NIVRA_6_01

8/10/2019 NIVRA_6_01

1/97

Tom Copeland [email protected] Director, Monitor Corporate Finance www.corpfinonline.comMonitor Group, Cambridge, Massachusetts www.monitor.com

For mo re reading s ee:

Copeland, T, T. Koller, J. Murrin, Valuation: Measuring and Managing the Value of Companies

Copyright 2001 by Monitor Company Group, L.P.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means

electronic, mechanical, photocopying, recording, or otherwise without the permission of Monitor Company Group, L.P.

This document provides an outline of a presentation and is incomplete without the accompanying oral commentary and discussion.

COMPANY CONFIDENTIAL

Trends in Valuation

NIVRA, Amsterdam, June 1, 2001

8/10/2019 NIVRA_6_01

2/97

Copyright 2001 Monitor Company Group LP Confidential CAMZKN-MFR-NIVRA 6 01-TEC 2

Changes in Value are at the Heart of Economic Decision-Making

Discounted Cash Flow Valuation DCF

Expectations-Based Management

Real Options Analysis


8/10/2019 NIVRA_6_01

3/97


Discounted Cash Flow Definition

DCF has three components:

Free Cash Flow = EBIT - Cash taxes on EBIT + accrued taxes due

+ depreciationCapital Expendituresoperating workingcapital

WACC =

Continuing Value =

VSK

VBK Sb )ratetaxmarginal1(

gWACC

rgEBIT

)/1)(ratecash tax1(

8/10/2019 NIVRA_6_01

4/97


Source: Value Line forecasts; Copeland, Koller, Murrin, Valuation, 2nd edition, 1994

0.0

2.0

4.0

6.0

8.0

10.0

12.0

0 1 2 3 4 5 6 7 8 9 10

35 Large U.S. Companies, 1988

1988 DCF / Book

1988Mark

et/Book

R2= 0.94

DCF Works Well For Large Publicly Held Companies

R2 = 0.92

0

5

10

15

0 5 10 15

1999 DCF / Book Value

1999Market/

BookValue

Source: Value Line Forecasts, Monitor Analysis

31 Large U.S. Companies, 1999

8/10/2019 NIVRA_6_01

5/97


High Correlation Between Market Value and DCF Value

for 28 Japanese Companies 1993

The R2for 28 Japanese companies was 89 percent

Market /

BookValue

0

1

2

3

4

5

0 1 2 3 4 5

DCF / Book (Using Value Line Forecasts)

R2= 0.89

Comments:1. Underutilized land2. Cross-holdings

8/10/2019 NIVRA_6_01

6/97


. . . for 15 Italian companies (the R2was 95.4 percent) . . .

DCF / Book

Market /BookValue

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6

Correlation Between DCF and Market

Valuefor 15 Italian Companies* 1990

Snia

Pirelli

Sip

Falk

Burgo

FiatMagneti M.

Montedison

Stet

Fidenza

AuschenMerloni

Cementir

Benetton

R2= 0.954

2.0 3.0

2.0

3.0

Olivetti

Correlation between DCF and Market Value Italy

* Using publicly available information

** Capitalization on September 28, 1990 (Borsa valori di Milano), book value of companySource: Copeland, Koller and Murrin, Valuation

Comments:1. Mark to market inflation accounting2. Holder assets

8/10/2019 NIVRA_6_01

7/97Copyright 2001 Monitor Company Group LP Confidential CAMZKN-MFR-NIVRA 6 01-TEC 7

Brazil

8/10/2019 NIVRA_6_01


DCF Works Across Different Industries

16 banks

* 5 banks are non-U.S. banksSource: Global Vantage; Value Line

Market/BookValue

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0.0 0.5 1.0 1.5 2.0 2.5 3.0

DCF / Book Value

R2= 0.97

13 Insurance Companies

Marke

t/BookValue

DCF / Book Value

30 1 2

3

0

1

2

R2= 0.92

1. Equity Approach2. Income model/ interest spread model

1. Equity Approach2. Unrealized capital gains

8/10/2019 NIVRA_6_01


60

80

100

120

140

160

180

4-Jan-99

13-Jan-99

25-Jan-99

3-Feb-99

12-Feb-99

24-Feb-99

5-Mar-99

16-Mar-99

25-Mar-99

6-Apr-99

15-Apr-99

26-Apr-99

5-May-99

14-May-99

25-May-99

4-Jun-99

15-Jun-99

24-Jun-99

6-Jul-99

15-Jul-99

26-Jul-99

4-Aug-99

13-Aug-99

24-Aug-99

2-Sep-99

14-Sep-99

DCF Works for Robust Growth Companies

1999 Stock Price (AOL)

Note: 1999 elsewhere in valuation refers to FY 99 which ends in JuneSource: Compustat

Price PerShare

Volume(Millions)

0

10

20

30

40

50

60

4-Jan-99

13-Jan-99

25-Jan-99

3-Feb-99

12-Feb-99

24-Feb-99

5-Mar-99

16-Mar-99

25-Mar-99

6-Apr-99

15-Apr-99

26-Apr-99

5-May-99

14-May-99

25-May-99

4-Jun-99

15-Jun-99

24-Jun-99

6-Jul-99

15-Jul-99

26-Jul-99

4-Aug-99

13-Aug-99

24-Aug-99

2-Sep-99

14-Sep-99

1999 Trading Volume (AOL)

8/10/2019 NIVRA_6_01


AOL Revenue Assumptions for the Valuation Model Were Closely Tracked

to Analyst Estimates of Long Term Revenue Growth

$27,450

$25,183

$22,894

$20,260

$17,466

$12,233

$9,945$8,080

$6,288

$4,777

$14,801

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Revenue Growth

* Most analysts did not forecast beyond 2003

Note: FY for AOL ends in JuneSource: ING Barings; BankBoston Robertson Stephens; Donaldson, Lufkin, and Jenrette

$ Billions

Deviation fromAnalystProjections*

1.5% 1.9% 2.3% 0.1%

1999-2004 AverageGrowth Rate: 25.4%


Long-Term Revenue Growth: 9%

8/10/2019 NIVRA_6_01


AOL Projected Operating Margins Benefit From Both Significant Scale

Economies and Changes in Revenue Mix Toward Higher Margin Businesses

70% 67% 69% 65%60%

55%

21% 25% 24% 29%33%

38%

10% 8% 7% 7% 7% 7%

0%

20%

40%

60%

80%

100%

1999 2001 2003 2005 2007 2009

Enterprise

Advertising

Online Services

Revenue Mix

Source: ING Barings; BankBoston Robertson Stephens; Donaldson, Lufkin, and Jenrette

Percent ofRevenue

Operating Margin 12.9% 22.0% 28.9% 32.1% 33.9% 34.8%

Analyst Projections* 13.1% 22.6% 28.1% 32.0%

* Average

8/10/2019 NIVRA_6_01


AnalystProjections(CapEx)*

$355 $375 $375 $375

AOL: Increasing Capital Productivity

Capital Expenditures and Capital Turns (Rev / Invested Capital)

* Most analysts did not forecast beyond 2003Source: ING Barings; BankBoston Robertson Stephens; Donaldson, Lufkin, and Jenrette

Capital

TurnsCapEx

$312

$409 $404$448 $489

$592

$699

$810

$916$1,007

$1,043

$0

$200

$400

$600

$800

$1,000

$1,200

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0

1

2

3

4

5

6

7

8CapEx

Capital Turns

8/10/2019 NIVRA_6_01


AOL: Matures Led to the Use of a Changing WACC

99.7%92.5%

85.4%

0.3%7.5%

14.6%0%

25%

50%

75%

100%

1999 2004 2009

Equity

Debt

AOL Capital Structure

Source: Compustat, Bloomberg, Monitor Analysis

Based on comparables taken from telecom, software, and news media

Equity Beta 1.69 1.38 1.06

Debt Rating B1 BBB3 A3

WACC 15.6% 13.5% 11.0%

Percent

8/10/2019 NIVRA_6_01


AOL: Continuing Value

Return on New Investment

Continuing Value35% 40% 45%

8% $55,933 $58,038 $59,674

9% $80,934 $84,474 $87,228NOPLAT

Growth

10% $155,025 $162,820 $168,883

In the base case shown below, continuing value contributes 85% of total operatingvalue (approximately $76 out of $93 per share)

Continuing value growth rate has a particularly large impact because the growth rate isvery close to the ending WACC of 11%

WACC = 11% in the long run

8/10/2019 NIVRA_6_01


Example:

People inNetwork

2 3 4 5 6

Connections(graph)

Number of

Connections 1 2 + 1 = 3 3+ 2 + 1 = 6 4 + 3 + 2 + 1 = 10 5 + 4 + 3 + 2 + 1 = 15

AOL: Metcalfs Law (Interconnectivity) Makes Scale a Sustainable

Competitive Advantage Leading to Perpetually High ROIC

Metcalfs Law: I =N2 - N

2

AOL has 18 million customers 1.62 x 1014

connections MSN has 2 million customers 2.00 x 1012 connections

AOL has roughly 10 times as many customers as MSN,but roughly 100 times the number of connections

8/10/2019 NIVRA_6_01


PV of FCF1999-2009

PV ofContinuing

Value

MarketableSecurities andNon-operating

Assets

Debt Equity Value

AOL: The Changing WACC and Continuing Value Assumptions Bridge

the Analyst Projections and the Current Market Value

AOL Entity and Equity Value

Implied share price of $93 versus trading range of $89 to $104 between mid-Augustand mid-September

$MM $93 per Share

15,694

84,481 102,496

(348)

2,688

$0

$30,000

$60,000

$90,000

$120,000

8/10/2019 NIVRA_6_01


AOL Market Ratios Decline Over Time as the Firm Matures

138.7

123.3

89.5

33.434.435.738.1

41.9

55.4

71.3

47.2

6.26.97.89.010.612.715.5

19.122.826.6

33.9

0

20

40

60

80

100

120

140

160

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Price to Earning and Price to Book

P/E Ratio

P/B Ratio

8/10/2019 NIVRA_6_01


Amazon.com: Amazons Stock* (up to August 1999)

$42

$64

$37

$124

$100

$125

$119

$172$172

$117$107 $128

$0

$50

$100

$150

$200

Sep-98 Oct-98 Nov-98 Dec-98 Jan-99 Feb-99 Mar-99 Apr-99 May-99 Jun-99 Jul-99 Aug-99

* On August 12, 1999 Amazon.com undertook a 2 for 1 stock split. As our valuation reflects the value of thecompany in July 1999 we will use the number of outstanding shares before the split.

Dollars

8/10/2019 NIVRA_6_01


Monitors Valuation Results: Amazon.com (July 1999)

$361 $349 $16,447$15,086

$1,329

$0

$5,000

$10,000

$15,000

$20,000

PV of FCF1998-2008

PV ofContinuing

Value

PV ofMarketableSecuritiesand Non-operatingAssets

Debt andRetirement-

relatedLiabilities

DCFEstimateof Equity

Value

$101 per Share

Note: Valuation as of July 1999 reflects pre-split price of $101/share. Trading range was $126.50 to $97.50

8/10/2019 NIVRA_6_01


Summary Operating Assumptions July 1999

Monitor

Revenue Growth 2000 50%

2001 39.2%

2002 onward 39.2% declining to 21%

COGS / Revenue 2000 77%

2001 76%2002 74%

SG&A / Revenue 2000 28%

2001 22.4%

2002 15% declining to 10.5%

Capex / Revenue 2000 2%2001 1.5%

2002 1.5%

Net Working Capital /Revenue

2000 - 16%

2001 -17.5%

2002 - 17.5%

8/10/2019 NIVRA_6_01


Amazon.com Revenue Assumptions Were Closely Tracked to Analyst

Estimates Except for Donaldson, Lufkin & Jenrette

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

* Donaldson, Lufkin, and JenretteNote: Most analysts did not forecast beyond 2003

Revenue(In Millions)



Long-Term Revenue Growth: 9%

DL&J* Revenue

Forecast

8/10/2019 NIVRA_6_01


Amazon.com: Sensitivity Analysis of Price Per Share

Return on New Investment

Continuing ValueSensitivity

10% 11% 12%

9% $66 $102 $132

8% $66 $82 $95NOPLATGrowth

7% $66 $75 $83

92% of the Amazons market value is realized after the year 2009 and is reflected in the

Continuous Value. The assumptions about the two parameters of Amazons Continuous

Value: NOPLAT Growth and Return on New Investment are key to its valuation.

WACC = 10% in the long run

8/10/2019 NIVRA_6_01


Amazon.com

Company TSR vs. S&P 500, 1999-2000

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

De

c-

98

Ja

n-

99

Fe

b-

99

Ma

r-

99

Ap

r-

99

Ma

y-

99

Ju

n-

99

J

ul-

99

Au

g-

99

Se

p-

99

Oc

t-

99

No

v-

99

De

c-

99

Ja

n-

00

Fe

b-

00

Ma

r-

00

Ap

r-

00

Ma

y-

00

Ju

n-

00

J

ul-

00

Au

g-

00

Se

p-

00

Oc

t-

00

No

v-

00

De

c-

00

Ja

n-

01

TRS

Amazon

S&P 500

8/10/2019 NIVRA_6_01


Amazon.com: Valuation Results July 1999 vs. January 2001

$ Million$ 15.3 per

share

$5,433

$2,114$1,045

$5,373

$1,130

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

PV of FCF 2000 -2009

PV ofContinuing

Value

PV of ExcessCash and Non-

OperatingAssets

Total Debt DCF Estimate ofEquity Value

Value Build-Up January 2001

$15,086 $361 $349 $16,447

$1,329

$0

$5,000

$10,000

$15,000

$20,000

PV ofFCF1998-2008

PV ofContinuingValue

PV ofMarketableSecuritiesand Non-operating

Assets

Debt andRetirement-relatedLiabilities

DCFEstimateof EquityValue

$101 per Share

Note: Valuation as of July 1999 reflects pre-split price of $101/share.

Trading range was $126.50 to $97.50

Value Build-Up July 1999

8/10/2019 NIVRA_6_01

25/97


Amazon.com: Operating Assumptions

1997 1999

History

Jefferies Merrill Lynch Bernstein RobertsonStephens

Monitor

January 01

Monitor

July 99

RevenueGrowth

Avg 440% 2000 70.5%

2001 43.1%

2002 38.7%

2000 67.7%

2001 29.2%

2000 67.7%

2001 35%

2002 20%

2000 67.7%

2001 36.4%

2002 30%

2000 68.7%

2001 38.2%

2002 onward29.6% decliningto 17.5%

2000 50%

2001 39.2%

2002 onward39.2%declining to21%

COGS /

Revenue

Avg 78.2%

1998 76.5%

1999 80%

2000 74%

2001 74.2%

2002 73.8%

2000 75.2%

2001 75%

2000 75.2%

2001 75.5%

2000 75.2%

2001 76%

2002 74.1%

2000 74.5%

2001 74.9%

2002 73.6%

2000 77%

2001 76%

2002 74%

SG&A /Revenue

Avg 37.5%

1998 32.1%

1999 41.1%

2000 37.4%

2001 29%

2002 23.3%

2000 35.1%

2001 27.2%

2000 35.1%

2001 29.2%

2000 35.1%

2001 27.5%

2002 23.5%

2000 35.6%

2001 28.2%

2002 23.4%declining to

20.2%

2000 28%

2001 22.4%

2002 15%declining to

10.5%Capex /Revenue

Avg 10.1%

1998 5%

1999 19.8%

2000 4.5%

2001 3.1%

2002 2.3%

2000 10.3%

2001 1.6%

2002 0.9%

2000 7.4%

2001 2.4%

2002 1.6%

2000 2%

2001 1.5%

2002 1.5%

NetWorkingCapital /

Revenue

Avg -19.3%

1998 -16%

1999 -23.5%

2000 -18.8%

2001 -12.5%

2002 -13.2%

2000 - 16.8%

2001 -10.5%

2002 - 12.7%

2000 - 16%

2001 -17.5%

2002 - 17.5%

8/10/2019 NIVRA_6_01

26/97


Amazon.com: WACC & Continuing Value Assumptions

Monitor Assumptions

January 2001

Monitor Assumptions

July 1999

WACC

Barra Beta

Risk Free Rate

Credit Rating

Pre-tax Cost of Debt

Cost of Equity

WACC

2.09

5.3%

B

10.9% (Debt / Total Capital(market value) 21.7%)

16.8% (Equity / Total Capital(market value) 78.3%)

14.5% declining to 10% by 2009

1.91

6.3%

B

11.8% (Debt / Total Capital(market value) 2.1%)

16.8% (Equity / Total Capital(market value) 97.9%)

16.6% declining to 10% by 2009

Continuing Value

Growth in NOPLAT

Return on Net NewInvestments

9%

11%

9%

11%

8/10/2019 NIVRA_6_01

27/97






A E l

8/10/2019 NIVRA_6_01

28/97


Metric Critique

Sales Growth Ignores profitability, ignores balance sheet

EPS Ignores balance sheet

EPS Growth Ignores balance sheet

ROIC = EBIT / Invested Capital Encourages harvesting behavior

ROIC-WACC* Encourages harvesting

EVA=(ROIC-WACC) x Invested Capital Not correlated with TRS

Rational Expectations Best of short-term metrics

An Example:

Performance Measurement

Most traditional performance metrics create perverse incentives to management. OnlyRational Expectations focuses on shareholder value creation

Whi h C Did B tt ?

8/10/2019 NIVRA_6_01

29/97


Sears** Wal-Mart

1994 1995 1996 1997 CAGR 1994 1995 1996 1997 CAGR

Sales Revenue(billions)

$54.6 $34.9 $38.2 $41.3 -8.9% $82.5 $93.6 $104.9 $118.0 12.7%

EBIT (billions) $3.4 $3.1 $3.5 $3.9 4.7% $3.6 $4.1 $4.1 $4.4 6.9%

Net Income (billions)*** $1.2 $1.0 $1.3 $1.2 0.0% $2.6 $2.7 $3.1 $3.5 10.4%

ROIC 19.5% -5.3% -4.2% -5.2% 10.4% 8.9% 8.9% 9.8%

WACC 9.1% 7.3% 8.1% 7.5% 12.5% 10.0% 11.0% 10.6%

ROIC-WACC 10.4% -12.6% -12.3% -12.7% -2.1% -1.1% -2.1% -0.8%

Invested Capital(billions) $21.66 $28.20 $30.19 $34.22 16.5% $29.84 $33.54 $34.56 $36.60 7.0%

Economic Profit(billions)

$2.24 -$3.56 -$3.72 -$4.33 -$0.63 -$0.36 -$0.73 -$0.28

Change in EP(billions)

-5.80 -0.16 -0.61 0.27 -0.37 0.45

* Sears destroyed on aggregate of $9.37 billion while Wal-Mart destroyed $2.00 billion

** Excludes Allstate*** Before extraordinary items

Which Company Did Better?

Sears vs. Wal-Mart

A good example is found in the comparison between Wal-Mart and Sears over the 19941997 four-year interval. Can you tell from the data below which company had superior total

return to shareholders?

8/10/2019 NIVRA_6_01

30/97


0.0

0.5

1.0

1.5

2.0

2.5

3.0

1/94

3/94

5/94

7/94

9/94

11/9

41/95

3/95

5/95

7/95

9/95

11/95

1/96

3/96

5/96

7/96

9/96

11/96

1/97

3/97

5/97

7/97

9/97

Sears Index

Wal-Mart Index

Total Returns to ShareholdersSears vs. Wal-Mart, 19941997

Total Return

Between January 1994 and December 1997 the Total Return to Shareholders of

Sears Was Consistently Higher Than the Total Return to Shareholders of Wal-mart

8/10/2019 NIVRA_6_01

31/97


Sears

7/18/97 Excluding unusual items, yesterdays earnings report signals that the four-yearold rebound at Sears stores is continuing . . . The better-than-expected results

prompted several analysts to raise their Sears earnings forecasts.

Wal-Mart

11/18/96 They gradually recognize that the gap between expected and reportedearnings has narrowed. Wal-Marts earnings fell off the table and its stocknever fell way down. It just stopped going up as investors rotated into othertypes of names.

5/17/94 Wal-Mart Stores Inc.s earnings soared in its first fiscal quarter while profit

sank at Kmart Corp. Analysts had expected Wal-Mart to perform a bit better. .. . In Big Board composite trading yesterday, Wal-Mart shares fell $1.25 ashare to close at $22.75.

A Search of News Articles Provides a Clear Message That Sears Repeatedly

Exceeded the Markets Expectations While Wal-Mart Met or Fell Short of Expectations

Quotations

8/10/2019 NIVRA_6_01

32/97

8/10/2019 NIVRA_6_01

33/97


Analysts expectations of Coca Cola remained fairly constant during 1995 and 1996. However,

falling expectations during 1997 and 1998 resulted in below market stock performance

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

Analyst Expectations of Coca-Cola EPS, 19951998: The Asian Crisis

Earnings per Share

(adjusted for spli ts)

2 Years Ahead 1 Year Ahead

1 Year Ahead

2 Years Ahead 1 Year Ahead

1.18

1.41

1.67

1995 1996 1997 1998

Numb er of Analysts: 25 2527 22 22 20 20 19

Source: IBES, Monitor Analysis

1 Year Ahead

Expectations for Current Year (1 Year Ahead)

Expectations for Next Year (2 Years Ahead)

Actual Earnings Reported (Annual) 2 Years Ahead

8/10/2019 NIVRA_6_01

34/97


0.4

0.6

0.8

1.0

1.2

1.4

Jan-95

Mar-95

May-95

Jul-95

Sep-95

Nov-95

Jan-96

Mar-96

May-96

Jul-96

Sep-96

Nov-96

Jan-97

Mar-97

May-97

Jul-97

Sep-97

Nov-97

Jan-98

Mar-98

May-98

Jul-98

Coca-Cola Total Return to Shareholders Relative to the Market 19951998

Expectations RevisedDownward

. . . And Its Total Return to Shareholders Relative to the Market

Total Shareholder Return (TSR) Regression Results*

8/10/2019 NIVRA_6_01

35/97


Total Shareholder Return (TSR) Regression Results*

Traditional Performance Measures

Performance MeasureNumber of

ObservationsAdjusted R-

squared

Basic EPS (Scaled by Lagged Share Price) 2,522 4.5 %

Change in Basic EPS 2,522 5.1%

EVA (Scaled by Lagged Market Value) 2,182 0.3 %

Change in EVA 2,182 3.0 %

*The dependent variable for all regressions is market-adjusted TSR. Sample includes S&P 500 firms during 199298

Traditional performance metrics like EPS and EVAare very poor predictors of returns toshareholders

8/10/2019 NIVRA_6_01

36/97


Multiple Regression Results*

* S&P 500 firms during 199298. Sample has 2,390 observations

Variable RepresentingChanges in Analyst

Expectations

Regression Coefficients(T-Statistics in Parentheses)

Percent Change in AnalystForecasts of Current Year's

Earnings (EPS)

-0.01(-0.34)

Percent Change in AnalystForecasts of Next Year'sEarnings (EPS)

0.70(21.3)

Change in Analyst Forecastsof Long-Term (35 year)EPS Growth

8.6(12.9)

Adjusted-R2 41.6%

Expectations about currentearnings have no significant

impact on TSR

Expectations about next year andlong-term earnings havesignificant impact on TSR

Multiple regressions of market-adjusted total shareholder return (TSR) vs. changes inanalyst earnings (EPS) expectations indicate a strong correlation between expectations

and returns

Correlation is much higher thantraditional metrics (EPS, EVA)

8/10/2019 NIVRA_6_01

37/97


Two Examples

Actual ROIC 200x WACC

Business A 30% 10%

Business B 5% 10%

Market ExpectedROIC 200x

Managements RevisedExpectations 200x

Project X 40% 40%

Project Y 40% 20%

Which bus iness uni t did better?

Two pro jects are expected to earn 40% each and the co st of c apital is 10%

Should we invest?

8/10/2019 NIVRA_6_01

38/97


The Complete Picture

Value-Based Management:

Economic Profit = (ROIC-WACC) x Invested Capital

Expectations-Based Management:

EP = [Actual ROICExpected ROIC] x Invested Capital Work Core Assets Harder

[Actual WACCExpected WACC] x invested Capital Lower Cost of Capital

+ [ROICWACC] x [Actual ICExpected IC] Invest Profitably

8/10/2019 NIVRA_6_01

39/97


Integrated Framework for Expectations-Based Management

Operating ValueDrivers, e.g.,

Cycle time Customer

retention rate

Churn rate

Non-performingloan rate

Actual vs.Expected

Annual EconomicProfit

DCF ValueDrivesSummed

Over

Time

Shareholder Value~~

Used by all levels oforganization to setgoals and measure

performance; used forbenchmarking andsensitivity analysis

Measures short-termoverall performance

by business

Value and comparestrategies; measurelong-term trade-offs

Together, DCF, EP, and value drivers form an integrated framework for value creation. DCFis comprehensive, long-term based, EP is a comprehensive, short-term measure, and valuedrivers are specific, short-term measures

EBM

8/10/2019 NIVRA_6_01

40/97


Implications

Need to set expectations correctly with:

Analysts, and shareholders Internal management team

Need to exceed expectations to have TRS exceed cost of equity

Take all new investments that are expected to have ROIC > WACC

Avoid the expectations treadmill with a two part incentive design

TRS = Cost of equity

+ Unexpected company performance

+ Unexpected market movements

Total Compensation = Salary + Bonus

Salaryt = f (Financial Performance in year t-1)

Bonust = f (Exceeding Expectations for year t )

8/10/2019 NIVRA_6_01

41/97






8/10/2019 NIVRA_6_01

42/97


Source: Dixit and Pindyck in Investment Under Uncertainty, Princeton University Press, 1994

Simple Investment Decision Introduction

I l lustrat ive

Facts:

Investment outlay = $1,600

Once made, the investment is irreversible

Replacement expense equals depreciation

Perpetual level cash inflows

Price level = $200 now

50 / 50 chance of price changing to $300 or $100 in one year

The price will stay at its new level forever

Cost of capital = 10%

200

(1.1)t

NPV = -1600 +

= -1600 + 2200

= 600

t=0

Consider the net present value approach to the following simple investment. When theexpected cash flows are discounted at the cost of capital, the NPV is $600 and the decisionis to invest. However . . .

8/10/2019 NIVRA_6_01

43/97


. . . We have made an implicit assumption. We do not have to invest immediately, we candefer. If the project is deferred one year, it is possible to take advantage of priceinformation. We would invest only if the price goes up. Regardless of whether it goes upor down, the NPV with deferral is $733 today

-1600

1.1NPV = .5

t=1

300

(1.1)t+ + .5

-1600

1.1

t=1

100

(1.1)t+

-1600 + 3300

1.1= .5 + .5

-1600 + 1100

1.1

= .5 + .5 [0]1700

1.1

= = $733850

1.1

Conclusion: Since the NPV of deferring is $133 higher than investing immediately,we would choose to defer, even though the NPV of investing immediately is large and positive

Do not inv est i f

pr ice fal ls to

$100

The Investment Decision as a Deferral Option

8/10/2019 NIVRA_6_01

44/97


-1600

1.1NPV = .5

t=1

400

(1.1)t+ + .5

-1600

1.1

t=1

0

(1.1)t+

-1600 + 4400

1.1= .5 + .5

-1600 + 0

1.1

= .5 + .5 [0]2800

1.1

= = $1,2731400

1.1

Conclusion: The value of the deferral option goes up as there is greater uncertaintyPossible Macroeconomic Implication: Greater uncertainty in the economy (e.g., due to politicalunrest; uncertainty about taxes, interest rates or inflation) can cut investment because the deferraloption becomes more valuable

Do not inv est i f

pr ice fal ls to $0

The value of deferral is a call option that is exercised when the i r revers ib leinvestment isundertaken. The value of this option is affected by variance of prices (or costs), by the levelof prices, by the scale of investment, by the level (and variance) of interest rates, and by thelength of time that the deferral option lasts

Suppose the price in the previous example is equally likely to go to $400 or $0 (rather than $300 or$100)

The Value of a Deferral Option Increases with Variance

8/10/2019 NIVRA_6_01

45/97


In environments with high uncertainty and room for managerial flexibility investments willhave considerable option (strategic) value, which needs to be considered

An Option Definition

Is the right but not the obligation to take an action (at a cost, called the exerciseprice) for a predetermined period of time (called the maturity of the option).Options capture the element of flexibility in decision-making

Financial Option

The option is contingenton the uncertain value ofa financial security, e.g.,a CBOE call on a stock

Real Option

The option is contingenton the uncertain value ofa real asset, e.g., anirreversible investmentopportunity in a newproject

An option:

Management

Can Affect the

Value of the

Underly ing Real

Asset

A Side Bet

8/10/2019 NIVRA_6_01

46/97

8/10/2019 NIVRA_6_01

47/97


When is Managerial Flexibility Valuable?

Moderate

Flexibility Value

High

Flexibility Value

LowFlexibility Value

ModerateFlexibility Value

High

Low

Low HighLikelihood of Receiving New Information

Uncertainty

Roomfor

ManagerialFlexib

ility

Abilitytorespon

d

Flexibility Value Greatest When:

1. High uncertainty about the future Very likely to receive new

information over time2. High room for managerial flexibility

Allows management to respondappropriately to this newinformation

+

3. NPV without flexibility near zero If a project is neither obviously

good nor obviously bad, flexibilityto change course is more likely

to be used and therefore is morevaluable

Under these conditions, the differencebetween ROA and other decision toolsis substantial

In every scenario flexibility value is greatest when theprojects value without flexibility is close to break even

The flexibility value comes from the ability to respond to information that may be received inthe future. The greater the likelihood that this new future information will elicit a managerialresponse and alter the course of a project, the more value the option will have

8/10/2019 NIVRA_6_01

48/97


To

Applicability Progress to Date

The complication is that although real options are valuable, up to now option valuation hasbeen an esoteric subject accessible only to those trained in stochastic calculus and otheradvanced mathematics. Recent advances in theory and technology, however, haveallowed us to implement option pricing capability in simple algebraic formulas in Excelspreadsheets. Moreover, we can now handle more complicated situations when there aremultiple sources of uncertainty that are not necessarily traded world commodities

From

Source of uncertainty not necessarilymarket priced

Algebra and Excel spreadsheets

Multiple sources of uncertainty(rainbow options)

Options on options (compound options,learning options)

Many applications

Uncertainty driven by world commodityproduct

Higher mathematics necessary forapplication

Single source of uncertainty

Simple options

Limited application

American Call Deferral Option

8/10/2019 NIVRA_6_01

49/97


p

Coal Lease Valuation

This first example is a simple deferral option on the development of a coal lease for up tofive years after the lease was acquired

Comments

Single source of uncertainty price of coal

NPV approach ignored flexibility

Option was particularly valuablebecause it was near-the-money*(options on deep in-the-moneysituations are not worth muchbecause you invest immediately)

$116

$72

$59

0

25

50

75

100

125

NPV Valuation (No

Flexibility)

Successful Bid Option Value with

Deferral

Dollars(Millions)

$57

* The price of coal was close to the cost of extraction

American Put Cancelable Operating Lease

8/10/2019 NIVRA_6_01

50/97


It was possible to value cancelable operating leases because there is a relatively activemarket in second hand aircraft

Comments

Single source of uncertainty price of second hand aircraft

Option value significantly underestimated by management

Leasing strategy changed

19%3%

16%

0%

5%

10%

15%

20%

25%

Pre-Delivery

Put Option

Walk-Away

Option

Total

Percent ofEnginePrice

83%25%

58%

0%

30%

60%

90%

Pre-Delivery

Put Option

Walk-Away

Option

Total

Wide-Body Aircraft Narrow Body Aircraft

p g

The Value of Cancelable Operating Leases on Aircraft

Percent ofEnginePrice

Switching Option

8/10/2019 NIVRA_6_01

51/97


g

The Value of Switching Options in Mining

Switching options apply to any situation where it is possible to shut down then reopen anoperation

Comments

Study provided insight into whento open up and shut downoperations

Single source of uncertainty

Value depended on the quantityof mineral in the ground,extraction costs, and the fixedcost of startup or shutdown, inaddition to the usual list ofvariables

Flexibility

ValueDollars

(Millions)

$1,160

$710

$447

0

500

1,000

1,500

Initial NPV Estimate Scenario Based

NPV

Total

Switching Option

8/10/2019 NIVRA_6_01

52/97


Despite the strong growth, consumer PC assembly players have found their marketparticipation to be mostly dissatisfying as they are not earning their cost of capital

-2.3%

-1.5%

8.2%

11.0%

12.5%

-6.0%

-10% 0% 10% 20%

Consumer PC

Assembly

Automobiles

Consumer

Electronics

Sports Shoes

Commercial IT

Beverages

Consumer Markets

Exit and Reentry Decision

Source: Analyst Reports; Annual Statements

-7.0%

-4.1%

-2.0%

29.7%

-11.0%

-20% 0% 20% 40%

Packard Bell

Apple

Compaq

Acer

Gateway

Consumer PC Assembly

Spread: ROICWACC Spread: ROICWACC

8/10/2019 NIVRA_6_01

53/97


ROA Gives Different Decisions Than NPV and Economic Profit

Scenario ROV NPVEconomic Profit(WACC = 13.7%)

In Operation, Gross Margin = 13% Continue Continue Exit (ROIC = 7.6%)

In Operation, Gross Margin = 11% Continue Exit Exit (ROIC = 5.6%)

Not in Operation Dont Enter Dont Enter Dont Enter (ROIC = 7.6%)

Traditional valuation techniques give mixed decisions about whether the unprofitableplayers should immediately exit the business. However, ROA suggests that players shouldstay in the market and exit only if conditions do not improve

Valuation Methodologies

8/10/2019 NIVRA_6_01

54/97


ROA Gives Different Values* of Staying in Business than NPV and EP

Gross Operating Margin

ROA

NPV + FlexibilityValue

NPV

(Cash Flows)

Economic Profit

(Short Term)

(ROICWACC) x IC

15% $2.98 $2.62 $0.05

13% $1.71 $1.02 -$0.07**

11% $0.79 -$0.59 -$0.09

9% $0.36 -$1.79 -$0.11

ROA gives significantly different value to the business than EP and NPV approaches(1997, $Billions)

Valuation Methodologies

* Assume a volatility of 16% annually for the gross operating margin (GOM)** ROIC before taxes = 7.6%, tax rate = 30%, WACC = 13.7%, invested capital is 26% of sales of $3.6 billion

Compound Option Multiphase investment

8/10/2019 NIVRA_6_01

55/97


Today (year 0), management does not need to commit to the entire project; it can simplybegin the design process (at a cost of $50 million) and learn more about the operatingspread uncertainty. Six months later, management has a similar option, to begin the pre-construction process without a full commitment and learn more about the uncertainties. Atthe end of the year, management no longer has the flexibility to learn more about theuncertainty and must choose between a full commitment or abandonment

Year 0 Six Months End of Year 1

Decision Node

Invest $50 million for designprocess only

Full commitment no flexibility

Abandon no flexibility

Invest $200 million only to start

pre-construction work

Full commitment no flexibility

Abandon no flexibility

Full commitment invest $400

million

Abandon

Uncertainty evolves but wecannot react

Eliminated managerialflexibility, and thereforedestroyed option value

Uncertainty evolves but wecannot react

Eliminated managerialflexibility, and thereforedestroyed option value

The Value of Compound Options in Plant Construction

8/10/2019 NIVRA_6_01

56/97


The Source of Uncertainty

0

200

400

600

800

1,000

1,200

1,400

1Q79 4Q79 2Q81 1Q81 1Q82 3Q83 2Q84 1Q85 4Q85 3Q86 2Q87 1Q88 4Q88 3Q89 2Q90 1Q91 4Q91 3Q92 2Q93 1Q94 4Q94 3Q95 2Q96 4Q96

Operating Spread = Output Price / TonInput

At first there seems to be two sources of uncertainty: the price of the output per ton, andthe cost of the input per ton. However, these can be combined into a single source ofuncertainty, the operating spread

Estimated Data

Output Price

Input Price

Price History First Quarter 1979 to Fourth Quarter 1996

8/10/2019 NIVRA_6_01

57/97


Summary Phased Investment

$ Millions

The traditional NPV approach dramatically undervalues this investment since it does notconsider the value of flexibility. Since this is a multi-staged investment, management hasthe flexibility to re-evaluate the project at each stage and refine their strategy based on newinformation. A full commitment (to either accept or abandon) eliminates managerialflexibility and destroys the option (flexibility) value

-$71.2

$354.5

$425.7

NPV Valuation: No

Flexibility

Flexibility Value Total Value (ROA)

Compound Rainbow Option

8/10/2019 NIVRA_6_01

58/97


Planned

Abandon

Planned + 50%

Planned

Abandon

The decision tree below shows a stylized version of the decision to develop a large energyresource. There were two sources of uncertainty, the price of energy and the amount ofresource in the ground, and there were compound options

Illustrative

* Simplified for illustrative purposes** Capacity planned before ROA analysis

11

11

11

11

11

11

Assumed decision nodes

Initial capacity decision

Year 3 initial capacity decision

Year 11 capacity addition decision

Exploration decision

Event nodes (uncertain outcomes) Prices go up or down? Reserves in existing fields are

higher or lower than EV? Resource quantity found in 4

add-on fields worth developing ornot?

1

3

11

E

OPM Cases

Capacity lock-in

Defer capacity decision and exploration

Defer capacity decision / explore today

1

2

3

Planned capacity

50% of planned capacity

Abandon

Planned capacity

50% of planned capacity

Abandon

11

11

11

1

Planned capacity** plus 50%

Planned capacity*

Abandon

Planned capacity**+ 50%

Planned

Abandon

Planned + 50%11

11

11

E

$ High

2

2

2

$ Low

Explore

EHow much to invest in

exploration during Year 1

through Year 3?

What capacity tolock-in in Year 3?

Do not explore inthe near term

95

What capacitylevel to lockinto today?

Lock incapacitynow1

3

Defercapacity

decision

Explore in the interim?(Year 1-Year 3)

Lock in capacitytoday or deferdecision until Year 3?

Add capacityin Year 11?

2

Exploration and Development

8/10/2019 NIVRA_6_01

59/97


OPM Case

A.

Initial CapacityDecision

B.

ExplorationDecision

C.

Add-on CapacityDecision

No-options base case

Capacity

"lock-in"

Year 6

Defer capacitydecision andexploration

Year 3 Year 6

Defer capacitydecision /explore today

Year 3

ROA Model Valuation Results*

The optimal solution provided more than twice the value and was completely different fromthe clients base case

225

200

150

100

0 100 200

Total Project Value Estimates**

Normalized Currency Units

* Throughout the document the results have been normalized and rounded off to provide general insights while maintaining client confidentiality** For comparison purposes and because of lack of information, each of the 4 cases assume a Year 1 exploration cost equal to 0; if best-guess exploration

cost of estimates of 40 is used, the NPV for the 3 option cases are 120, 175, and 185, respectively Analogous to traditional DCF case (i.e., assumes deterministic inputs and no managerial flexibility)

1

2

3

+Value of reservesize information

Value of priceinformation

Value of Better capacity

lock in decision Exploration option Expansion option

Today(plannedcapacity)

Today(No exploration)

Today(No exploration)

Today (planned

capacity +50%)

TodayExplore

Most attractive operating plan

Year 11

Year 11

Year 11

8/10/2019 NIVRA_6_01

60/97


Classic Questions and Their Answers

1. Option values are contingent on the current value and the expected volatility of the

underlying security or asset. If one holds a call option on a share of stock, the marketprice is observable and we can estimate the expected volatility. But a real option iscontingent on an asset that is not traded in a capital market (e.g., a cure for baldness).What do we do?Marketed Asset Disclaimer (MAD): We assume that the present value of the assetwithout flexibility is the same as the market price for which the underlying asset (withoutflexibility) can be bought or sold

2. Lattices (Binomial tress in particular) are a discrete approach to modeling the Gauss-Wiener continuous scholastic process that Black-Scholes assumed for the underlyingsecurity when they derived the closed-form solution For European call options. But,project cash flows do not follow, or even roughly approximate a regularized binomiallatticeProperly Anticipated Process Fluctuate Randomly (PAP): Paul Samuelson provedthat the bid of any pattern of the future cash flows contains all expectations andtherefore moves randomly through time (obeying a Gauss-Wiener Process), deviatingonly with unexpected changes in the problem of cash flows

8/10/2019 NIVRA_6_01

61/97


-20-10

20

10

3020

10

20

40

A Four-Step Process

Free Cash Flows

PV Free CashFlow

Year

0 1 2 3 4 5 6 7 8

PV

Value

Year

Cash In

Cash Out

Free Cash Flows1 2 . . . . . . 10 CV

Price

Quantity

Variable Cost

Interest Rates

The Year Spread Sheet

Evolution of

Project Value

Value (t = 1) n (V1/ V0) =r

Monte CarloSimulation

V0

uV

dV

u2V

duV

d2V

u3V

u2dV

d2uV

d3V

Event Tree(Sans

Dividends)

Step One

Complete the base case present value

(without flexibility) based on Expected future free cash flows

Cost of capital based oncomparables

Step Two

Estimate the volatility of the value ofthe project in order to derive thevolatility of the rate of return

A Monte Carlo approach cancombine many uncertainties

The volatility of the drivers ofuncertainty may be estimated frominternal data or from subjectiveestimates made by management

The output is a binomial lattice in value

Note that the expected value of the project

evolves through time as shown in the figureto the right

udeu /1, ==

s

T

WACC = 10%

8/10/2019 NIVRA_6_01

62/97


Four Step Process (cont.)

Go, Stop

Expand, Abandon

Expand, Abandon

Expand, Contract

Expand, Contract

Expand, Abandon

ROA0Go

ROA2Expand

ROA1Abandon ROA2

Abandon

ROA1Go

ROA2Go

Step Three

Put decisions into the nodes of theevent tree

Can have multiple decisions pernode

Payouts may include cash flows asdividends

Step Four

Work backward in the tree (unlessthere is path dependency) to obtainvalues at each node and to makeoptimal decisions

Use no arbitrage condition to

conform to law of one price Output is the value of the project

with flexibility and decision rules

Project Analysis

8/10/2019 NIVRA_6_01

63/97


Overall Approach A Four Step Process

Objectives

Comments

Compute base casepresent value withoutflexibility at t = 0

Value the total projectusing a simple algebraicmethodology

Identify majoruncertainties in eachstage

Understand how those

uncertainties affect the PV

Analyze the event treeto identify andincorporatemanagerial flexibility to

respond to newinformation

Still no flexibility; thisvalue should equal thevalue from Step 1

Explicitly estimateuncertainty

Incorporating flexibilitytransforms event trees,which transforms theminto decision trees

The flexibilitycontinuously alters the

risk characteristics ofthe project, and hencethe cost of capital

ROA includes the basecase present value withoutflexibility plus the option(flexibility) value Under high uncertainty

and managerial

flexibility option valuewill be substantial

Steps

Output Projects PV withoutflexibility

Detailed event treecapturing the possiblepresent values of theproject

A detailed scenario treecombining possibleevents andmanagementresponses

ROA of the project andoptimal contingent plan forthe available real options

Model the

UncertaintyUsing Event Trees

Identify and

Incorporate ManagerialFlexibilities Creating a

Decision Tree

Calculate RealOption Value (ROA)

Compute Base Case

Present Value withoutFlexibility Using DCF

Valuation Model

8/10/2019 NIVRA_6_01

64/97


Step 4 Valuation Using the No Arbitrage Condition

Using the traded twin security we can value our project in year 0 using either the traditional cost ofcapital approach, or the replicating portfolio method. Under the cost of capital approach we calculate theexpected rate of return using the twin and then discount the cash flows from our project at this rate*.

Alternatively, we can calculate how many shares (N) of the twin security would replicate the cash flow ofour project** in any state, and calculate the value of those shares in year 0 (N shares x price / share).These two methods will yield the same result since the cost of capital approach is essentially a shortcutfor the replicating portfolio method***

* Since the twin security is a traded security with the same risk characteristics as our project (by definition), its required rate of return (discount rate)must be equal to the discount rate on our project. CAPM simply generalizes this by claiming all securities with the same Beta (systematic risk) willhave the same cost of capital (if all equity financing); therefore, identifying a securitys Beta is equivalent to finding a priced twin security

** Typically the replicating portfolio will be a leveraged position that will also entail borrowing*** Since the project and this portfolio provide the same future returns, to avoid risk-free arbitrage they must have the same value in year 0

Year 0

TwinSecurity

OurProject

P0= 20 V0= ?

Year 1

Twin

Security

Our

Project

$34 $170

Twin

Security

Our

Project

$13 $65

Calculating V0

Method 1:

Cost of Capital Approach

Method 2:

Replicating Portfolio**

1. Calculate cost of capitalusing twin security

20 = (0.5)(34)+(0.5)(13)1+k

k = 17.5%

2. Discount expected cashflows

V0= (0.5)(170)+(0.5)(65)1.175

V0= 100

1. Replicating cash flowsof our security using aportfolio of twin andborrowing in year 1

34N + B = 170

13N + B = 65

N = 5; B = 0

2. Value of this portfolio inyear 0

V0= 20N + B

V0= 100

NPV / DCF V l i Fl ibili N V l d

8/10/2019 NIVRA_6_01

65/97


NPV / DCF Valuation Flexibility Not Valued

* [(0.5) (170) + (0.5) (65)] / 1.175 = 100** 115 / 1.08 = 106.48: The investment is discounted at the risk-free rate because the decision to invest was made in Year 0

Using the NPV / DCF methodology, this project would be rejected since it has a negativeNPV of -$6.5

100

-106.5

-6.5

Present Value ofCash Flows*

Present Value ofInvestments**

NPV

Decision

Made inYear 0

Cash Flows

170

65

Investment

-115

-115

Value in Year 0 Decision

Do NotInvest

Since the decision toinvest was made in Year 0,

we are bound into anegative NPV project in the

unfavorable state

Year 0 Year 1

R l O ti A l i Fl ibilit V l d ( t )

8/10/2019 NIVRA_6_01

66/97


Real Option Analysis Flexibility Valued (cont.)

* To see derivation of this column see Decision Tree Analysis chart** See NPV / DCF valuation Total value less NPV; this could be valued separately 2.62 shares X $20 / share -$31.43 = $20.95

27.4

-6.5

20.9

NPV** Flexibi li ty

Value

Total Value

DecisionDeferred

UntilYear 1

55

0

Invest;Based onFlexibility

Value

Value of N shares @$34 / share

Value of loan (B)34N+B(1+rf)=55

Value of N shares @$13 / Share

Value of loan(B)13N+B(1+rf )=0

NetCFs*

CFs Replicated UsingN Shares of Twin

Security and Borrowing

ReplicatingPortfolio in

Year 0

Year 0 Year 1

The ROA approach values the total project, with flexibility, at $20.95 ($2.54 less than theDTA value). Since the ROA method is calculated using replicating portfolios, this must bethe correct value otherwise there would be arbitrage opportunities


Buy 2.62shares @$20 /share

Borrow$31.43

Value =20.95

R l O ti A l i Fl ibilit V l d

8/10/2019 NIVRA_6_01

67/97


Real Option Analysis Flexibility Valued

* To see derivation of this column see Decision Tree Analysis chart** See NPV / DCF valuation Total value less NPV; this could be valued separately 0.52 shares X $100 / share -$31.42 = $20.95

27.4

-6.5

20.9

NPV** Flexibil ity

Value

Total Value

DecisionDeferred

UntilYear 1

55

0

Invest;Based onFlexibility

Value

Value of N shares @$170 share

Value of loan (B)170N+B(1+rf)=55

Value of N shares @$65 / Share

Value of loan(B)

65N+B(1+rf )=0

NetCFs*

CFs Replicated UsingN Shares of PV Type

(without flexibility)and Borrowing

ReplicatingPortfolio in

Year 0

Year 0 Year 1

Rather than searching for a fictitious twin security we use the present value of the project

itself, without flexibility, as the underlying risky asset. What is better correlated with theproject that the project itself? We call this the Marketed Asset Disclaimer (MAD)


Buy0.524shares@ $100 /share

Borrow$31.53

Value =

20.95

M k t d A t Di l i A ti

8/10/2019 NIVRA_6_01

68/97


Marketed Asset Disclaimer Assumption

Both the replicating portfolio approach and the risk-adjusted method (as we will apply themin this section) rely heavily on the Marketed Asset Disclaimer assumption

Both the replicated portfolio approach and the risk-adjusted method rely on our abilityto buy shares of the base case present value (without flexibility) when creating thereplicating portfolios. If the present value is traded (as in the case of a stock) this willnot be a problem; however when the present value is not explicitly traded (as willusually be the case with real options) our ability to build the replicating portfoliobecomes dubious

The Marketed Asset Disclaimer assumption implies that we assume that even if thebase case present value is not marketed we can still build the replicating portfolios,because if it were marketed, the value we calculated (with our DCF model) would beapproximately equal to the publicly traded market value (if it existed); therefore thereplicating portfolio approach (and equivalently the risk-adjusted method) would stillproduce the correct value

There are other approaches in the academic literature, however, noted academicsSteve Ross and Eduardo Schwartz support the Marketed Asset Disclaimer method

Th C t C t f C it l

8/10/2019 NIVRA_6_01

69/97


20.9 = (0.5)(55)+(0.5)(0)

1+k

k = 31.9%

The original cost of capitalwas 17.5%

The Correct Cost of Capital

The cost of capital, as calculated from correct ROA value is 31.9%. Since this differs fromthe original cost of capital for the project without flexibility (17.5%), flexibility has thereforealtered the projects riskiness

* To see derivation this column see Decision Tree Analysis chart

Net CFs*

55

0

Cost of CapitalYear 0 Year 1

Value20.9

Step 3 Decision Trees

Initial Conditions (No Fle ibilit ) E ent Tree for Underl ing Asset

8/10/2019 NIVRA_6_01

70/97


Initial Conditions (No Flexibility) Event Tree for Underlying Asset

Assumptions

Risk-free rate of 5%

WACC of 12% Initial investment of $105MM

Five year time frame (analyzing one periodper year)

Underlying Asset

A factory with a (no flexibility) present value of$100MM

The standard deviation of the rate of change of thefactory value (volatility) is 15%

No Flexibility (NPV)

($5MM) = $100MM$105MM

212

182

157 157

135 135

116 116 116

100 100 100

86 86 86

74 74

64 64

55

47

t=0 t=1 t=2 t=3 t=4 t=5

Value =

Investment = -105

-5NPV

Value-basedEvent Tree

Step 3: Real Options Calculations Examples

Option to Expand

8/10/2019 NIVRA_6_01

71/97


Option to Expand

Management has the right to expand the scale and the value of the factory by 20% at anypoint in time by investing an additional $15MM

239

204

175 173149 148

127 126 124

108 107 106

91 90 88

77 75

65 6455

47

t=0 t=1 t=2 t=3 t=4 t=5

Underlying Asset ValuesPV+ = 86

PV- = 64PV = 74

Managerial Decisions (t=4,5)88 = Max (86, 86*1.2-15)64 = Max (64, 64*1.2-15)75 = Max (75, 74*1.2-15)

Portfolio Replicationn = (88 - 64) / (86 - 64)

B = [88 - n (86) ] / (1+5%)n = 1.1, B = -5.54

Value of Option (ROA at t=4)ROA = n (74) + BROA = 75

Note: In this case management will never exercise its option prior to the five year expiration date. In general, a call option on a non-dividend paying asset

will never be exercised early

= Decision to Expand


Option to Abandon

8/10/2019 NIVRA_6_01

72/97


Option to Abandon

At any point in time management has the option to abandon the factory. Abandonmentwill yield a salvage value of $100MM

212

182

157 157135 135

118 118 116

106 106 105

100 100 100

100 100

100 100100

100

t=0 t=1 t=2 t=3 t=4 t=5

Underlying Asset ValuesPV+ = 116PV- = 86

PV = 100

Managerial Decisions (t=4,5)116 = Max (116, 100)

86 = Max (86, 100)105 = Max (105, 100)

Portfolio Replicationn = (116 - 100) / (116 - 86)

B = [116 - n (116) ] / (1+5%)n = 0.5, B = 51.5


= Decision to Abandon

212

182

157 157135 135

118 118 116

106 106 105

100 100 100

100 100

100 100100

100

t=0 t=1 t=2 t=3 t=4 t=5


Option to Contract

8/10/2019 NIVRA_6_01

73/97


Option to Contract

At any point in time management has the option to decrease the scale and the value of thefactory by 25%, generating savings of $25MM

212

182

157 157135 135

117 117 116

102 101 101

90 90 90

81 81

73 7366

60

t=0 t=1 t=2 t=3 t=4 t=5

Underlying Asset ValuesPV+ = 116PV- = 86

PV = 100

Managerial Decisions (t=4,5)116 = Max (116, 116*0.75+25)90 = Max (86, 86*0.75+25)101 = Max (101, 100*0.75+25)

Portfolio Replicationn = (116 - 90) / (116 - 86)B = [116 - n (116) ] / (1+5%)n = 0.87, B = 14.4


= Decision to Contract


Option to Expand Contract or Abandon

8/10/2019 NIVRA_6_01

74/97


239

204

175 173150 148

129 127 124

113 112 110

102 101 100

100 100

100 100100

100

t=0 t=1 t=2 t=3 t=4 t=5

Underlying Asset ValuesPV+ = 116PV- = 86PV = 100

Managerial Decisions (t=4,5)124 = Max (116, 116*0.75+25,

116*1.2-15, 100)100 = Max (86, 86*0.75+25,

86*1.2-15, 100 )110 = Max (110, 100*0.75+25,

100*1.2-15, 100)

Portfolio Replicationn = (124 - 100) / (116 - 86)B = [124 - n (116) ] / (1+5%)n = 0.8, B = 29.7


= Decision to Contract

= Decision to Abandon

= Decision to Expand

Option to Expand, Contract or Abandon

At any point in time management has several options available:

Expand the scale and the value of the factory by 20% by investing an additional $15MM

Decrease the scale and the value of the factory by 25%, generating savings of $25MM Abandon the factory with a salvage value of $100MM

Step 2 Modeling Uncertainties and Building the Event Tree

8/10/2019 NIVRA_6_01

75/97


For the time being, assume that the uncertainties all move continuously through time andremember that the annualized volatility (we need to calculate is the volatility of the percentvalue which is usually hard to observe. Several factors combine to convert the uncertainty

of the real market prices, quantities, and costs that feed into the company to the equityuncertainty that is manifested in the financial markets

Price

Quantity

Cost

OperatingLeverage

Diversification

FinancialLeverage

RealMarkets

Data

Project Uncertainties Asset Uncertainties

EquityUncertainty

FinancialMarkets

Data

Not directly observable

Step 2 Modeling Uncertainties and Building the Event Tree

8/10/2019 NIVRA_6_01

76/97


The base-case present value without flexibility for the investment is estimated a thousandtimes to generate the standard deviation of the rate of return

Valuation ModelDCF

Net present valuefor the investment

Valuation Inputs

Revenue growth rates

Margin assumptions

Capital expenditures

U

d

eU T

1=

= s

Monte Carlo

Random Number

Generator

rVVn =

0

1

s based on r

Calculating Volatility Direct From Historic Market Data

8/10/2019 NIVRA_6_01

77/97


Calculating Volatility Direct From Historic Market Data

If we have historical market data we can calculate the volatility of present value directly

Transforminto NaturalLogs

CalculateVariance

ComputeGrowthRate

Jan 89:

Annualize

var t

Convert

intoVolatility (v)

SQRT (VAR)( )

Date ValueGrowthRate

LN (GrowthRate)

Variance VolatilityAnnualize

Example:

Comments:

Feb 89:

Mar 89:

April 89:

2

4

3

5

G1=4/2

G2=3/4

G3=5/3

Ln4-ln2= .69

Ln3-ln4= -.29

Ln5-ln3= .51

.27.27

1/12= 3.26 SQRT (3.26) = 1.81

t is based on the time series data; in this example t = 1/12 since the data is monthly

Once we know the annualized volatility, we can use a different t in the building the tree

Get Time SeriesData

Calculating Volatility from Management Estimates

8/10/2019 NIVRA_6_01

78/97


Calculating Volatility from Management Estimates

What is the 95% confidence level in year 5?

$

100

20

o

r

o

o

lower

i

P

Pn

lr

ePP

P

pr

6

6

2

=

=

=

s

Expected

Keeping Uncertainties Separate

8/10/2019 NIVRA_6_01

79/97


Keeping Uncertainties Separate

When technological uncertainty evolves discontinuously and other uncertainties evolvecontinuously, we use a quadrarial approach

TechGood

TechBad

TechGood

TechBad

Tech

Average

Market Up

Market Down

Market Up

Market Down

Market Up

Market Down

Market Up

Market Down

Market Up

Market Down

Portes Case Situation

8/10/2019 NIVRA_6_01

80/97


Portes Case Situation

1. Portes founded 10 years ago, 60 employees, CEO Diane Mullins

2. Slow growth of profitable systems recovery product, Recovery

3. New high-end data recovery software can be sold over the Internet

4. Bill, the CFO, finds that selling in France The Portes Project via the Internet, has a negative NPV. Monte Carlo analysisdoesnt help [see table 1 for the analysis]

Sales of 200 programs in year 1, doubles to 400 in 5 years

Unit price starts at $30,000 and falls to $20,000 in 5 years

COGS is $9,000 per program in year 1 and falls to $7,000 in 6th year

Fixed cost $20,000 per year SG&A? is 10% of revenue

Initial investment is $35 million, depreciated over 10 years

No debt

40% tax rate

13% cost of capital

Beyond year 10, FCF grows at 4%, and ROIC 12%

5. Risk estimates, in 6th year

Unit sales, expected level is 400 programs and the lower 95% confidence limit is 190

Unit price, expected level is $20,000 and the lower 95% confidence limit is $25,000

6. Flexibility in decision-making

Expansion (prevent loss product), invest $10.5 million and increase value 30%

Abandonment value is $15 million

Table 1

NPV Analysis of the Investment Proposal

8/10/2019 NIVRA_6_01

81/97


NPV Analysis of the Investment Proposal

Item Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Quantity (units) 200 230 264 303 348 400

Continuous Annual Growth Rate 13.9%

Price per unit 30.00 27.66 25.51 23.52 21.69 20.00

Continuous Annual Growth Rate -8.1%

Cost per unit 9.0 8.6 8.1 7.7 7.4 7.0

Revenues 6,000 6,355 6,732 7,130 7,553 8,000

Cost of Goods Sold 1,800 1,966 2,148 2,346 2,563 2,800

Gross Income 4,200 4,389 4,584 4,784 4,990 5,200

Gross Margin% 70% 69% 68% 67% 66% 65%

Rent 200 200 200 200 200 200

S&A expenses 600 636 673 713 755 800

EBITDA 3,400 3,554 3,711 3,871 4,034 4,200

Depreciation 3,500 3,500 3,500 3,500 3,500 3,500

EBIT (100) 54 211 371 534 700

EBIT Growth -154% 294% 76% 44% 31%

Taxes 0 21 84 148 214 280

Net Income (100) 32 126 223 321 420

Depreciation 3,500 3,500 3,500 3,500 3,500 3,500

Initial Investment 35,000

Free Cash Flow (35,000) 3,400 3,532 3,626 3,723 3,821 3,920Change in FCF 4% 3% 3% 3% 3%

Continuous Value 50,960

Discount Rate 13%

PV 34,681 36,096 37,575 39,165 40,880 42,735 44,748

TPV (319) 39,496 41,107 42,792 44,603 46,555 48,668FCF as a % of PV 8.6% 8.6% 8.5% 8.3% 8.2% 8.05%

Outputs of the Initial NPV Analysis

8/10/2019 NIVRA_6_01

82/97


Outputs of the Initial NPV Analysis

The free cash flow of the project has the usual profile with a significant initial investmentfollowed by a small positive cash inflows and a considerable terminal value

Free Cash Flows

Dollars($ 000)

-40

-30

-20

-10

0

10

20

30

40

50

60

1 2 3 4 5 6 7

Continuous Value

Investment

Depreciation

Net Income

Year

Inputs for the Monte Carlo Simulation: Price per Unit

8/10/2019 NIVRA_6_01

83/97


Inputs for the Monte Carlo Simulation: Price per Unit

Price Uncertainty Range (95% confidence interval)

30

27.6

25.3

23.3

21.4

20.0

3031.5

30.629.4

28.1

30.0

24.3

21.3

18.816.8

15.0

26.7

10

20

30

40

1 2 3 4 5 6Year

$ Price

per Unit

Expected Price

Upper Range

Lower Range

Minimum Price per unit in year 6 15

With 95% Confidence

EC

A

D

B

We will obtain the management estimate of the price volatilities indirectly by asking them:"In the NPV analysis we expect the price at year six to be 20. We all understand that thisis an average estimate. We need to ascertain, with 95% confidence, your estimate of how

low the actual price can fall at year six."

T

P

PLnr

lowerT

n

ii

2

01

==

s

We assume that the sales willfollow a Geometric BrownianProcess

Using the floor estimate for theyear six we can find the annualprice volatility and use it in theMonte Carlo simulation

2030

%)11.8(5

16 === eePP

Tr

%43.652

30

15%)1.8(*5

=

=

Ln

s

Inputs for the Monte Carlo Simulation: Units Sold

8/10/2019 NIVRA_6_01

84/97


puts o t e o te Ca o S u at o U ts So d

Units Sold: Uncertainty Range (95% confidence interval)

200

229 264300

348400

200

320.5

422.6

539.6

677.7

200 164.7 164.8 170.3 178.9 190.0

842.1

0

100

200

300

400

500

600

700

800

900

1 2 3 4 5 6

Year

Numberof Units

Expected Quantity

Up Range

Low Range

Minimum Sales Quantity in year 6 190

With 95% Confidence

E

C

A

BD

To obtain management's estimate of the sale quantity volatility we ask a similar question:"Given that the expected average sales for year six is 400, what is the level where we canexpect with 95% confidence that the actual sales will be higher?"

T

P

PLnr

lowerT

n

ii

2

01

=

=s

400200 86.13*5

16 === eeQQ

Tr

We assume that the sales willfollow a Geometric BrownianProcess

Using the floor estimate for theyear six we can find the annualsales volatility and use it in theMonte Carlo simulation

65.1652

200

19086.13*5

=

=

Ln

s

Output of the Monte Carlo Simulation: Volatility of the Projects Value

8/10/2019 NIVRA_6_01

85/97


p y j

Frequency Chart

.000

.009

.018

.026

.035

0

8.75

17.5

26.25

35

-7 5% -3 1% 13 % 56 % 10 0%

1,000 Trials 4 Outliers

Forecast: Expected Annual Return

Now we can complete the whole Monte Carlo simulation, and run the uncertainties throughthe NPV model to get an estimate for the volatility of the project's value.

For 1000 trials the distribution of the rate of return approximates normal distribution with amean value of 12%. The volatility (standard deviation) of the rate of return is 30%

Event Tree for the Present Value of the Project Without Flexibility

8/10/2019 NIVRA_6_01

86/97


j y

Having combined management estimates of uncertainty about price and quantity into asingle uncertainty of the value of the project, we can build a value-based event tree.

Adding back the initial $35 million investment yields the present value of the project atnode A, namely $34.681 million

PV Uncertainty Tree

34,681

39,49636,096

48,725

44,538

60,120

55,025

74,277

68,077

91,895

84,354

113,865

104,694

26,741

24,443

32,99530,199

40,76437,362

50,433

46,294

62,491

57,457

18,10816,573

22,37220,505

27,678

25,407

34,29631,533

12,27811,253

15,19013,944

18,82217,306

8,3377,65210,3309,498

39,49636,096

26,741

24,443

18,10816,573

12,27811,2538,3377,652

5,6695,212

(319)

-$20,000

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

0 1 2 3 4 5 6 7

A B

C

D

E

F

G

HI

J

We have assumed that uncertainty evolves from year 1. Alternately, one

could assume that it starts immediately and that there are two branches ratherthan one.

K

L

M

N

O

44,748

Expected Present Value

PV Uncertainty Tree

Free Cash Flows Corresponding to the Project without Flexibility

8/10/2019 NIVRA_6_01

87/97


p g j y

Free Cash Flow

3,400

2,298

1,535

1,025684

457

4,187

2,796

1,867

1,247

832

5,095

3,402

2,271

1,516

6,199

4,139

2,762

7,541

5,033

3,400

4,187

5,095

6,199

7,541

9,171

2,298

2,796

3,402

4,139

5,033

1,5351,867

2,271

2,762

1,025 1,247

1,516

684 832

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

0 1 2 3 4 5 6 7

Year

$

From the event tree we can derive the possible Free Cash Flows for each of the scenariosthe project may follow

Free Cash Flow

Real Option to Expand

8/10/2019 NIVRA_6_01

88/97


p p

PresentValue

CashFlow

Illustrative

Year 2000

Option to Expand Description: Introduction of the new

product PreventLoss to the French market

Time-horizon: Within the next six years

Benefit: Increase the operations and thepresent value by 30%

Additional Investment: Estimated at$10.5 million

Optimal Execution: The expansionshould take place only if the increase ofthe projects present value is larger than

the expected additional investment

$MM

Real Option to Abandon

8/10/2019 NIVRA_6_01

89/97


Year 2000

PresentValue

CashFlow

Illustrative

Option to Abandon Description: Opportunity to stop baring

additional losses and close the operation

Time-horizon: Within the next six years

Benefit: Stop a negative cash flow andre-deploy resources. Sell the hardware for$15 million

Additional Investment: Closing of theFrench operation and redirecting theresources is not expected to requireadditional investment

Optimal Execution: The operation shouldbe abandon when its present value turnsbelow $15 million

$MM

Real Options Calculations for a Final Node of the Event Tree

8/10/2019 NIVRA_6_01

90/97


134,774

106,701 125,602

84,200 99,160

69,22866,12878,001

53,821 64,19452,270 61,033

42,407 49,682

34,296

42,121 48,083

34,34939,005

27,678 31,533

38,721

28,684 31,553

23,568 25,407

18,822

26,386

20,866 21,701

17,756 17,30619,332

16,949 16,510

15,832

15,924

15,684 15,000

15,000

15,45715,000

1 2 3 54 6

We start at the end of the tree and analyze the optimal execution of the two options ateach final node

Real Options Calculations for a Final Node of the Event Tree (cont.)

8/10/2019 NIVRA_6_01

91/97


The repl ication pro cess starts from the end of the PV tree and mov es backwards

The maximum value of the project af ter paying out f ree cash f low is the maximum o f i ts int r ins ic value and

the values of the expansion o r abandonm ent opt ions

The total PV of a project at this poin t is the maximum present value plus the free cash f low

)000,15/602,125/694,104(602,125

000,15/500,10%)301(*694,104/694,104

Max

MaxMaxValue

=

=

172,9602,125774,134 =

Real Options Calculations for an Intermediary Node of the Event Tree

8/10/2019 NIVRA_6_01

92/97


134,774

106,701 125,602

84,200 99,160

69,22866,12878,001

53,821 64,19452,270 61,033

42,407 49,682

34,296

42,121 48,083

34,34939,005

27,678 31,533

38,721

28,684 31,553

23,568 25,407

18,822

26,386

20,866 21,701

17,756 17,30619,332

16,949

16,510

15,83215,924

15,684 15,000

15,000

15,45715,000

After we have identified the Real Options Values at the final nodes, we move backwards aperiod and repeat the same procedures

Real Options Calculations for An Intermediary Node of the Event Tree

(cont.)

8/10/2019 NIVRA_6_01

93/97


Firs t we have to f ind the repl icat ion value for the no de

The maximum value of the project af ter paying ou t f ree cash f low is the maximum of i ts int r ins ic value and

the values of the expansion o r abandonm ent opt ions

The total PV of a project at this poin t is the maximum present value plus the free cash f low

)000,15/160,99/633,97(160,99

000,15/500,10%)301(*354,84/633,97

Max

MaxMaxValue

=

=

n=(134,774-69,228)/(113,865-62,491)=1.276

B=(134,774-1.276*113,865)e -.05=-9,988

ROV = 1.276*84,354-9,988 =97,633

541,7160,99701,106 =

Outputs from the Real Options Analysis: Optimal Execution

8/10/2019 NIVRA_6_01

94/97


Expand

OPTIMAL REAL OPTION EXECUTION Expand

Expand Expand

Expand Expand

Go Go Go

Go Go Go

Go Go Go

Go Go

Go Abandon

Abandon

Abandon

Year 1 2 3 4 5 6

Both the option to expand and the option to abandon add to the flexibility of the project asthey will be executed in many possible scenarios

As can be expected, the option to expand will be optimally executed if the project does welland the option to abandon if it does badly

Outputs from the Real Options Analysis: Projects Value with Flexibility

8/10/2019 NIVRA_6_01

95/97


Because of the projects high level of uncertainty, the flexibility has added a significant

value to its NPV

By enhancing the projects upside in case of success, and bounding the down side in case

of failure, the options have moved its net present value from negative $319,000 to positive$1,986,000

ROA vs. NPV

ROV

No Follow-up

$

$1,986

($319)

($500) $0 $500 $1,000 $1,500 $2,000 $2,500

Insights

8/10/2019 NIVRA_6_01

96/97


1. NPV requires mutually exclusive alternatives, ROA does not. For example consider a deferral option

NPV Mutually Exclusive Alternatives

MAX0 E [NPVt] = NPV < ROA=E [MAXt NPVt]

Defer

Defer

Defer

Defer

Defer

Invest

Invest

Abandon

InvestDefer

The value with flexibility is always greater than the value without. Furthermore, The ROA results yielddecision rules regarding what action to take in each future state of nature

2. Capital spending should be evaluated as a program rather than one project at a time. If we are evaluating a CAPEXprogram; we should take into account a variety of flexibilities Excess capacity vs. inventories Economics of scale vs. smaller plants more geographically diverse

ROA Decision Tree

NPV0

NPV1

NPV2

NPVN

Start immediately

Defer one year

Defer two years

MAX0

Defer Nyears

...

Issues

8/10/2019 NIVRA_6_01

97/97

Much remains to be done

1. Game theory and real options

2. Path dependent solutions

3. More than two discontinuous sources of uncertainty

Documents

NIVRA_6_01