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Executive summary:
Subject: Optimization of the capital structure and Valuation of the management’s flexibility with the Real-Options’ approach
The capital structure decision is a permanent topic of any company. It is in fact very important for the management to know the debt level of his company, compare to its optimal level, in order to take the right decision, for financing new investments. The optimal capital structure of a company give the maximum valuation’s level for the company, because it gives the lowest WACC of the company. It gives also the information about the financial flexibility of the company.
This question is not a new one: starting form the Modigliani & Miller’s work, a number of theories have emerged and have been developed. And now, it is possible to obtain this optimal level of debt with the real problems of the capital markets.
It is now possible to calculate the optimal capital structure of any company!
This development has significant consequents, because these allow shareholders to value, to appreciate and to judge the decisions that are taken in their companies and the work that is done by those managers.
More over the Real-Options approach allow the valuation of the financial flexibility, owned by each company (differential between the real level and the optimal level), and by that way to value more precisely the whole company. In fact, the Real-Option approach allows the valuation of the flexibility, existing inside the company. The capital structure and its optimization implicate the existence of a real option, which represents the financial flexibility of the company. This option has a value, which should be valued, otherwise your valuation based on the DCF approach in not correct. To be unaware of the existence of such an option means that you are not correctly estimating the value of your investment or of your company.
The implementation in 2005 of those concepts to the PPR’s group shows that the company is currently overextended, compare to its optimal level; but not so much (a sign of the management qualification…). This capital structure has a negative impact on the group’s valuation: the enterprise value is miss-valued by 1% (which is not so much but…). Because of this level of debt, the company does not have any financial flexibility, and therefore the value of the real option is negative. In this case the real option is 3.2% negative on the Enterprise value. This means a negative impact on the valuation of approximately 4%, only identified with one real option… (… did you see what I mean, if you think and value the others real options…?).
The Real-Options approach, a new tool to help managers to take decisions in our changing world…: The question of: Is the market really going to value those real-options?, is not the most important. I really think that we have to take care about the vision that this approach gives more generally: here again, it is the global corporate strategy that will suffer from this lack of financial flexibility.
Traditional financial advisors used:
1) Accounting approaches
2) Public Comps
3) M&A Comps
4) DCF
One of the main tasks fading managers is resource allocation:
1) The allocation task is both a strategic and a financial task
2) Neglecting the financial aspects of the decision might divert the manager from his ultimate goal of creating wealth for the shareholders
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In most real investment projects, with the operating flexibility to switch among different operating modes in response to the cycle market movements, the project cash flows are path dependents:
1) When the project includes only one source of uncertainty, this management flexibility can be easily dealt with using the widely known techniques for valuing real options such as finite difference and binomial methods
2) For more complex projects, where there are many uncertain state variables affecting the project value, the valuation process becomes more and more complex. In such cases, the valuator has to deal with the uncertainty of many variables simultaneously with different and complex stochastic processes, while conducting the real options valuation
Black & Scholes is not the only valuation tool available...
Real options analysis provides a number of insightful lessons and implications:
1) Uncertainty and flexibility are two key determinants of the value of an asset of a firm.
The traditional valuation paradigm based on cash flows from expected plans under the implicit assumptions of passive management has proven inadequate in dynamic settings
The role of the uncertainty in the presence of management flexibility is not penalising
Greater variability of potential outcomes around the expected result may be beneficial in the presence of options and an asymmetric managerial position
2) Managerial flexibility to revise future decisions when there are deviations from the expected plans introduces beneficial asymetry in the distribution of project value returns by enabling value creation opportunities to be exploited fully, while limiting downside losses
Managerial flexibility or real option value may be higher for firms or industries facing higher uncertainty
3) Higher uncertainty tends to increase the value of the option to defer
The flexibility to delay or wait-and-see enables acquiring more and better information and making a more informed future decision
4) Multi-stage opportunities may have significant option value that may justify making strategic investments despite having negative NPV
In an increasingly uncertain world, real options have different applications as a management tool. They will change the way you value opportunities. They will change the way you create value => both reactively and proactively. And they will change the way you think about how and where to invest your money.
Today, we compete in a global market that is highly unstable, rapidly changing and unpredictable, where profitable customers are hard to find and even harder to keep. Competitors can appear from anywhere at anytime, driving down prices and lowering margins. This unpredictability is fuelled by the fast-paced electronic commerce environment; volatility in capital markets affecting stocks, currencies and interest rates; and the emergence of new technologies impacting almost every area in business.
Companies, who can make better decisions faster, will create competitive advantage. As a result, planning and budgeting is becoming a significant concern and focus for improvement in today’s challenging business environment.
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
To find more about this application, please feel free to contact-us
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