical Considerations Risk-Neutral Valuation Exchange Options and Volatility Generalizing the Real Options Approach to Other Industries Result 12.2 A mine can be viewed as an option to extract (or purchase) minerals at a strike price equal to the cost of extraction. Like a stock option, the option to extract the minerals has a value that increases with both the volatility of the mineral price and the volatility of the extraction cost.

10. Valuing Vacant Land - Exhibit 12.4 Binomial Trees for Land Valuation Financial Markets and Corporate Strategy, David Hillier

11. Valuing Vacant Land - Exhibit 12.4 Binomial Trees for Land Valuation Financial Markets and Corporate Strategy, David Hillier

12. Valuing Vacant Land - Exhibit 12.4 Binomial Trees for Land Valuation Financial Markets and Corporate Strategy, David Hillier

13. Result 12.3 Financial Markets and Corporate Strategy, David Hillier Vacant land can be viewed as an option to purchase developed land where the exercise price is the cost of developing a building on the land. Like stock options, this more complicated type of option has a value that is increasing in the degree of uncertainty about the value (and type) of development.

14. Exhibit 12.5 Cash Flows for Clacher’s Brewery Timing Decision in Example 12.5 Financial Markets and Corporate Strategy, David Hillier

15. Result 12.4 Financial Markets and Corporate Strategy, David Hillier Most projects can be viewed as a set of mutually exclusive projects. For example, taking the project today is one project, waiting to take the project next year is another project, and waiting three years is yet another project. Firms may pass up the first project, that is, forego the capital investment immediately, even if doing so has a positive net present value. They will do so if the mutually exclusive alternative, waiting to invest, has a higher NPV.

16. Valuing the Option to Expand Capacity Financial Markets and Corporate Strategy, David Hillier Example 12.6: Valuing the Option to Increase a Brewery’s Capacity Clacher Industries is considering building another cider brewery. The brewery will generate cash flows two years from now, as described in Exhibit 12.6. The cash flows from the brewery will be £200 million following two good years (point D), £150 million following one good and one bad year (point E), and £100 million (point F) following two bad years. The initial cost of the plant is £40 million (point A). After one year, however, if the state of the economy looks good, the firm has the option to double the plant’s capacity by investing another £140 million.

17. Exhibit 12.6 Cash Flows If There Is No Capacity Change at Year 1 Financial Markets and Corporate Strategy, David Hillier

18. Exhibit 12.7 Cash Flows If Plant Capacity Is Doubled at Good Node in Year 1 Financial Markets and Corporate Strategy, David Hillier

19. Exhibit 12.8 Market P ortfolio Payoffs for Determining Risk-Neutral Probabilities in Example 12.6 Financial Markets and Corporate Strategy, David Hillier

20. Valuing Flexibility in Production Technology: The Advantage of Being Different Financial Markets and Corporate Strategy, David Hillier Example 12.7: The Effect of Capacity Expansion on the Choice to Be Different The tree diagram in panel A of Exhibit 12.9 illustrates some of our assumptions, namely: 1.In a good economy, the cost of producing refined sugar with sugarcane is €0.60 per pound and the cost of using sugar beets is €0.54 per pound. 2.In a bad economy, the cost of producing refined sugar with sugarcane falls to €0.40 per pound. However, the demand for sugar beets is somewhat less cyclical than sugarcane because it is not generally used to produce refined sugar. Thus, the cost of producing refined sugar with sugar beets falls somewhat less to €0.50 per pound. 3.The risk-neutral probabilities associated with each of these two states of the economy (seen next to the branches of the tree diagram in panel A of Exhibit 12.9) are assumed to be.5. 4.The price of refined sugar is always €0.03 per pound greater than the cost of production using sugarcane, which is reasonable because virtually all producers use sugarcane as their input.

21. Exhibit 12.9 Production of Refined Sugar Financial Markets and Corporate Strategy, David Hillier

22. Exhibit 12.9 Production of Refined Sugar Financial Markets and Corporate Strategy, David Hillier

23. Exhibit 12.9 Production of Refined Sugar Financial Markets and Corporate Strategy, David Hillier

24. The Ratio Comparison Approach Financial Markets and Corporate Strategy, David Hillier Result 12.5 (The Price/Earnings Ratio Method.) The present value of the future cash flows of a project can be found by (1) obtaining the appropriate price/earnings ratio for the project from a comparison investment for which this ratio is known and (2) multiplying the price/earnings ratio from the comparison investment by the first year’s net income of the project. In a similar vein, a company should adopt a project when the ratio of its initial cost to earnings is lower than the price to earnings ratio of the comparison investment. (Alternative ratio comparison methods simply substitute a different economic variable for earnings.)

25. The Ratio Comparison Approach Financial Markets and Corporate Strategy, David Hillier Result 12.6 The price/earnings ratio of a portfolio of stocks 1 and 2 is a weighted average of the price/earnings ratios of stocks 1 and 2, where the weights are the fraction of earnings generated, respectively, by stocks 1 and 2. Algebraically where P/NI = price/earnings ratio of the portfolio P i /NI i = price/earnings ratio of stock i (i = 1 or 2) w i = fraction of portfolio earnings from stock i

26. Example 12.8: Price/Earnings Ratio Comparisons with Multiple Lines of Business Financial Markets and Corporate Strategy, David Hillier Ford is considering the opportunity to enter the European passenger bus market. Assume that General Motors (GM) currently produces similar buses from which it realizes 10 percent of its earnings. The rest of GM’s cash flows come from automobile lines that are essentially the same as Ford’s. If GM’s price/earnings ratio is 11.07, and if the price/earnings ratio of its automobile division is (as seems reasonable) assumed to be the same as the price/earnings ratio of Ford, which is 11.2, what is the implied price/earnings ratio for the bus division? Answer: Ninety percent of GM’s earnings have a price/earnings ratio of 11.2, 10 percent of the earnings have a price/earnings ratio of x, and the total GM value is 11.07 times the company’s total earnings. Viewing GM as a portfolio of a pure automobile business and a pure bus business, and applying Result 12.6, implies that x must solve.9(11.2) +.1x = 11.07 Thus, x = 9.9.

27. The Effect of Earnings Growth and Accounting Methodology on Price/Earnings Ratios Financial Markets and Corporate Strategy, David Hillier The Effect of Leverage on Price/Earnings Ratios Result 12.7 Assume the market value of the firm’s assets is unaffected by its leverage ratio. Also assume that all debt is risk free. Then, if the ratio of price to earnings of an all-equity firm is larger than 1/r D, where r D is the interest rate on the firm’s (assumed) risk-free perpetual debt, then an increase in leverage increases the price/earnings ratio. If the price/earnings ratio of an all-equity firm is less than 1/r D, then the increase in leverage lowers the price/earnings ratio of the firm Adjusting for Leverage Differences

28. The Competitive Analysis Approach Financial Markets and Corporate Strategy, David Hillier Result 12.8 (The Competitive Analysis Approach.) Firms in a competitive market should realize that they can only achieve a positive NPV from a project if they have some advantage over their competitors. When other firms have competitive advantages, the project has a negative NPV. Determining a Division’s Contribution to Firm Value Disadvantages of the Competitive Analysis Approach

29. When to Use the Different Approaches Financial Markets and Corporate Strategy, David Hillier Valuing Asset Classes versus Specific Assets Tracking Error Considerations Other Considerations

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