Real Options Analysis in

Mergers and Acquisitions

Ankit Singhal
IFMR GSB
 Introduce real options analysis as an
alternative to the DCF methodology
 Outline the different types of real options
 Highlight the types of real options

encountered in mergers and acquisitions

 Options
 An option gives its holder the right, but not the
obligation, to buy (call option) or sell (put option) a
designated asset at a predetermined price (exercise
price)

 An option holder earns profit from price moves in

one direction without bearing (or limiting) risk in the
other direction.

 Characteristics of the underlying asset and the terms

of the option have an impact on the option value
 An American–style option gives the right to
exercise the option at any time before
maturity

 A European-style option may be exercised

only at the maturity
Real Options in Corporate Finance
 The term “real options” was coined by Prof. Myers
of MIT in an article published in 1994

 Strategic planning needs finance. Present value

calculations are needed as a check on strategic
analysis and vice versa.
 However, standard discounted cash flow

techniques will tend to understate the option value

attached to growing profitable lines of business.
 Corporate finance theory requires extension to

deal with real options

 Introduction
 DCF approach to capital budgeting states that
a project with a positive NPV should be
pursued.
 Assumption that the project is passively held
 Decision – whether or not to invest
 Corporate investments are seldom held static;

actively managed with management

continuously making decisions and
implementing changes
 A real option, like a financial option, is the
right, but not the obligation, to take further
strategic action at a future date with respect
to an underlying asset or investment

 Can be valued similar to financial options

based on the time to expiry, the variability
and the value of the potential outcomes.

 Unlike financial options, real options likely do

not have a secondary market
Categories of Real Options

Timing option
 Growth option
 Abandonment option
 Option to expand scale
 Option to switch inputs and outputs and
 Option to contract scale
Timing Option
 Capital projects are like call options in the sense
that both involve the right but not the
obligation to acquire an asset at a specified
price on or before a certain date.
 TN-2

 X- Amount spent on the project is the exercise

price.
 S- present value of cash flows from the project

is the stock price.

 T- The length of time the company can defer

the investment decision without losing the

investment opportunity corresponds to time to
maturity.
 Sigma - uncertainty in the project’s cash
flows corresponds to the standard deviation
of returns.
 Dividends - cash flows lost due to

competitors who have fully committed

corresponds to dividends.
 TN-3
 NPV of a project = PV of cash flows – Initial

Investment
 NPV = S - X
 Timing options enable managers to defer
investment for a certain period of time without
losing the opportunity.
 If an investment can be deferred for 1 year, one
could deposit the money in a bank for 1 year
and withdraw it when the time is ripe to invest.
 That is, the proceeds of X would be available
after 1 year. Since the money was deposited at rf
for 1 year, the present value of X discounted at rf
represents the amount to be deposited now.
 PV (X) = X / (1+ rf)t
 Since our objective is to refine NPV to
incorporate other option variables like rf, t
and  lets redefine NPV as S – PV (X).
 As with financial options this can be

expressed as a ratio.
 = S / PV (X)
 and cumulative variance = 2t (cumulative
volatility is the square root of cumulative
variance)
 We can use these two values to estimate the

value of the option as percent of value of

underlying assets
Illustration
 An oil company has an investment opportunity to
develop some reserves.
 The PV of future cash flows is currently $100m.
 The firm can lock in the investment now by
incurring an expenditure of $80 m.
 Alternatively, it may wait for two years by paying
an up-front fee of $6m and then make an
investment of $90m to develop the reserves.
 Based on the volatility of price of oil, the annual
standard deviation of returns for the oil field is
35%. Interest rate is 8 %.
 It is not correct to estimate the volatility of
the cash flows from the oil project on the
basis of volatility of oil prices.
 It can at best give a first-cut measure.
 The value of the first alternative is $20 m.

That is NPV = $ 20 m.
 The value of the second alternative is:
 X= 90, S = 100
 PV (exercise price) = 90/1.082 = 77.16
 Value of operating assets / PV (X) = 100 / 77.16
= 1.296
  (t) = 0.35 *  2 = 0.50
 Look for the corresponding row and column from
the option pricing table (TN).
 The option value is 31 % of asset value = 0.31 *
100 = $31m.
 NPV = $31m - fees = $31m – $6m = $25m
 The value of flexibility, therefore, is $25m – $20m
= $5m.
 Obviously it makes sense to wait and then invest.
 Timing options are important in all natural
resource extraction industries, real estate
development, farming and paper products.
Growth option

 A growth option is characterized by an early

investment (in R&D say), which leads to a
chain of inter related projects opening up
future new generation products & processes,
access to new market, oil reserves etc.
 Companies derive their value from two
sources: assets in place and present value of
growth opportunities.
 The estimated value of growth option for
some well-known American companies is
presented in Exhibit 4
 Rule of the thumb - the option component
embedded in projects should be evaluated
separately and then added to the value
obtained from the DCF methodology.
 Assume that a project is expected to lead to a

second-generation investment.
 The NPV of the entire proposal may be

written as:
 NPV = NPV (Phase 1) + Call Value of Phase 2.
Steps to evaluate Growth options
1. Segregate discretionary expenditure and its
associated cash flows from phase 2 project
from phase 1.
2. Find the NPV of phase 1 using the
traditional DCF approach.
3. Discount the discretionary spending to the
present using an appropriate risk free rate.
4. If the discretionary spending that leads to
Phase 2 project is Y to be made in the third
year, discount it to the present by using a
three-year risk free rate. This constitutes X
Steps to evaluate Growth options
 Find the present value of cash flows (net of
inflows and routine expenditure on working
capital and fixed assets) using WACC. This is
S.
 Find S / PV(X) .
 Estimate cumulative volatility (t); t is 3

years in this case.

 Find the value of the call option and add it to

the NPV of Phase 1.

 Most capital investments are phased
investments and phased investments are
compound options.
 That is, an option on an option.
 When there are multiple stages in expansion,

each stage represents an option on the next

stage
 Ex 5
 So it is inappropriate to treat projects with
multiple stages of expansion as simple call
options.
 These are call options on call options or call

options on put options, or put options on put

options and so on
Abandonment Option
 If market conditions deteriorate severely,
management can abandon operations and
realize resale value of project assets in second
hand markets.

 Important in capital-intensive industries,

financial services and new product introduction
in uncertain markets.

 Management has to continuously consider

whether to stay or get out; depends on the value
of the project
Example
 A mining company is considering opening up a gold
mine for 2 years.
 If gold price goes up, revenue would go up; whereas
if gold prices go down, revenues would go down.
 The NPV analysis is based on the assumption that
the company will continue digging even if revenues
are down (thereby incurring a loss).
 The company might choose to abandon if gold price
goes down in both the years.
 The NPV calculation does not recognize this
possibility.
 Abandonment options exist in most
businesses and are more valuable when
uncertainty is high.
 An option to abandon is a put option.
 The value of the put option can be found by

replicating the pay off from the put option.

 It is possible to construct a portfolio

consisting of a fraction of the project () and

lending an amount B at the risk free rate r
that replicates the pay off on the put.
 Let the payoffs from the project be V1, 1 and
V1, 2, and those from the replicating portfolios
be P1, 1 and P1, 2 in the two states of the world.
 The pay offs from the replicating portfolio
are:
 P
1,1 =  V1,1 + B(1+r)
 P1,2 =  V1,2 + B(1+r)
 Solve for  and B.
 (P1, 1 – P1, 2)
=
(V1, 1 – V1, 2)
 
P1,1 -  V1,1
and B =
(1+r)
 Since the pay offs from the portfolio are
identical to the pay offs on the put, the
current price of the put must be equal to the
current value of the portfolio.
 P = ( ) (V ) +B
0 0
Natural Resource Investments

 Natural resource investments like mining, oil

exploration are uniquely suited for real options analysis.
 The owner of a mine, for example, has the option to
defer exploration, close or reopen or even abandon a
mine.
 The owner of the mine has the right to acquire the
output of the mine (e. g., copper) at a fixed exercise
price (the variable cost of production).
 When output prices are low and the fixed costs of
operating the mine are high it might be prudent to shut
down the mine, at least temporarily till output prices
bounce back
 Assume that you have a two-year right to mine a
copper deposit. The mine is known to have 8 million
pounds of copper
 The development of the mine involves a cash outlay

of $1.25m and the development itself is expected to

take 1 year at the end of which the owner can mine
or subcontract extraction to a third party by paying
an extraction cost.
 Assume that the extraction costs are 85 cents per

pound.
 The owner can then sell the output to another party

at the spot price one year from now.

 Percentage changes of Copper prices follow a
normal distribution with a mean of 7%
standard deviation of 20 %.
 Current price of copper is 95 cents per

pound.
 The required rate of return for the project is

10% and the risk free rate is 5%.

 Ex 6
 This analysis ignores the fact that the owner
can abandon the project after the
development if the spot price is less than 85
cents.
 This is a one year call option on copper with a

strike price of 85 cents.

 The value of the call option can be estimated

as in Ex 6
 In many natural resource investments like oil
exploration there are two sources of
uncertainty – the quantity of oil in the ground
and the price of oil.
 Options that derive their value from two or

more sources of uncertainty are called

rainbow options.
Other Options
 If price or demand change, management can
change the output mix of the facility.
 Such options are termed option to switch

(output).
 These are important in those cases where the

good is sought in batches or subject to

uncertain demand.
 Examples are consumer electronics, toys, and

specialty-paper.
 Management may have the option to switch
inputs as in the case of oil, electric power and
agricultural crops.

 The flexibility comes at a price and can be

advantageous depending on the relative
prices of alternatives
Estimating Volatility
 One of the inputs to the option-pricing model is
the variance of returns.
 In case of equity options the standard deviation
of stock returns in the immediate past (say, 6
months or 3 months) is used to estimate the
value of volatility.
 Another approach is to estimate the volatility
“implied” by past option prices.
 That is, given all parameters and the option
price one may find out volatility by trial and
error.
 In case of real options, the underlying asset is
the project. How?
 There are many alternatives:

1. Estimate the volatility of a stock market

index and take it as proxy for volatility of
project returns.
2. Calculate the implied volatility of the
options on the company’s stock and take it
as proxy for the project’s variance.
 Use spreadsheets (or sophisticated packages
like Crystal Ball) to simulate project’s cash
flows and estimate the standard deviation of
the project’s returns.
Managing Real Options

The value of the real option depends on the

underlying variables
 Present value of operating cash inflows
 Present value of operating cash outflows
 Time to maturity
 Volatility of cash flows
 Risk free rate of interest
 Cash flow lost due to competition.
 One may reduce the value lost by waiting, for
example, by erecting entry barriers to
competitors (e. g., locking in key customers).
 Likewise, the present value of cash inflows
can be increased by raising prices or reducing
expenses
 The value of an option can be expressed as a

function of two metrics S/ PV (X) and  t.

 The value of option increases if either (or

both) increases.
 A company may classify projects on an option

space as shown in Ex 7
 In sum, a manager is required to proactively
cultivate a company’s projects.
 Proactive cultivation needs constant

monitoring and support to promising

projects.
 Assume that a company has a portfolio of

projects of which some have negative NPV.

 Conventional capital budgeting suggests that

they should be discarded. That’s incorrect.

 The principal insight gained from real options
analysis is that these projects should be
actively cultivated if they have high
cumulative volatility.
Applications of Real Options in
Mergers and Acquisitions
 Real options in Strategic Planning
 When managers discuss M&A plans from a

strategic perspective they tend to use terms

such as “rights”, “flexibility”, and
“commitments”.
 These are veiled terms denoting optionality.
 Some acquisitions tend to create flexibility

while others destroy them.

 Flexibility is an option and should be treated
as such in financial analysis.
 Examples of flexibility options include the

holding of excess cash, inventory or

manufacturing capacity.
 Insurance is like a put option that can hedge

firm’s exposure to risk

 “First mover advantage” and “winners takes
all” approaches have given way to a more
sober “second mover” approach in recent
years.
Real Options in Deal Design
 The formal contract in many instances is
structured as a contingent right.
 If terms and conditions are satisfied, then the

buyer is allowed to acquire the target.

 In many cases, a buyer typically approaches

target shareholders with an offer to buy the

shares at a stated price within a stipulated
period.
 The buyer has effectively granted a put

option to the target shareholders.

 Many M&A deals include topping fees and
penalties for not completing the deal.
 These are rights to payments in the event of

nonperformance by one party or another.

 Since these are contingent payments they are

like options.
 The ability to sell an asset on demand is like

a put option.
 Control works like holding a call option on

future strategy.
 Mergers and Acquisitions sometimes involve
the use of contingent payments such as
Earnouts.
 These contingent payments are call options

on future performance.
 Both buyers and sellers face transaction risks
in concluding M&A transactions.
 This risk can be mitigated by the use of caps,

collars, floors and contingent value rights.

 Takeover defenses such as poison pills, lock-

ups, and control rights are options.

 Liquidity as an option
 

 Liquidity and control are rights and their

value must be estimated in terms of their
option value.
 Liquidity discounts have been modeled using

option pricing theory.

 Alli and Thomson (1991) compute the value

of liquidity as the value of a put option with a

strike price equal to the share price at the
date of the issue
 It is seen that the discount due to illiquidity is
driven by two major factors: Uncertainty and
Time.
 The greater the uncertainty in the value of the

underlying stock, the greater will be the

discount for illiquidity.
 Furthermore, the longer the delay in exiting

from an investment, the greater will be the

discount for illiquidity.
Control as an option

 Control is a call option on the alternate

strategies and policies of the firm.
 Control bestows the right to direct the

strategies and activities of the firm.

 Furthermore, the right to allocate resources

and to distribute the economic wealth of the

firm also ensues from control.
 Two key characteristics of control that have

option-like features: contingency and

volatility.
 The value of control is contingent on the
success of current strategies.
 If current strategy works well, the option to

switch strategies is out of the money.

 If existing strategy works inadequately, then

the option to switch is in the money.

 Furthermore, the value of control depends on
the volatility of the values of the firm under
current and alternate strategies.
 The value of control also depends on the

uncertainty of those values.

 Control will be worth more in situations of

greater uncertainty
Option-like Contingent Payments in M&A

 Earnout Plans
 Targeted Stocks
 Stock Options
 Bonus payments
 Escrow funds
 Holdback Allowance
 Earnout Plans: In an earnout plan, the trigger on
payment may be determined by complicated
formulas and agreements for measuring progress.
 The earnout plan is usually a legally binding
contract
 Targeted Stocks: The buyer can issue target’s
shareholders shares of stock whose dividends are
pegged to the performance of the target.
 Stock Options: These are rights to acquire shares of
the buyer. The exercise price is normally set above
the buyer’s stock price at closing.
 Bonus payments: Bonus payments are made to
sellers, especially managers of the selling firms if
they agree to stay on with the target firm.
 Escrow funds: In some transactions, a part of the
total payment is set aside in an escrow account to
be released to the seller on satisfactory completion
of some stipulated condition.
 Holdback Allowance: This is similar to escrow
funds with the exception that no escrow account is
created.
Potential Benefits of Earnouts

 There are three major advantages of using

earnouts in an M&A transaction:
 The most commonly mentioned rationale for

employing an earnout is to bridge the

valuation gap.
 Let’s assume that a seller is optimistic and values
the target firm at $60 million.
 The buyer is somewhat pessimistic and values the

deal at $40 million.

 No deal is possible with this gap in valuation. Now

both parties can agree to an immediate payment of

$40 million and a $20 million contingent payout if
certain performance targets are achieved.
 Thus earnouts serve to bridge the valuation gap

and serve to expedite closure of a M&A transaction

 Earnouts serve to facilitate retention of key
managers with the combined firm.
 If a portion of the purchase price is

contingent on performance goals after the

closure of the sale, target firm managers have
an incentive to remain with the firm in order
to participate in potential future payments.
 Earnouts also motivate target’s managers and
shareholders to continue aggressive growth
strategies even after closing the sale.
 Ex 8 (earnout deal statistics)