Chapter 17: Finance and
Corporate Strategy
Objective
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Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley
Understanding:
Mergers & Acquisitions
Spinoffs
Real Options
Chapter 17 Contents
• 17.1 Mergers and Acquisitions
• 17.2 Spinoffs
• 17.3 Investing in Real Options
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Introduction
• First we analyze corporate decisions
regarding mergers, acquisitions and
spinoffs
• Then we show how option theory may be
applied to evaluate management’s ability
to time the start of an investment
project, to expand it, or to abandon it,
after it has begun
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17.1 Mergers and
Acquisitions: Definitions
• Acquisition
– one company acquires a controlling interest
in another
• Merger
– two firms join together to form a new firm
• Synergy
– The incremental value obtained by
combining two companies
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Valid Purposes
• There are three valid reasons why the
shareholders of a firm could be wealthier
after combining two firms
– Synergistic benefits resulting from
eliminating duplicated cost of production,
marketing, administration and research
– Tax shelters (Unusable tax credits)
– Bargains not recognized by the stock market
(better information / sub-optimal
management)
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Questionable Purposes
• Monopolistic control over a technology
(intellectual property rights), a market
sector, labor, raw materials, production
facilities, et cetera, may be acquired by
consolidation of ownership
• This category of synergistic effect may be
exploited to generate incremental profits
– Policies for controlling monopolistic power is
a difficult and complex issue for the courts
and legislators of all developed countries
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Invalid Purposes
• Corporate Diversification
– A merger or an acquisition is one way to
achieve corporate diversification--the topic of
the next section
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Corporate Diversification
– We have learned that the shareholders of a
company can reduce s-risk (to the degree
that diversification can reduce it) at very
little cost
– Empirical studies have shown that
consolidation is a costly way to reduce the srisk of a business:
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Corporate Diversification:
Shareholder Vantage
– In order for the investor to gain from the
consolidation of two firms, some service
must be provided that the investor was not
able to provide for herself
– Prior to consolidation, the investor could own
any combination of both firms, but after
consolidation, only a fixed ratio of the assets
may be owned
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Corporate Diversification:
Empirical Evidence
– In order to takeover another firm, the
acquiring firm must pay a substantial
premium to the shareholders of the target
• You will have noticed that share prices
generally rise on takeover rumors, and
continue to rise as the managements of the
two companies negotiate, and third parties
enter the bidding
• Contested takeovers result in significant legal
fees for the acquiring firm
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Corporate Diversification:
– The management of the acquiring firm
should believe that (given information it has
about the ‘true potential’ of the target firm)
these costs should be more than recovered
– However, if the only reason for the takeover
is to reduce risk, then the takeover is almost
certainly not in the interests of acquiring
firm’s current shareholders
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17.2 Spinoffs
• Occurs when a corporation divests itself
of one or more of its business units and
creates a separate company with assets,
liabilities, and stock of its own.
• Example:
– Pepsico (1997)
– Nabisco (Proposed spring 1999)
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• Spinoffs occur when the market value of
the whole is less than the market value
of the sum of the parts
– This may occur because
• management is not employing assets
efficiently (Slater-Walker liquidations, U.K.
during the 70’s)
• the market is characterizing a company by
one of its divisions Nabisco = tobacco, and so
undervaluing the whole
• management may not have the specialized
skills required to manage a specialized
subsidiary effectively (e.g. pharmaceutical
parent with beauty product subsidiary)
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Effect on Debt Holders
• Existing debt holders have greater
exposure after a spinoff than before
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17.3 Investing in Real Options
• To date we have ignored management’s
ability to
– delay the start of a project
– expand a project
– abandon the project
• Failure to take these options into account
will result in an understated NPV
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The Movie Industry (Example)
• We will examine a decision in the movie
industry in order to understand the
importance of options in evaluating
projects
• We add some hypothetical numbers, and
to keep the central ideas clearly in focus,
the example will the simplest possible
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Derwyn Productions: Time A,
Rights Purchase Decision
– Derwyn Productions, is considering
purchasing the exclusive movie rights to
“Unfinished Business.” (An unpublished
book, authored by Lou Grymshew who has
several movie ‘hits’, and a couple of ‘bombs’)
– Cost $1 Million if purchased
– Cost $0 Million if not purchased
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Derwyn Productions: Time B,
Book’s Debut (Event)
– Critics and the public provide information
valuable in determining the ultimate success
of the movie
– Management has no influence over this node
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Derwyn Productions: Time C,
Production Decision
– Contingency: Successful book (Prob=0.5)
• Make the movie, NPV of movie = $4 million
• Don’t make the movie, NPV movie = $0
million
– Contingency: Unsuccessful book (Prob=0.5)
• Make the movie, NPV of movie = -$4 million
• Don’t make the movie, NPV movie = $0
million
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Derwyn Productions:
Decision Tree (yes, no)
(Probability = 0.5)
Make the movie?
(NPV $4 Million)
Book a
Success?
(Probability = 0.5)
Make the Movie?
(NPV -$4 Million)
Buy the movie
rights to book?
(Cost $1 Million)
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Decision to Acquire Rights
– If the decision to undertake the project is
made under the assumption of a single upfront decision
– then the project must always be rejected
– But…
• If Derwyn makes the logical managerial
decision at each stage, then (as long as the
cost of capital for the project is less than
100%) the project should be undertaken
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Volatility and Project
Evaluation
– There is a common notion that risk in
investment decisions is something that needs
to be penalized: Risky cash flows are often
discounted at a higher rate
– But … we have just seen an investment
decision containing an option-like feature,
and we know that options always become
more valuable with higher volatility
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“Unfinished Business”
– The publisher also has another book, “Risky
Business,” and Derwyn believes that it’s
identical to “Unfinished Business” in all
economic respects other than the payoff,
which is (-$8 million, 8 million)
– Running the numbers shows:
• the more volatile project increases
shareholders’ wealth more than the less
volatile one
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Summary
– Some projects are naturally rich in valuable
managerial options (R&D), while other
projects have options that are relatively hard
to find, and then discovered, are not
particularly valuable (fast-food franchisee)
– Sometimes, management’s ability to
recognize the options in a business situation
is the key that distinguishes a winning
business from its less successful siblings
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Applying the Black-Scholes
Formula to value Real Options
• This section shows how to apply the
Black-Scholes option pricing formula in
capital budgeting by using two examples
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Raider’s Takeover of Target
using an option
• Suppose that Raider Inc. is considering
acquiring Target Inc. Assume:
– that both companies are 100% financed by
equity divided into 1-million shares
– that Target is worth $100,000,000
– Target offers Raider the option to purchase
100% of Target’s shares one year from now
– Rf=6%, cost of option $6 million,
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sTarget=0.20
Raider’s Takeover of Target
Using Options: Computation
• Observe that the Targets Future is equal
to the option’s strike, so the simplified BS
equation may be used
T
1
C  Ss
 $100,000,000 * 0.20 *
 $7.98 million
2
2
• The NPV of the investment is therefore
$(8-6) millions = $2 millions (do it)
– The premium distributed to the shareholders
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Implicit Options: ElectroUtility
• ElectroUtility has the opportunity to
invest in a project to build a powergenerating plant
• Phase 1:
– invest $6 million now for the building
• Phase 2:
– purchase equipment costing $106 million in
one year
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Implicit Options: ElectroUtility
• Suppose that, viewed from today’s
perspective,
– the value of the completed plant is $112
– the standard deviation of the capital return
from the project is 0.20
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Implicit Options: ElectroUtility
• The expected value of the cash flow from
the plant a year from now is $(122-106)
million
– The initial project outlay is $6 million, so a
conventional DCF would reject this project
(for any positive cost of capital)
– But:
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Implicit Options: ElectroUtility
• But:
– management will abandon the project (and
not invest the additional $106 million) if the
value of the plant is less than $106 million
– The cash flows of ElectroUtility are identical
to those of Raider, so taking the option into
account, the project has a NPV of $2 million
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Implicit Options
– We conclude that accounting for managerial
flexibility explicitly always increases the value
of a project
– From option theory, we know that increasing
volatility always increases an option’s value.
Using simplified BS:
• a sigma of 0.40 gives the NPV of the project
of $(16-6) million = $10 million: an increase
of $8 million over the sigma of 0.20 case
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