Chapter 11 APPLICATION OF REAL OPTION TECHNIQUES TO CAPITAL BUDGETING AND CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin

TRADITIONAL APPROACH TO OPTION THEORY Option theory is tailor-made for capital budgeting in a volatile environment. The optimal exercise policy for the option effectively provides the firm with its investment policy in respect to a project. Traditional theory involves either the binomial framework or the Black–Scholes framework. risk-neutral probabilities

Cont… In both frameworks, options are valued by computing the expected value of cash flows using the risk-neutral probabilities and then discounting at the risk-free rate of interest.

Do Managers Use Real Option Techniques? Some do. Merck & Co. Hoffman-La Roche Texaco BP Amoco Anadarko Petroleum New England Electric Intel Toshiba Most don't. 2000 and 2002 surveys of management techniques. real options ranked 24/25. 32% of real-options users abandoned the technique.

Do executives find that real-option framing is opaque framing or transparent framing? opaque framing “Describing a decision task in a manner that renders the consequences of the decision difficult to discern”. transparent framing “Describing a decision task in a manner that renders the consequences of the decision easy to discern”.

Roundtable on Real Options Example: Sun Microsystems 2000 Roundtable included CFO of Sun Microsystems. Sun did not use real option techniques, but CFO indicated the firm was ready to learn. A year later, CFO indicated that real options might have rationalized bubble prices, but offered no value to the firm.

Example: A Levered Firm Trees show value of cash flows to debt and equity. Sum is value of firm. Bottom node at Year 4 shows impact of default, when value of firm less than value of interest and principal. Traced back to Year 0.

Implied Put Option Risk neutral probability of up move = Risk free rate – Down Return .05 – (-.04) --------------------------------------- = ----------------- = .1667 Up return – Down return .5 – (-.04)

Small New Project Value of firm = 95. New project increases cash flow in Year 4 by 20 if up decreases cash flow in Year 4 by 1.8 if down requires a Year 3 investment of 1.75 discount rate of 352% NPV < 0, but close to 0. Is probability of default affected? No, it's still 0.

Large New Project Value of firm = 95. New project increases cash flow in Year 4 by 200 if up decreases cash flow in Year 4 by 18 if down requires a Year 3 investment of 17.5 discount rate of 352% NPV < 0, but close to 0. Is probability of default affected? Yes.

Asset Substitution If larger new project adopted, and down move occurs at Year 4, firm's value declines $9.45 million below debt obligation. Implied put option increases by $9.45 at Year 4. Value of put option at Year 3 is 7.5 = 0.833 x 9.45 / 1.05 where 0.833 = 1 – 0.1667. Managers increase shareholder value, decrease value of debt, by adopting new larger project.

Debt Overhang Value of firm = 61 < debt obligation 68.25. New project increases cash flow in Year 4 by 20 if up decreases cash flow in Year 4 by 1.8 if down requires a Year 3 investment of 1.75 discount rate of 352% NPV < 0, but close to 0. Value of put option increases. Project adopted.

Capital Structure Debtholders anticipate possibility of asset substitution and debt overhang. They respond by increasing the cost of debt. Firms' managers choose to hold less debt than is optimal. Value of firms' equity less as a result, due to foregone tax shields.

Overconfidence and Asset Substitution Value of firm = 96. New project: overconfident beliefs vs. actual increases up cash flow in Year 4 by 20 vs. 63 decreases down cash flow in Year 4 by 1.8 vs. 12.6 requires a Year 3 investment of 1.75 NPV < 0 not affected by overconfidence. Overconfident managers reject project, rational managers adopt project.

Unbiased Decision Task Investment policy obtained by exercising when value of exercising exceeds value of holding. Optimal investment policy is to wait for an up-move before exercising.

Excessive Optimism Excessively optimistic managers underweight the value of waiting, and exercise in circumstances less favorable than is optimal. In this example, managers exercise (invest) immediately.

Biased Backdrop Excessive optimism and overconfidence induce managers to overestimate project NPV overestimate tax shield benefits from debt underestimate the costs associated with financial distress These biases increase the tendency to be overleveraged. Agency conflicts operate in the other direction.

Behavioral Biases Counter Agency Conflicts Once a debt contract is in place, investment policy can impact the value of the implicit put. Shareholders and debtholders share the value of a positive NPV project, but the shares need not be positive amounts. Agency conflicts increase the cost of debt. Mild excessive optimism and overconfidence induce managers to behave more favorably towards debtholders, thereby leading to increased leverage.