Valuation of Real Options

Case Analysis: Aqua Bounty

Cone of Uncertainty

2
Cone of Uncertainty including Real Option

3
DCF and Real Options

4
 Real Option
Right but not the obligation to take an action
at a pre determined cost, exercise price,
predetermined time

Value of flexibility can be estimated

using the theory of pricing options and Deferring Expanding
the related contingent claims analysis

Flexibility may be valuable

Contracting Abandoning
Magnitude of cash flows that will be
generated by an option are usually very
sensitive to the state of nature that obtains

5
 Real Option

RO is a way of thinking Options are contingent decisions

Option valuations are aligned with

financial market valuations - Compares
all type of options, managerial options, Options thinking can be used to design
financial market alternatives, internal and manage strategic investments
investment opportunities, transaction proactively
opportunities, JVs, technology licenses,
and acquisitions
6
 Real Option

Financial option theory to Hitech

Payoff of option is
options on real (non
nonlinear
financial) assets
Major capacity
Pharmaceuticals
expansions

Address the gap between Works well

Embedded in strategic
strategic planning and in industries
investments
finance like..,

R&D Oil exploration

In investment decisions,
moving forward on arrival
of information, should
there be flexibility to vary IT
the decisions

7
 Use of Real Option

Not to use
real • Very little uncertainty
• No real option at all

option..
• There is contingent investment decision

Use real • Uncertainty is large enough and sensible to wait for more
information

option..
• Values are in future growth option
• Uncertainty is large enough to consider flexibility in option
• There will be project updates and mid-course strategy corrections

8
 Issues with Real Options
Underlying = Non trading
Long term – stretching
assets - Neither price of
into years causes
underlying and nor the
instability on variance
variance is observable

Difference between
Exercised early and get European and American
their value option value will be much
larger

9
 Issues with Real Options
Exercising the option
takes time - true life
Incomplete market Multiple risk factors
of option is often less
than the stated life

Convenience yields,
Insufficient data Transactions costs
carrying cost

Liquidity issues

10
 Waiting-to-
Invest
Options
Compound Growth
options – options –
sequential expanding
options possibility
Types of
Real
Option
Flexibility
Learning options –
options switching
option
Exit options
–
abandoning
project
11
Option to Delay a Project

Value in waiting for Type: call option Underlying: project

information

Strike price: investment Life of option: period for

needed to take the which the firm has right to
Project having a – project the project
NPV now may
have +NPV in Value of underlying asset:
future present value of the cash
flows on the project (not
including upfront
investment)

12
 Option to Delay a Project
Based on
past
experience
Risk less rate: rate
that corresponds to
Variance:
expected
variance in the
the expiration of the
Variance of
present value

Simulation
option
the firm s

13
 Payoff Diagram on a Option to Delay

PV of cash flows

Initial investment in project

Present value of expected cash flows

Project has negative NPV in this range Project’s NPV turns positive in this range

14
 Option to Expand a Project
Project having a –NPV now may
have +NPV in future due to further Underlying: expansion
Type: call option
expansion project

Life of option: period for

Strike price: cost of
Unexploited investment expansion
which expansion option
opportunities typically have the applies
characteristics of an option

Value of underlying
asset: present value of
It may not be optimal to exercise a the cash flows from
call option as soon as the expansion, if done now
underlying asset is greater than the
exercise price – should allow for
more value
15
 Option to Expand a Project
Based on
past
experience
Strategic consideration acquisitions –
entry into a growing firm, technological
expertise, brand name

Variance:
expected
variance in the
expansion Used in.. R&D and test market expenses
project

Variance of
Simulations
the firm
Multi stage project investment

Risk less rate: rate that corresponds

to the expiration of the option

16
Option to Expand or Grow

17
 Payoff Diagram on a Option to Expand

PV of cash flows

Cost of expansion

Present value of expected cash flows

Expansion has negative NPV in this range Expansion’s NPV turns positive in this range

18
 Test for Option to Expand a Project

Is the first investment Does the firm have

a prerequisite for the an exclusive right to
later investment / the later investment /
expansion? expansion?

How substantial are

competitive
advantage?

19
 Option to Abandon a Project

Underlying:
Type: put option
abandoned project

Project having a –NPV

now may have +NPV if Strike price: salvage
value from
Life of option: period
for which expansion
abandoned during the abandonment option applies

life of the project Value of underlying

asset: present value
of the cash flows
from the project

20
 Option to Abandon a Project

Based on
past
experience
Risk less rate: rate
that corresponds to
the expiration of the
Variance:
expected
variance in the
expansion

option Variance of
project

Simulations
the firm

21
Option to Abandon

22
Payoff Diagram on Option to Abandon a Project

PV of cash flows from project

Salvage value from abandonment

23
 Black-Scholes Model Assumption

Price changes
Price process is become smaller as No jumps in asset
continuous time period gets prices
shorter

Option price does not

Value European
Dividend-protected affect the value of
options
the underlying asset

By Fischer Black and Myron Scholes

Applies when the limiting distribution is the normal distribution
24
 Black-Scholes Model

Value of call = S N (d1) - K e-rt N(d2)

 S  2
ln + (r + )t
K  2
d1 =
 t
d2 = d1 - σ √t
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ2 = Variance in the ln(value) of the underlying asset
N(d1) and N(d2) = probabilities estimated by using cumulative standardized normal distribu

Option delta = number of units of the underlying asset that are needed to create the replicating
25
Portfolio
 Black-Scholes Model
(Adjusted for Dividends)

C = S e-yt N(d1) - K e -rt

 2
N(d2)
S 
ln  + (r - y + )t
K  2
d1 =
 t d2 = d1 - σ √t
Dividend yield (y = dividends/ Current value of the asset) of the
underlying asset is expected to remain unchanged during the life
of the option
Adjustments:
Value of the asset is discounted back to the present at the dividend yield to take into
account the expected drop in asset value
Interest rate is offset by the dividend yield to reflect the lower carrying cost from holding
the asset
Other dividend adjustment options
Estimate the pv of expected dividend and subtract it from the current value of the asset 26
to use as S in the model
Financial Option vs. Real Option

27
Real Option and Black-Scholes Inputs

28
 Option Details
Exercise Price Cost of asset – CITIC HK$ 1.6 billion
Tower II

Value of underlying PV of CITIC Tower II HK$1.54 billion

Time to option Length of time One year or four

expiration development quarters
decision may be
deferred

Risk free rate of Time value of money 1.89%

return

Variance of quarterly Riskiness of Citic 0.0233

returns Tower II

29
 Black-Scholes Model

Value of call = S N (d1) - K e-rt N(d2)

 S  2
ln + (r + )t
K  2
d1 =
 t
d2 = d1 - σ √t
S = Current value of the underlying asset
K = Strike price of the option
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ2 = Variance in the ln(value) of the underlying asset
N(d1) and N(d2) = probabilities estimated by using cumulative standardized normal distribu

Option delta = number of units of the underlying asset that are needed to create the replicating
30
Portfolio
 Option Value

 1.54  0.0233
ln   + (0.0189 + )4
1.60 2
d1 =    - 0.122
0.1526 4

d2 = -0.122 – 0.1526 √4 =
-0.427
Value of call = 1.54 * 0.4602 – 1.6 e-0.0189*4 0.3446 = 197.49 million

31
 Value of Investment

Expanded NPV = HK$

Expanded NPV = Passive (1,540 – 1,600) + HK$ ROA = HK$ 137.49 / HK$
NPV + Value of option 197.49 = HK$ 137.49 1,540 = 8.93%
million

Lower interest rates,

longer time to expiration,
Cost of option = 5%* HK$ Value of option > cost of
or higher volatility could
1,540 =HK$77 million option
probably make the option
more attractive

32
 Black-Scholes

Volatility of stock
return is known

By: Black and M. Stock prices

In: 1973 follow a random
Scholes walk, and the
price, time t, is log
Risk free rate is
constant over time
normally
distributed

Published paper title: Assumptions..,

The pricing of options Published in: Journal
and corporate of Political Economy No transactions
costs, and the
liabilities No dividends seller receives the
proceeds from
short sales

Taxes are not

relevant

33
 Black-Scholes

Assumed economic
environment: arbitragers can
Value of option is derived with
replicate the payoffs from the
theme that profitable riskless
call option during the next
arbitrage is imll possible
instant with a hedge portfolio
of stocks and bonds

34
Six Levers of Financial and Real Option

35
Managing Real Options Proactively

36
Pulling the Real Option Levers

37
 Aqua Bounty
• Elliot Entis, CEO of Aqua Bounty
Technologies, gazed across the snow-
covered fields as he pondered his next
move
• It was February 2006, and Entis was
facing his biggest decision yet – how to
value the firm ahead of its initial public
offering (IPO)
• Waltham-based Aqua Bounty was a
young biotechnology company at the
cutting edge of the rapidly growing
aquaculture industry
• The firm had developed genetically
modified strains of salmon and trout that
could grow to full size far more quickly
than conventional fish
• If licensed by the FDA, these fish would
represent the first ever genetically
modified animals approved for human
consumption
• However, Aqua Bounty had not yet
received regulatory approval for these
products, still less begun to produce
them on a commercial scale and, typically
for a young biotech firm, was still running
at a considerable loss
• In 2005, the firm had lost over $5 million
on revenues of around $1 million, taking
cumulative losses over the firm’s history
to $30 million
• To fund the development and
commercialization of its pipeline
products, the firm planned to raise
capital on the equity markets
• Entis and his team had to decide how to
price the firm ahead of its IPO
• Too high a valuation would dissuade
investors, while too low a figure would
significantly dilute the stake held by the
management team and existing investors
 Aqua Bounty
• Established in 1992 as a division of the • Efforts to develop the company’s genetically
biotech company A/F Protein, Aqua Bounty modified (GM) fish continued apace, and
began investigating the genetic properties of Aqua Bounty was soon able to produce fish
fish in order to identify and isolate the genes stock for commercial farmers (broodstock)
or gene sequences linked with growth capable of reaching market size
hormones in fish approximately twice as quickly as their
conventional counterparts
• In 1993, the company obtained the exclusive
licensing rights to a gene construct derived • However, the field quickly attracted
from Arctic fish that it believed could be considerable attention from environmental
applied to other fish species with a view to campaigners opposed to the concept of
speeding up the development of genetically modified products
commercially-farmed fish
• Although the concept had been embraced in
• In order to develop and commercialize the agriculture, with GM varieties making up 20%
aquaculture applications of its discovery, of all crop seed sales worldwide, the
Aqua Bounty was spun off as an independent technique had not yet been approved for
entity in March 2000 animal cultivation
• By this point, the company had invested
around $4 million in its research, raised
through a series of private placements
• Research facilities for salmon were centered
on Prince Edward Island, Canada
• However, recognizing the rapid growth of the
South American market, and the fact that
American consumers were likely to be more
receptive to the notion of genetically
 Aqua Bounty
• Given the controversial nature of the product,
Aqua Bounty had gone to considerable lengths to
demonstrate the safety of their AquAdvantage
fish
• Although easier regulatory paths were available,
the firm chose to pursue the FDA’s onerous New
Animal Drug Application (NADA) process, in order
to conclusively prove the safety of the fish
• By early 2006, the firm had authorized seven
major studies conducted under the US Food and
Drug Administration (FDA) practices to assess
their salmon, none of which had found any
nutritional differences between AquAdvantage
fish and conventionally farmed varieties
• However, the firm was still waiting for FDA
approval of the safety of the fish, which it hoped
to receive within 18 months
• Once this had been obtained, a further
submission would be required to allow the FDA
to consider the environmental implications of
farming rapidly-growing fish, although Aqua
Bounty expected this to be a more
straightforward process
• Facing a long and uncertain route to market for
its genetically modified fin-fish products, Aqua
Bounty continued to search for additional
aquaculture products that might offer some
diversification to their product line
• A partnership with a shrimp producer in San
Diego led to the company locating its shrimp
research efforts on the West Coast
• After the partner company folded, Aqua Bounty
took over its R&D unit, which was incorporated
as a wholly-owned subsidiary, Aqua Bounty
Pacific, in 2002
• At this time, while studying how growth
hormones act on the immune systems of fish and
shellfish, the firm found that growth peptides
appeared to offer health benefits to
commercially- farmed shrimp
• Seizing upon the opportunity, Entis’ team began
developing a range of products aimed at shrimp
farmers
 Aqua Bounty
• By this point, the firm had • See Exhibits 1 and 2 for the
grown to include a small firm’s income statement and
regulatory team, balance sheet since 2002.
headquartered in St. John,
Newfoundland, and around 10
researchers, along with in-kind
support from a number of
scientists in academic
institutions in the US and
Canada
• Aqua Bounty’s first shrimp
therapeutic drug, the immune-
system enhancer Shrimp IMS,
was launched in Mexico in
2004
• By 2006, the company had
built a pipeline of products for
 AquAdvantage Fish Stocks
• Commercial fish farming experienced rapid
growth during the 1990s, with growth
particularly strong in South American countries
that bred fish for sale into the North American
market
• By 2006, the industry generated annual revenues
of over $6bn, and was growing at over 5% a year
(Exhibit 3), with growth rates of 7-8% a year
expected in Asia and Latin America
• The most common farmed species were the
Atlantic Salmon and the Rainbow Trout
• For these fish, eggs would generally be produced
in specialized hatcheries before being transferred
to freshwater tanks upon hatching, where they
were then grown for around 15 months
• At this stage the young fish would typically be
transferred to sea cages until they reached a
marketable size - normally at around 28-36
months of age
• Aqua Bounty had developed new strains of fish
that could reach marketable size in around half
the time of standard fish
• By placing the salmon growth hormone under the
control of a gene switch from an edible arctic
fish, called the Ocean Pout, Aqua Bounty was
able to ensure year-around production of salmon
growth hormone (as opposed to seasonal
production) to speed growth throughout the
early stages of development
• More importantly, the location of production of
the growth hormone within the salmon ensured
that a higher percentage than usual was actually
used for growth and the total concentration of
the hormone within the fish remained at levels
found in the wild
• Although these fish did not reach a larger final
size than their standard counterparts, by
accelerating growth in the early stages they could
reach a marketable size in around half the time
• In the case of salmon, this would reduce farming
time from 28-36 months to 18 months; trout
farming time might be reduced from 8-12
months to just four
 AquAdvantage Fish Stocks
• This had a number benefits, both economic and
environmental
• Central to the product’s attractiveness to farmers
was the fact that it would allow them to double
production without increasing the size of farm or
capital investment
• Exhibit 4 illustrates the growth rate of Aqua
Bounty salmon relative to standard fish
• While the opportunity presented by
AquAdvantage fish was sizeable, numerous
obstacles remained as Aqua Bounty sought to
bring the fish to market
• Regulatory approval from the FDA was required
before salmon bred from Aqua Bounty eggs or
broodstock could be sold into the US market
• Moreover, under the New Animal Drug
Application (NADA) framework, additional
precautions such as ensuring the sterility of
genetically modified fish to prevent them from
breeding with their natural counterparts were
required before approval for scaled-up
manufacturing would be granted
• Further uncertainty stemmed from the fact that
consumers might not be particularly receptive to
genetically modified fish, even if they were
shown to be safe for human consumption
• While the firm had worked closely with the FDA
over recent years, conducting a number of
studies demonstrating that the fish were not
harmful to humans, they were still waiting to
receive approval for the product, and were
unsure of how consumers would react to the fish
• In order to secure regulatory approval for their
products, Aqua Bounty anticipated the need for
some additional investments over the next three
years
• Given the level of controversy surrounding
genetically modified products, the firm believed
they had around a one in three chance of gaining
full approval for commercial production of
AquAdvantage fish
• While there was no certainty over how long the
approval process would take, Aqua Bounty’s best
estimate based on past dealings with the
regulator was that a final decision would be
received in around three years’ time
 AquAdvantage Fish Stocks
• The firm’s best estimates of revenues and
associated costs from the product, assuming FDA
approval was received, are laid out in Exhibit 5
• Given the revolutionary nature of the product,
however, actual revenues might be considerably
higher or lower than this, and Entis knew that he
would have a clearer sense of what to expect if
and when FDA approval was received
• Although Aqua Bounty’s licensing approach
meant CAPEX requirements were negligible and
net working capital was unlikely to change over
time, the firm would face considerable
commercialization costs associated with the roll-
out of the products, in the event that approval
was received for them to begin commercial
production of AquAdvantage broodstock
 Shrimp Aquaculture
• Since the 1970s shrimp farming had grown from
a highly fragmented industry based almost
exclusively in South East Asia to a global industry
worth over $10bn
• While 80% of production remained in South East
Asia, Latin American shrimp production had
grown to represent 20% of the total
• Much of the shrimp produced in Latin America
was exported to the United States, which at
500,000 tons represented the largest single
importer
• Shrimp were generally farmed in sea water
coastal ponds, which, until the 1980s, had
typically been stocked with young wild shrimp
caught by local fisherman
• However, with the depletion of the fishing
grounds, farmers had increasingly begun to take
shrimp from hatcheries where adult shrimp were
maintained for reproductive purposes
• This not only ensured supply, but also eliminated
one route for the introduction of infection
• Disease had repeatedly affected the shrimp
farming industry
• However, with substantial growth only beginning
in the 1980s and limited knowledge of shrimp
immunology, there had been limited
development of options to control disease
amongst farmed shrimp
• The global nature of the industry meant that
diseases could spread rapidly across the world
• As a result, the shrimp industry had been badly
affected by disease on a number of occasions,
with both bacterial and virus-borne maladies
proving troublesome
• Farmers looking to protect or treat their shrimp
had few options
• Outbreaks of bacterial infections could be treated
by antibiotics, but the efficacy of such treatments
was limited, and excessive use of antibiotics was
a cause of environmental concern
• Indeed the misuse of agents such as
chloramphenicol had been known to lead to
import bans on treated shrimp
 Shrimp Aquaculture
• Few options existed for the prevention or • The potential market was large, and Aqua
treatment of bacterial infections Bounty believed that up to 25% of shrimp
feed sold globally might contain VPX within
• As a result, the market opportunity in shrimp
ten years
therapeutics and disease defense was
significant • Finally, Aqua Bounty had developed
diagnostic kits that would allow commercial
• Since commencing work on shrimp
farmers to test for the presence of common
therapeutics in 2002, Aqua Bounty had
developed two means of providing farmed diseases in their shrimp stock and receive
shrimp with effective protection real-time results on the health of their flock
• Shrimp IMS was developed from a growth • By 2006, the kits had been trialed on a small-
hormone which, administered in small scale in Asia, and plans were afoot to roll-out
quantities to shrimp, proved capable of the product across South America
boosting the immune system and general • Based on the revenue projections given in
disease-resistance of shrimp in commercial Exhibit 6, Aqua Bounty’s advisors had valued
farms Aqua Bounty’s shrimp therapeutics business
between £35m and £50m
• The product was successfully launched in
Mexico in 2004, and Aqua Bounty planned to
roll it out across South America and Asia in
the near future
• The second treatment, VPX, was designed
specifically to prevent shrimp developing
white spot syndrome virus (WSSV), one of
the most common and virulent shrimp
pathogens
 The IPO Process
• Since spinning out from its parent in 2000, Aqua
Bounty had raised a further $12 million in small-
scale equity financings and debt issuances which
were subsequently converted into common
shares
• By 2005, the long wait for regulatory approval
had eaten into Aqua Bounty’s capital reserves,
and the firm was in need of additional investment
• Rather than seek further small-scale funding
from individual investors, Entis believed that a
public offering would be the best way of raising
the substantial amount of capital required to
continue the development and commercialization
of the firm’s key product lines
• Moreover, the success of laboratory and field
trials left Aqua Bounty’s management confident
that they would be able to attract equity capital
• Armed with the results from the latest set of
trials, Entis embarked on an extensive tour of the
US. Starting on Wall Street and finishing in
California, he met with more than thirty
individuals and institutions to test their appetite
for investing
• Frustratingly, there was little interest in Aqua
Bounty
• It appeared that US investors had little
knowledge of aquaculture, while the few
individuals who had previously invested in the
space had typically lost money
• It was only when an associate connected Entis
with the British investment bank Nomura Code
Securities that he began to gain traction
• The European market was much more familiar
with the aquaculture industry, and the bank was
confident that Aqua Bounty would be able to
attract the investment it required.
• As a relatively small-cap company, Aqua Bounty
would be eligible to list on London’s Alternative
Investment Market (AIM), which did not require a
minimum market capitalization or number of
shares placed
• This contrasted with the US-based NASDAQ,
which operated a tiered system according to the
size of the firm hoping to list, and required firms
to be above a minimum size even for its lowest-
tier, the NASDAQ Capital Market (see Exhibit 7)
 The IPO Process
• A further attraction of the AIM
was that the regulatory
requirements for listing were less
onerous than those of other
markets
• Following the passage of the
Sarbanes-Oxley Act in July 2002,
US-listed public companies faced
strict requirements on financial
reporting and corporate
governance
• These were particularly
problematic for smaller companies
such as Aqua Bounty, for which
the costs of compliance could be
significant
• Indeed one study found the
average compliance cost in 2006
to be over $3 million
• Listing on the AIM required only
compliance with the lighter-touch
Financial Services Authority
regulations, and the passage of
the Sarbanes-Oxley Act coincided
with a sharp increase in AIM
listings (see Exhibit 8)
• One final attraction of a European
listing was a perception that the
market appetite for agriculturally-
oriented biotech IPOs was high, as
evidenced by recent successful
offerings such as that of Devgen
(see Exhibit 9)
 Pricing the IPO
• Given Aqua Bounty’s early stage of
development and unusual range of products,
valuing the firm was challenging
• Two aspects were particularly problematic
• Firstly, there was enormous uncertainty
around the company’s future revenues,
driven by the degree of regulatory
uncertainty surrounding its AquAdvantage
products, along with the unpredictability of
the product’s route to market
• Secondly, due to the unique nature of Aqua
Bounty’s operations, the firm suffered from a
dearth of comparable companies
• Entis knew of only one firm operating in
somewhat similar fields – Devgen, a Belgian
agricultural biotech firm which had
developed pioneering genetically modified
agriculture products, and recently listed on
the Euronext
• See Exhibit 9 for details of Devgen’s stock
price performance and other relevant
financial information
• Entis knew that Aqua Bounty needed to raise
around $30m (£17m) in order to fund the
firm’s pursuit of regulatory approval and the
commercial development of both the shrimp
and fish lines
• As the shadows lengthened across the fields,
he considered once again the valuation issue
• What was the value of the AquAdvantage
opportunity?
• This would be a key determinant of the
company’s overall value, and the size of the
stake that he and his fellow shareholders
would have to part with in order to raise the
required capital
 Synopsis
• Aqua Bounty is a US biotech company
considering an initial public offering
• The company is developing two product lines
• One is an antibiotic product for farmed
shrimp, which it has just begun to roll out to
the market, with an estimated market value
of £35-50m pounds
• The other is genetically modified salmon
eggs, which grow into adult salmon twice as
fast as regular farmed salmon
• The so- called AquAdvantage fish have yet to
receive approval from the US Food and Drug
Administration (FDA), which is expected
within the next 18 months
• Aqua Bounty is seeking to list on the London
AIM (Alternative Investments Market)
• The key point of the case is to determine the
valuation of the company’s salmon product
• This valuation has two main sources of
uncertainty: whether the product will be
approved by the FDA; and whether the
product will be acceptable to consumers, if it
should be approved
• Owing to the early stage and revolutionary
nature of the product, the company has few
comparables and is best valued using a
decision tree or option pricing approach
• The case offers an ideal opportunity to
review and combine these two approaches
to valuing risky projects: uncertainty over
FDA approval is best captured by a binary
(“yes” or “no”) probability tree; uncertainty
surrounding consumer take-up of the
product is more continuous, and may thus be
more appropriately modeled using a Black-
Scholes option pricing model.
 Related Cases
• The cases which precede it in the module are
(in order of teaching): “Real Options Exercises”
(HBS case no. 9-208-045); “Arundel Partners:
The Sequel Project” (HBS case no. 9-292-140);
and “MW Petroleum (A)” (HBS case no. 9-295-
029)
• “Auctioning Morningstar” (HBS case no. 9-
206-023)
 Objectives
• The Aqua Bounty case is interesting • Discuss the decision as to whether to
because it presents an extreme seek FDA certification for a
example of the difficulty in valuing controversial product which did not
young start-up firms with big actually require FDA approval for
opportunities but no revenues manufacture and sales
• It also allows an interesting discussion • Valuing the AquAdvantage product
of the advantages and disadvantages of line,
requiring more transparency from
listing firms, since the AIM – where
Aqua Bounty proposes to list – imposes
a lesser regulatory burden on firms but
correspondingly greater risk on
investors
• One further interesting aspect of the
case is that the arduous route to
market, via FDA approval, was chosen
voluntarily by the firm as a way to
increase the chances of consumer
acceptance: in principle, FDA approval
was not required for the company to
produce its product
• The presents opportunities to
 Opportunities for Analysis
• The class begins with a discussion of Aqua
Bounty’s business in order to bring out the two
main sources of uncertainty facing the company
• We also briefly discuss the reasons why Aqua
Bounty is choosing to come to IPO now, and why
the business is hard to value conventionally
• Aqua Bounty has two lines of business: shrimp
therapeutics and AquAdvantage fish, which grow
to adult size twice as fast as regular salmon or
trout
• These fish are produced by taking a gene that is
responsible for growth in salmon or trout (which
grow only in the summer) and replacing it with a
growth gene from arctic pout fish (a species that
grows year round)
• This makes farmed salmon or trout grow year
round and reach marketable size twice as quickly
• The genetically modified fish ultimately stop
growing at normal size, so they are no bigger
than regular salmon or trout – see case Exhibit 4
• The main advantage to salmon or trout farmers
from using AquAdvantage broodstock is that their
capital stock (fish farm) can produce twice as
many fully-grown fish in a given time period (with
an appropriate increase in variable inputs), thus
economizing on fixed costs
• Note that Aqua Bounty does not actually produce
fish itself, but plans instead to license its
technology; thus its capital expenditures,
depreciation and net working capital
requirements are likely to be negligible
• The instructor may wish to keep discussion of the
business brief, in order to reserve more class time
for discussing and comparing valuation
methodologies
• But it is important – at a minimum – to point out
that Aqua Bounty faces two main sources of the
risk
• First, the FDA may not approve the product at all
• Second, even after FDA approval, the extent of
customer acceptance is uncertain
 Opportunities for Analysis
• There is an interesting side point on business
strategy
• When the company first approached the US
Government for a license to insert the arctic pout
gene into salmon and trout, and then sell the
eggs, they were told that they did not need a
license
• The response of the Aqua Bounty CEO, Eliot Entis,
to this advice was that – if they started producing
GM salmon – then it was certain that they would
need a license as soon as the news got out! So
the company decided to apply for FDA approval
under the “New Animal Drug Act”, as if the new
gene inserted into the fish were actually a new
drug given to fish (which it was not, which is why
this route was optional)
• This way, with FDA approval, it would be
absolutely clear to everyone that their product
was entirely safe
• This is important for consumer acceptance of the
product
• It also provides some protection against ex post
US Government intervention or rule changes, as
well as uninvited interventions from
environmental activists
• Aqua Bounty was spun off from the biotech
company A/F Protein in order to focus on
commercializing products using the introduction
of the arctic pout gene to increase the rate of
growth of commercially farmed fish (case, p. 1)
• It is interesting to spend a couple of minutes
asking why it diversified into shrimp therapeutics
• The discovery was somewhat serendipitous, but
clearly Entis and his team had been actively
searching for other products to reduce their
exposure to the risks facing the salmon/trout
product
• Such a search for diversifying products benefits
Entis and the other managers by diversifying their
personal portfolio, which is very much tied up in
the success of Aqua Bounty
• But it is less clear that it benefits their other,
more diversified shareholders, who may care only
about the systemic risk of the business
 Opportunities for Analysis
• The valuation of the company at the time of the
case is necessarily very uncertain because it has
essentially no revenues
• The shrimp business is just starting to produce
revenues, but these are still very small compared
to the steady state revenues that the firm expects
• So it is not possible to do any multiples valuation
of the firm
• In any case, there are essentially no comparable
firms: the only public comparable of which the
Aqua Bounty management was aware was
Devgen, a firm producing genetically modified
agricultural products (case, p. 6, with statistics
listed in Exhibit 9)
• We know that IPOs tend to be underpriced due to
the large amount of asymmetric information
when firms go public, so this seems to be likely to
be a big problem for Aqua Bounty
• So why is it nevertheless considering an IPO at
this point? Three reasons can be identified
• First, they believe that they are close to the end
of the approval process
• Second, they can no longer wait – they need cash
now (as evidenced by the fact that they are
already borrowing from existing shareholders –
see the “Notes to shareholders” item in the
balance sheet in case Exhibit 2)
• Third, the London AIM is currently “hot” for IPOs
(see case Exhibit 8), and comparable firm Devgen
has recently had a successful IPO
• Why list on the London AIM?
• The choice is not obvious, given that Aqua
Bounty is a US-based firm
• One reason was that Entis had had little interest
from US investors (case p. 5), whereas AIM
offered access to a more international group of
investors with greater risk appetite
• At this time, AIM was enjoying a boom period;
this has been attributed, at least partly, to the
costs of complying with the 2002 Sarbanes-Oxley
Act in the US
 Opportunities for Analysis
• Estimates put the cost of • For an analysis of the empirical
complying with section 404 of the effect of the Sarbanes-Oxley Act
Act at up to $1m, even for smaller on the decision to list on the
firms NASDAQ and the AIM, see
• Of course, these costs might have Srinivasan, Suraj, and Joseph
offsetting benefits Piotroski, 2008, “Regulation and
bonding: the Sarbanes-Oxley Act
• Notably, improved transparency and the flow of international
for investors might make them listings”, Journal of Accounting
willing to provide capital on better Research, 46(2)
terms, owing to less fear of
adverse selection (hidden
information) or moral hazard
(hidden actions) on the part of
management
• But the AIM also has the
advantage that, in contrast to the
NASDAQ, it has no minimum
listing requirements (case, p. 5)
• While firms with market
• 1 For example, see Angus Loten, “Bill seeks to
ease Sarbanes-Oxley for smaller firms”, Wall
Street Journal, September 26, 2011, available
at:
http://blogs.wsj.com/in-charge/2011/09/26/bi
ll-seeks-to-ease-sarbanes-oxley-for-small-firms
/
 The Problem with a Standard DCF
Approach to Valuation
• The case provides a set of projected expected
cash flows in case Exhibit 5
• I begin by asking the students the simplest way to
use these to value Aqua Bounty – can we value
the company without even needing to draw a
decision tree?
• We are told in the case text (p. 5) that these are
the firm’s best estimates of revenues and costs,
assuming that FDA approval is received; we can
take this to mean that they are the point
estimates of expected revenues and costs,
conditional on approval
• Since DCF forecasts are supposed to use expected
cash flows, we can work with these to produce
the most basic valuation estimate, using the
“cash flow recipe”: REV-COGS-SGA-Product
commercialization costs = EBITDA
• We will assume that CAPX, Depreciation and
Changes in Net Working Capital are all negligible
(since, as mentioned above, Aqua Bounty intends
simply to license its product)
• Subtracting taxes at 35% (given in the assignment
questions) from EBITDA gives EBIAT, which is
equal to cash flow in this case
• However, the probability of approval is only one-
in-three, so the resulting EBIAT needs to be
multiplied by 33%
• Aqua Bounty will incur costs of £2.5m per year
for three years to obtain FDA approval
(information given in the assignment questions);
this is regardless of whether approval is, in fact,
obtained and so does not need to be multiplied
by 33%
• I lay out this approach on the board
• It is the standard way to approach a valuation in
corporations where uncertainty is limited (in
these cases, students should do forecasts using
expected cash flows, not best case or worse case,
unless they are planning to do more than one
scenario)
• The next step would be to discount the cash
flows from each year using an appropriate
discount rate
 The Problem with a Standard DCF
Approach to Valuation
• The assignment questions ask students to use a
discount rate of 14%, which is what analysts used
when valuing the company for Nomura securities
• We briefly discuss whether this looks like an
appropriate discount rate, reviewing the
students’ knowledge of the CAPM
• Some students will find the rate appropriate, on
the basis that the company is highly risky
• Yet others will recall that only systematic risk –
and not idiosyncratic risk – should be priced,
according to the CAPM
• This discount rate implies a very high beta, about
twice that of Devgen (given in case Exhibit 9 as
1.09)
• Most of the risk of Aqua Bounty’s products is
presumably idiosyncratic, not systemic, so the
discount rate used is probably excessively high
• It might be intentional on the part of the analyst,
in case the cash flows themselves do not take
sufficient account of possible failures
• But the correct way to proceed is to
appropriately account for all the risk of failure in
the expected cash flows, and to allow the
discount rate to reflect only systematic risk)
• One factor that might justify a higher discount
rate, compared to Devgen, is that the latter is
producing genetically modified crops, whereas
Aqua Bounty is producing genetically modified
salmon
• Salmon might be a higher beta product, if it is
more of a “luxury” good
• Another factor is that Aqua Bounty is at an earlier
stage in the approval process, which might imply
greater operating leverage
• Operating leverage increases equity betas in
much the same way as financial leverage (since
FDA approval costs will have to be paid before
shareholders will receive any cash flows, in the
same way that debt has to be paid before
shareholders receive any cash flows)
 The Problem with a Standard DCF
Approach to Valuation
• Having laid out this “standard DCF” approach in • There are three different problems
principle, I proceed no further with it in the • Students will see one of them easily and point it
interests of time out; the other two are more subtle and may be
• But laying things out in this way serves two useful noticed only by one or two students
purposes • The most obvious problem
• First, it provides us with a model for calculating
the cash flows in each particular scenario
• Second, it provides a benchmark that students
can use when discussing the benefits of a
decision tree or real options approach
• A valuation using this standard approach is
provided in TN Exhibit 2, for completeness
• I do not provide this in class; instead, I ask
students what will go wrong if we continue to
simply model expected cash flows without
forecasting good, bad and medium scenarios
separately
• invariably comes up first, and motivates the move to the next section of the class. The problem is that, although case Exhibit 5 is the firm’s
best estimate of revenues and costs, “actual revenues might be considerably higher or lower than this, and Entis knew that he would have
a clearer sense of what to expect if and when FDA approval were received” (case, p. 5). In the assignment questions, I quantify the extent
of this uncertainty by telling students that they should assume the following:
• Assuming approval is forthcoming, there is an equal chance of each of the three commercialization scenarios occurring. Under the “low”
scenario, revenues would be 75% lower than under baseline scenario provided in case Exhibit 5. Under the “high” scenario, revenues
would be 75% higher. In all three scenarios, COGS will be 20% of revenues, and annual SG&A costs of £4m plus 5% of revenues will be
incurred. Commercialization costs will be the same in all three scenarios.
• I provide the students with an excel spreadsheet (available from the author on request) laying out the revenue, COGS and
commercialization costs under all three scenarios in order to facilitate class preparation. A copy of the contents of the spreadsheet is
provided in TN Exhibit 3.
• Clearly, if one were to take a probability-weighted average of each of the three scenarios then one would get case Exhibit 5 back; so the
idea of forecasting, based on case Exhibit 5 as just discussed, is not crazy. But students who have done forecasts using each of the three
scenarios separately will have noticed that the “low” scenario generates negative NPV; so if Aqua Bounty knew that it were in the “low”
scenario then it would not proceed with paying commercialization costs. Thus, in forecasting based on case Exhibit 5 alone, we are
missing the option value of “waiting to see” the situation before proceeding, and then proceeding with commercialization only if it is
worthwhile. On this basis, a valuation based on case Exhibit 5 would be an underestimate.
• There are two other reasons why valuing the company based on expected cash flows will be inaccurate. One concerns discount rates.
Corporate Financial Management students are now at the end of the real options module, where discretionary capital expenditures take
the form of an exercise price. Hence they suggest using a different rate to discount discretionary capital expenditures (which are less risky)
than other, more routine, cash flows from the business. We will come back to this point shortly. The other reason is that it will be difficult
to accurately assess taxes by looking only at the expected scenario for Aqua Bounty. This method might work perfectly well when a
business has other sources of income to offset any losses. But Aqua Bounty has substantial net operating losses and might never pay any
taxes at all (and hence never recoup “negative” taxes payable) if the “low” scenario occurs. So taxes should be forecast separately for this
branch in this case. We now proceed to undertake this more detailed valuation for each branch.
• Decision tree approach to valuation
• The first step for students to take in valuing Aqua Bounty’s AquAdvantage product is to sketch out a probability tree laying out the
possible trajectories for the product. This should incorporate both the issue of FDA approval and the uncertainty over future commercial
revenues if the product is approved. Under the “scenarios” approach, the tree would be drawn as shown in TN Figure A below:
• The next step is for students to calculate the revenues and costs associated with each branch of the tree. In all
cases, the FDA process results in costs of £2.5m per year for the first three years, discounting back to a present
value of £6.9m using the risk free rate (denoted rf), which is 4.22% in case Exhibit 9.2 As noted above, we will
discount the expenditures associated with FDA approval at the risk free rate because they are pretty well
anticipated and, in particular, are very unlikely to be at all systematic. The further advantage of this choice is
that it will facilitate comparison with the Black Scholes valuation, which is to come later.
• For now, we will discount all post-approval revenue and cost streams at the cost of capital (denoted rA) of 14%.
To calculate the value of these streams, students will need to build three simple cash flow models (one for each
scenario). Examples of such valuations are presented in TN Exhibits 4, TN 5 and TN 6 (all discounting assumes
cash flows occur at the end of the year). The value of the project, gross of FDA costs, is £81.3m in the
“baseline” scenario, £165.1m in the “high” scenario and minus £2.6m in the “low” scenario (final lines of TN
Exhibits 5, TN 6 and TN 4 respectively).
• As noted above, an examination of the three forecasts shows that taxes paid will be quite different under the
three scenarios. In forecasting taxes paid, we have taken into account that Aqua Bounty already has $30m
worth of Net Operating Losses (NOLs) at the start of 2006 (case, p. 1); we assume an exchange rate of 1.6 to
convert these into UK pounds sterling. NOLs can be carried forward for twenty years in the US, and so we
assume that these existing NOLs can eventually be used as tax shields in the cases in which the firm becomes
profitable. As can be seen from TN Exhibit 4, however, this will not be the case in the low scenario. So
calculating taxes in the normal way (as simply a percentage of expected profits) would significantly
underestimate taxes paid – and thus over- estimate firm value – because the NOLs tax shield has no value if the
firm does not become profitable (except in some circumstances, such as if the firm is acquired). In forecasting
taxes paid in the exhibits, we have assumed that the firm is able to recoup the tax shields from its NOLs only
when its cumulative profit becomes positive. In fact, Aqua Bounty does have the shrimp business against which
it can offset these NOLs (indicating a benefit for Aqua Bounty shareholders of diversification
• 2 We assume that all values occur at the end
of the year and discount accordingly. In
principle, FDA costs could be discounted using
a shorter term rate than ongoing Cost Of
Goods Sold, for example; but, for simplicity,
the case provides only one risk free rate (the
10-year rate).
• into this business line), but we do not attempt the joint modeling of these two businesses here. (As is revealed in the “What happened” section below, the shrimp
business itself quickly became unprofitable and thus its existence is not germane to our analysis.)
• These three models can be combined to build a valuation of the AquAdvantage product using the decision tree above. Each outcome must be weighted by the
probability that it occurs. The resulting calculation of the value of the firm in early 2006 is shown in TN Exhibit 7. Take the expected cash flows from each scenario:
(2.6); 81.3; and 165.1. Then multiply each of them by the 11% probability with which they occur. Then subtract the FDA approval costs of £6.9m. This yields a valuation
of £20.2m. However, it is clear from TN Exhibit 4 that it is not worth pursuing commercialization when the “low” scenario is realized, because the present value of cash
flows following approval in 2009 are negative. In that scenario, it would be preferable simply to stop pursuing the project after approval in 2009, replacing these
negative cash flows by zero cash flows. So we should “prune the branch” of the probability tree in the low state, replacing it with a zero. This valuation, presented in the
two right hand columns of the exhibit, results in a slightly higher expected value for the business of £20.5m. The effect on overall valuation is small, both because the
losses that would arise from commercialization in the low scenario are small (only £2.6m) and because the probability of FDA approval – followed by the low scenario –
is also small (11%).
• In TN Exhibit 8, we also provide a valuation of the baseline scenario in which the both the FDA approval costs and the commercialization costs that the firm will face
are discounted at the risk free rate. (In TN Exhibit 4, TN 5 and TN 6, the commercialization costs were discounted at the cost of capital, rA, of 14%). There are two
rationales behind this alternative discounting. First, one can argue that the commercialization costs – like the FDA approval costs – very likely contain little systemic
variation; so, if they are discounted at 14%, then this may overstate the value of the business. Second, making this change will allow us to compare this valuation with
the Black-Scholes approach more easily, since in Black Scholes the exercise price is (implicitly) discounted at the risk free rate. All other cash flows are discounted using
the firm’s cost of capital (denoted rA and assumed to be 14%, as indicated in the assignment questions and discussed above). Note that the tax shields from the firm’s
expenditures are captured in these cash flows because they are as risky as the firm’s overall operations (they cannot be captured unless the firm is profitable, whereas
the costs themselves will be incurred regardless). Using this alternative discounting, the value of the baseline scenario, if reached, is £68.1m. A rough estimate of value
can be generated by multiplying this figure by 33% and then subtracting FDA costs, to arrive at a value of £15.8m. (Note that for simplicity, we assume here that FDA
costs are not tax-deductible. As noted above, it is difficult to calculate taxes correctly if NOLS will be recoverable only if the AquAdvantage line succeeds.) However, this
figure is biased downwards because, like the “standard DCF” method discussed above, it ignores the option value associated with the other two scenarios, high and
low. The same analysis could be repeated for these two scenarios but, in the interests of space and time, we do not pursue it here (details are available from the author
on request). Instead, we use the calculations in TN Exhibit 8 to provide inputs to a real options valuation using Black Scholes.
• A Black Scholes approach to valuation
• Clearly, the valuation reached above is highly uncertain and it is artificial to model the revenue stream as being high, baseline or low with equal probability. Is there
another approach that can be used to test robustness of the valuation and provide a more natural way of modeling the uncertainty? Students who have studied the
case on Real Options Exercises will know that, in general, there are two ways to model cash flow uncertainty – either using a probability/decision tree, or using Black
Scholes. Before tackling this case, students should ideally have some familiarity with mapping real
• cash flows into inputs for a Black Scholes model – perhaps from studying “Arundel Partners: the Sequel Project”, or “MW
Petroleum (A)”, or other real options cases – because the mapping is a little different to usual and not immediately obvious.
• The first, and key, step is to realize how to model the combination of the FDA uncertainty and revenue/cost uncertainty. We do
not model the FDA uncertainty as an option. Instead, we assume that it is worthwhile to spend the resources to obtain FDA
approval now, rather than to wait to gain information about the likelihood of FDA approval and then (perhaps) spend resources
later if approval looks likely. So we are implicitly assuming, here, and above, that only an insignificant amount of information
about the likelihood of approval will arrive – unless the FDA approval costs of £2.5m per year (£6.9m in total) are incurred. Thus
the FDA decision, with a binary outcome, remains best modeled using a probability tree.
• By contrast, if the FDA approves the product then a Black Scholes methodology can be used to estimate the value of the product
– instead of using a further branching of the tree, as was done in the previous section. The decision tree for such an approach is
illustrated in TN Figure B below. The figure makes it clear that Aqua Bounty has a one-third chance of gaining a real option to
commercialize its product. Aqua Bounty does not have an option to commercialize its product with one-third of the cash flows in
the case Exhibit 5. Many students have not thought about this difference clearly and are thus inclined to enter the wrong inputs
into their Black Scholes models (that is, they wrongly multiply cash flows by one-third before putting them into the Black Scholes
calculator). The figure helps them make the distinction and properly separate the two different sources of risk (FDA approval vs
option to develop if demand looks sufficient) for different analytical treatment.
• Inputs into the Black Scholes model should be expected values. Thus the baseline cash flow model presented in TN Exhibit 8 can
be used to generate inputs for a Black Scholes option value calculation. The required inputs, as set out in TN Table C below, are: a
Stock Price, S; an Exercise Price, X; a Time to Expiry of the option, t; a risk free rate over the same horizon, rf; and a volatility, σ.
• The “stock price” in a real options model is the expected value of cash flows, excluding the cost of exercising the option,
discounted at the cost of capital back to the present time. The intuition for this is that, by analogy with the way in which the value
of a true stock price is determined, our estimate for the “stock price” should represent the expected present value of future cash
flows discounted at a
• discount rate reflecting their systemic risk (here assumed to be 14%). The relevant cash flows to discount would be revenues minus COGS and
SG&A; that is, cash flows excluding the costs of pursuing FDA approval and commercialization. From TN Exhibit 8, the discounted value of these is
£104.6m. (Note that repeating the analysis leading to TN Exhibit 8, but simply assuming that taxes are 35% of profit before tax rather that
correctly accounting for when taxes are actually paid yields a very similar value of £106.3m here, because the baseline scenario is profitable, so
NOLs are recouped relatively promptly in this scenario.)
• Since we are assuming that FDA approval will take 3 years, our first presumption is that the option may be exercised in three years’ time. (It could
also be exercised later; we perform a sensitivity analysis on this below). Thus the time to expiry, t, is three years.
• The Exercise Price in a real options model is the cost that must be paid to exercise the option at the time of exercise. So we need the value of the
commercialization costs discounted at the risk free rate to the beginning of 2009 (end of 2008). These costs are the ones that we know must be
paid in order to exercise the option to develop the product after FDA approval. The Black Scholes pricing model will implicitly discount these costs
at rf (the rate at which it is assumed interest will arise on the bond that is put aside to finance the call in the duplicating hedging strategy used to
price the option); so it is important that these costs are neither systemic nor correlated with the cash flows from exercise, an assumption which
seems reasonable here. The other cash flow items – Revenues, SG&A and COGS – are, by contrast, included in the estimate of Stock Price ( S) as
cash flows which are systemic in nature and which will occur if we choose to exercise the option. This separation into Exercise Price and Stock
Price is necessary to implement the Black Scholes model. It could be regarded as a little arbitrary – one could argue that some part of SG&A could
be included in the exercise price – but arriving at a sensible valuation model requires good judgment and knowledge of the business.
• The final necessary input is an estimate of the volatility of the cash flows from AquAdvantage products. This is not obvious – since we are
effectively trying to estimate how much our view of the profitability of commercialization could change over the next three years. One
triangulation point provided by the case is the annual volatility of Devgen equity, which can be used as long as we are willing to assume that its
capital structure is similar to Aqua Bounty’s (it seems likely that neither firm has much debt, if any). From case Exhibit 9, Devgen’s volatility is 42%
(similar to the majority of US equities, which have 40-60% volatility). We put 42% into our model, and can perform a sensitivity analysis to see
how much it would increase the valuation to assume 60% volatility. In summary, we have the following inputs for the model, set out in Table C
below:
• Putting these values into the Black Scholes model gives a valuation of £69.5m, assuming that the firm is successful in gaining FDA approval. To
arrive at a valuation, this figure must then be multiplied by the one-third probability with which approval occurs – since only then is the option
• obtained – and the £6.9m costs of pursuing the FDA process must be subtracted. This generates an estimated valuation of £16.0m for the AquAdvantage
product. The estimate rises to £17.0m when 60% volatility is assumed. Consistent with the estimates obtained using the previous decision tree approach, there
is not much option value from the ability to “stop” the project when revenues are low because the option is a long way “in the money”.
• In reality, the firm need not pay the commercialization costs immediately after approval is received, but could wait longer if more information is expected about
the likelihood of a successful (“high”) outcome. The value of this possibility can be modeled by extending the duration of the option to (say) 4 or 5 years. A
longer time to expiry is always preferable with financial call options. But this is not necessarily true with real options. With financial options, waiting to exercise
the option reduces the present discounted value of the exercise price; but, with a real option, the exercise price might increase over time (for example, with
inflation). Moreover, with a financial option, stock prices are generally expected to increase over time when there are no dividends in order to provide investors
with the required return on equity; but the “stock price” of a real option does not necessarily increase in the same way. In the case of the Aqua Bounty project,
the cash flows from exercising in year 4 may increase only by inflation, compared to what the firm would have if it exercised the option in year 3; this is not
enough to compensate for the 14% rate at which these cash flows are discounted. In such a case, the value of exercise in year 3 is greater than the value of
exercise in year 4. For simplicity, assume that expected revenues and costs are the same if the project is undertaken after 4 years instead of 3; this reduces the
value of the option to £57.2m (calculated by putting t=4 and S=104.6/(1+14%), and keeping all other inputs the same as in Table C), corresponding to a firm
value of only £12.0m. This illustrates that delay in the approval process, although lengthening the option, is likely to be very costly for Aqua Bounty.
• Valuing the whole firm
• The decision tree approach above yielded an estimated value of around £20m, whereas the Black Scholes approach yielded a value of around £16m for the
AquAdvantage product. An estimate of the value of Aqua Bounty as a whole firm can be obtained by adding our estimated £16-£20m value for the
AquAdvantage product to the estimated £35-50m value of the shrimp therapeutics business (case, p. 4); this generates an estimated value for the whole firm in
the range of £50-70m. Aqua Bounty aims to raise about £17m in financing. If Aqua Bounty were successful in raising finance at a fair value then the post-
refinancing valuation would be £57-87m, of which the new investors would own about 20-30%.
• What happened
• A set of “what happened” slides are provided in TN Exhibit 9. The company had a successful IPO on the London AIM in March 2006. The AquAdvantage product
was valued at £15-20m. The company received £18.8m in exchange for 27% of the post-money stock. Unfortunately, the shrimp therapeutics product began to
falter almost immediately afterwards. It was relatively expensive for farmers to purchase and add to feed and – while results in the laboratory and in controlled
field trials had been good – results in real farms seemed to be much less consistent. In consequence, the product stopped selling. At the same time, the FDA
approval process for AquAdvantage took much longer than anticipated. FDA approval was obtained for the safety of the salmon (which was deemed to be
essentially no different from regular farmed salmon) in September 2010. So this stage took four and a half years, rather than the eighteen months that was
hoped for (case, p. 2). The case mentions that, after the safety of the salmon was proved, the FDA would also assess the environmental impact of the fish; this
was “expected to be a more straightforward process”. In fact, the environmental report was
• not published until December 2012 – although it had apparently been completed considerably
earlier – apparently because the political sensitivity of the topic resulted in its being delayed
until after the November 2012 US Presidential election. Periods for public comment on the
report followed and have been extended. As of writing, Aqua Bounty is still waiting for final
approval to produce its AquAdvantage broodstock.
• Suggested Class Plan (1 day)
• What are the main risks facing the business? Why did it diversify? Why is it difficult to value?
Why does it want to go to IPO now? (20 minutes.)
• What would a “standard” DCF approach look like? What are the problems with this? (10
minutes.)
• What does the probability tree look like? How do we get taxes right here? What valuation do
we reach? (20 minutes.)
• How would you use Black-Scholes to allow for the fact that revenue and cost uncertainty is
most likely continuous? What sensitivity analyses would you wish to conduct, and what is their
impact on value? (25 minutes.)
• What happened? (5 minutes.)
A suggested Board Plan for the two days is given in TN Exhibit 1.
• Suggested Assignment Questions
• What are the principal sources of uncertainty facing Aqua Bounty? Does it make sense for the firm to launch an IPO now?
• Baseline projections for Aqua Bounty’s revenues and costs from their product are given in case Exhibit 5. For discounting purposes, please assume that
these costs and benefits occur at the end of the year. Note that they will be realized only if FDA approval is received for the product, which the
company estimates as being a one-in-three chance. Assuming that approval is forthcoming, Aqua Bounty believes that there is an equal chance of each
of the three commercialization scenarios occurring. Under the “low” scenario, revenues would be 75% lower than under “baseline”; under the “high”
scenario, revenues would be 75% higher. In all three scenarios, COGS will be 20% of revenues, and annual SG&A costs of £4m plus 5% of revenues will
be incurred. Commercialization costs would be the same in all three scenarios, as shown in case Exhibit 5.
• Build a simple cash flow model for Aqua Bounty’s revenues from its AquAdvantage fish, assuming that FDA approval is received. Use this to calculate
the value of the product line under each of the three scenarios given. For each scenario, calculate:
– The PV of FDA approval costs (discounted at rf)
– The PV of product commercialization costs (discounted at rf)
– The PV of the free cash flows from the product line, not including commercialization costs or FDA approvals costs (discounted at rA)
• You should assume:
•  Aqua Bounty will face costs of £2.5m per year for the first three years, associated with its regulatory trials and submissions.
•  No interest payments, as the firm’s debts will be paid in full using revenues from the IPO
•  A corporate tax rate of 35%
•  An unlevered cost of capital of 14%
• b. Using your estimates of the costs and revenues generated above, sketch out a decision tree incorporating regulatory and commercialization
uncertainty. What would be the value of the product if Aqua Bounty were to proceed with commercialization in each of the three scenarios? What if
Aqua Bounty pursued commercialization only if, at that stage, the product were to have an NPV greater than zero?
• 3. Use the values calculated above, along with your knowledge of the situation, to generate inputs for a Black-Scholes model of Aqua Bounty’s option
to commercialize AquAdvantage fish if the FDA grants approval. How would you incorporate this into your decision tree? What value does this suggest
for the business unit?
• 4. How would further delay in the FDA process affect the valuation of the product line? Which factors within the real option framework would drive
this?