Chapter 12 Some Complications Equity Valuation and Analysis with eVal

Negative Values and the Abandonment Option – How do we interpret negative values? – Does it make sense to assume that a business will continue to lose money forever? Creating and Destroying Value through Financing Transactions – Is a firm’s value determined solely by its investment opportunities? – What about the opportunity to engage in strategic transactions in its own equity securities? Common Complications

Negative Values Valuation software, such as eVal, can produce negative values when the present value of the forecast future cash distributions on a security is negative Such valuations assume that investors will be sufficiently naïve to contribute new capital even though they are investing in a negative NPV investment opportunity In practice, investors in public companies have limited liability and cannot be forced to contribute new capital, hence we will never see a negative security price It is, however, possible for investors to lose more money than they initially invested in a firm if the investors ‘send good money chasing after bad’ and make additional follow-up investments that are never fully recovered.

The Abandonment Option In practice, it doesn’t make sense for a business to make losses forever. At some point, the business will be ‘abandoned’ and the losses will cease When valuing a company, we typically model the ‘most likely’ scenario and value the cash flows implied by that scenario. In practice, however, a range of outcomes are likely. Since investors can take full advantage of better than expected outcomes, but can ‘abandon’ the business in the case of worse than expected outcomes, the value of the business is greater than the value implied by the most likely scenario. The difference is attributable to the ‘abandonment option’ The value of the abandonment option tends to be greater when the probability of rationally exercising the option is higher

No Value to Abandonment Option Mean Value

Ignore Value to Abandonment Option Mean Value

Incorporating the Value of the Abandonment Option Added Value Abandon Mean Value

Value Creation Through Financing Transactions If a company is able to issue new shares in exchange for cash or other assets at a price that differs from the intrinsic value implied by its existing business opportunities, then this will change the intrinsic value of the company – issue price > intrinsic value => increase intrinsic value – issue price decrease intrinsic value

Summary of Wealth Transfers in Stock Transactions

Illustrations The AOL Time Warner Merger (in textbook) LinkedIn 2013 Example BV/share at end of June ≈ $10 ( ) Issues approx. 5 million shares for $1.2 Billion in September ( ) BV/share at end of September ≈ $20

Incorporating Stock Options in Valuation To the extent that a firm has outstanding options on its own stock at the valuation date, deduct the value of the options from the value of equity before dividing by shares outstanding To the extent that a firm plans to issue options in lieu of cash to meet future expenditures, assume that the firm instead uses the requisite amount of cash and issues shares to raise the cash