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

2. 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

3. 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.

4. 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.

5. 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”.

6. 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.

7. 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.

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

9. 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.

10. 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.

11. 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 = x 9.45 / 1.05
where = 1 –
Managers increase shareholder value, decrease value of debt, by adopting new larger project.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.