Mergers & Acquisitions: Acquiring an Option Prof. Ian Giddy New York University

Acquisition Viewed as an Option Why does Microsoft buy shares in start-up high-tech firms? Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. The value of these rights increases with the volatility of the underlying business. The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits. The value of an option will increase with the uncertainty associated with the cash flows and value of the project. Thus, firms should be willing to pay large amounts for the rights to technology in areas where there is tremendous uncertainty about what the future will bring, and much less in sectors where there is more stability. The expenses incurred on R&D can be viewed as the cost of acquiring these rights.

The Option to Expand/Take Other Projects Taking a project today may allow a firm to consider and take other valuable projects in the future. Thus, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the firm (to take other projects in the future) provides a more-than-compensating value. These are the options that firms often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects. A project may be the first in a sequence.

The Option to Expand PV of Cash Flows from Expansion Additional Investment Here, the initial project gives you the option to invest an additional amount in the future which you will do only if the present value of the additional cash flows you will get by expanding are greater than the investment needed. For this to work, you have to do the first project to be eligible for the option to expand. to Expand Present Value of Expected Cash Flows on Expansion Expansion becomes Firm will not expand in attractive in this section this section

An Example of an Expansion Option Disney is considering investing $ 100 million to create a Spanish version of the Disney channel to serve the growing Mexican market. A financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to Disney will be only $ 80 million. Thus, by itself, the new channel has a negative NPV of $ 20 million. If the market in Mexico turns out to be more lucrative than currently anticipated, Disney could expand its reach to all of Latin America with an additional investment of $ 150 million any time over the next 10 years. While the current expectation is that the cash flows from having a Disney channel in Latin America is only $ 100 million, there is considerable uncertainty about both the potential for such an channel and the shape of the market itself, leading to significant variance in this estimate. This is a negative net present value project, but it gives Disney the option to expand later. Implicitly, we are also saying that if Disney does not make the initial project investment (with a NPV of - $ 20 million), it cannot expand later into the rest of Latin America.

Call Value= 100 (0.7915) -150 (exp(-0.065)(10) (0.3400) Valuing the Expansion Option: Use option pricing model such as Black-Scholes Value of the Underlying Asset (S) = PV of Cash Flows from Expansion to Latin America, if done now =$ 100 Million Strike Price (K) = Cost of Expansion into Latin American = $ 150 Million We estimate the variance in the estimate of the project value by using the annualized variance in firm value of publicly traded entertainment firms in the Latin American markets, which is approximately 10%. Variance in Underlying Asset’s Value = 0.10 Time to expiration = Period for which expansion option applies = 10 years Call Value= 100 (0.7915) -150 (exp(-0.065)(10) (0.3400) = $ 52.5 Million This values the option, using the Black Scholes model. The value from the model itself is affected not only by the assumptions made about volatility and value, but also by the asssumptions underlying the model. The value itself is not the key output from the model. It is the fact that strategic options, such as this one, can be valued, and that they can make a significant difference to your decision.

Considering the Project with Expansion Option NPV of Disney Channel in Mexico = $ 80 Million - $ 100 Million = - $ 20 Million Value of Option to Expand = $ 52.5 Million NPV of Project with option to expand = - $ 20 million + $ 52.5 million = $ 32.5 million Take the project A bad project, with options considered, becomes a good one.

Case Study: Yahoo!-Broadcast.com Questions: How would you use the option model to value Broadcast.com? How would you measure the volatility of returns of Broadcast.com? In the acquisition of an option such as this one, what is the strike price?

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