1. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11 APPLICATION OF REAL OPTION TECHNIQUES TO CAPITAL BUDGETING AND CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin

2. 1 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.

3. 2 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.

4. 3 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.

5. 4 Implied Put Option Risk neutral probability of up move = Risk free rate – Down Return.05 – (-.04) --------------------------------------- = ----------------- =.1667 Up return – Down return.5 – (-.04)

6. 5 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.

7. 6 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.

8. 7 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.

9. 8 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.

10. 9 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.

11. 10 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.

12. 11 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.

13. 12 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.

14. 13 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.

15. 14 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.