Option Pricing Theory and Real

Option Applications

Aswath Damodaran

What is an option?

Anoptionprovidestheholderwiththerighttobuyorsellaspecified
quantityofanunderlyingassetatafixedprice(calledastrikepriceor
anexerciseprice)atorbeforetheexpirationdateoftheoption.
Sinceitisarightandnotanobligation,theholdercanchoosenotto
exercisetherightandallowtheoptiontoexpire.
Therearetwotypesofoptionscalloptions(righttobuy)andput
options(righttosell).

Aswath Damodaran

Call Options

Acalloptiongivesthebuyeroftheoptiontherighttobuythe
underlyingassetatafixedprice(strikepriceorK)atanytimepriorto
theexpirationdateoftheoption.Thebuyerpaysapriceforthisright.
Atexpiration,
Ifthevalueoftheunderlyingasset(S)>StrikePrice(K)
Buyermakesthedifference:SK

Ifthevalueoftheunderlyingasset(S)<StrikePrice(K)
Buyerdoesnotexercise

Moregenerally,
thevalueofacallincreasesasthevalueoftheunderlyingassetincreases
thevalueofacalldecreasesasthevalueoftheunderlyingassetdecreases

Aswath Damodaran

Payoff Diagram on a Call

NetPayoff
onCall

Strike
Price
Priceofunderlyingasset

Aswath Damodaran

Put Options

Aputoptiongivesthebuyeroftheoptiontherighttosellthe
underlyingassetatafixedpriceatanytimepriortotheexpirationdate
oftheoption.Thebuyerpaysapriceforthisright.
Atexpiration,
Ifthevalueoftheunderlyingasset(S)<StrikePrice(K)
Buyermakesthedifference:KS

Ifthevalueoftheunderlyingasset(S)>StrikePrice(K)
Buyerdoesnotexercise

Moregenerally,
thevalueofaputdecreasesasthevalueoftheunderlyingassetincreases
thevalueofaputincreasesasthevalueoftheunderlyingassetdecreases

Aswath Damodaran

Payoff Diagram on Put Option

NetPayoff
OnPut

Strike
Price
Priceofunderlyingasset

Aswath Damodaran

Determinants of option value

VariablesRelatingtoUnderlyingAsset
ValueofUnderlyingAsset;asthisvalueincreases,therighttobuyatafixedprice
(calls)willbecomemorevaluableandtherighttosellatafixedprice(puts)will
becomelessvaluable.
Varianceinthatvalue;asthevarianceincreases,bothcallsandputswillbecomemore
valuablebecausealloptionshavelimiteddownsideanddependuponpricevolatility
forupside.
Expecteddividendsontheasset,whicharelikelytoreducethepriceappreciation
componentoftheasset,reducingthevalueofcallsandincreasingthevalueofputs.

VariablesRelatingtoOption
StrikePriceofOptions;therighttobuy(sell)atafixedpricebecomesmore(less)
valuableatalowerprice.
LifeoftheOption;bothcallsandputsbenefitfromalongerlife.

LevelofInterestRates;asratesincrease,therighttobuy(sell)atafixedpricein
thefuturebecomesmore(less)valuable.

Aswath Damodaran

American versus European options: Variables

relating to early exercise

AnAmericanoptioncanbeexercisedatanytimepriortoitsexpiration,
whileaEuropeanoptioncanbeexercisedonlyatexpiration.
ThepossibilityofearlyexercisemakesAmericanoptionsmorevaluablethan
otherwisesimilarEuropeanoptions.
However,inmostcases,thetimepremiumassociatedwiththeremaininglifeofan
optionmakesearlyexercisesuboptimal.

Whileearlyexerciseisgenerallynotoptimal,therearetwoexceptions:
Oneiswheretheunderlyingassetpayslargedividends,thusreducingthevalueof
theasset,andofcalloptionsonit.Inthesecases,calloptionsmaybeexercisedjust
beforeanexdividenddate,ifthetimepremiumontheoptionsislessthanthe
expecteddeclineinassetvalue.
Theotheriswhenaninvestorholdsboththeunderlyingassetanddeepinthe
moneyputsonthatasset,atatimewheninterestratesarehigh.Thetime
premiumontheputmaybelessthanthepotentialgainfromexercisingtheputearly
andearninginterestontheexerciseprice.

Aswath Damodaran

A Summary of the Determinants of Option

Value
Factor
IncreaseinStockPrice
IncreaseinStrikePrice
Increaseinvarianceofunderlyingasset
Increaseintimetoexpiration
Increaseininterestrates
Increaseindividendspaid

Aswath Damodaran

CallValue
Increases
Decreases
Increases
Increases
Increases
Decreases

PutValue
Decreases
Increases
Increases
Increases
Decreases
Increases

Creating a replicating portfolio

Theobjectiveincreatingareplicatingportfolioistousea
combinationofriskfreeborrowing/lendingandtheunderlyingassetto
createthesamecashflowsastheoptionbeingvalued.
Call=Borrowing+BuyingoftheUnderlyingStock
Put=SellingShortonUnderlyingAsset+Lending
Thenumberofsharesboughtorsoldiscalledtheoptiondelta.

Theprinciplesofarbitragethenapply,andthevalueoftheoptionhas
tobeequaltothevalueofthereplicatingportfolio.

Aswath Damodaran

10

The Binomial Model

100

70

50

50
35

25

Aswath Damodaran

11

The Replicating Portfolio

Option Details
K = $ 40
t=2
r = 11%

100
50

Call=1*7036.04=33.96

70
35

Call=0.8278*5021.61=19.78

Stock
Price

Call

100

60

50

10

25

Call = 33.96
70

50
Call = 19.42

35
Call = 4.99
50
25

Call=0.4*359.01=4.99

Aswath Damodaran

12

The Limiting Distributions.

Asthetimeintervalisshortened,thelimitingdistribution,ast>0,
cantakeoneoftwoforms.
Ifast>0,pricechangesbecomesmaller,thelimitingdistributionisthe
normaldistributionandthepriceprocessisacontinuousone.
Ifast>0,pricechangesremainlarge,thelimitingdistributionisthe
poissondistribution,i.e.,adistributionthatallowsforpricejumps.

TheBlackScholesmodelapplieswhenthelimitingdistributionis
thenormaldistribution,andexplicitlyassumesthattheprice
processiscontinuousandthattherearenojumpsinassetprices.

Aswath Damodaran

13

The Black-Scholes Model

TheversionofthemodelpresentedbyBlackandScholeswas
designedtovalueEuropeanoptions,whichweredividendprotected.
ThevalueofacalloptionintheBlackScholesmodelcanbewritten
asafunctionofthefollowingvariables:
S=Currentvalueoftheunderlyingasset
K=Strikepriceoftheoption
t=Lifetoexpirationoftheoption
r=Risklessinterestratecorrespondingtothelifeoftheoption
2=Varianceintheln(value)oftheunderlyingasset

Aswath Damodaran

14

The Black Scholes Model

Valueofcall=SN(d1)KertN(d2)
where,
2

S
ln + (r +
)t
K
2
d1 =
t

d2=d1t

ThereplicatingportfolioisembeddedintheBlackScholesmodel.To
replicatethiscall,youwouldneedto
BuyN(d1)sharesofstock;N(d1)iscalledtheoptiondelta
BorrowKertN(d2)

Aswath Damodaran

15

The Normal Distribution

d

N(d 1)

d1

Aswath Damodaran

-3.00
-2.95
-2.90
-2.85
-2.80
-2.75
-2.70
-2.65
-2.60
-2.55
-2.50
-2.45
-2.40
-2.35
-2.30
-2.25
-2.20
-2.15
-2.10
-2.05
-2.00
-1.95
-1.90
-1.85
-1.80
-1.75
-1.70
-1.65
-1.60
-1.55
-1.50
-1.45
-1.40
-1.35
-1.30
-1.25
-1.20
-1.15
-1.10
-1.05
-1.00

N(d)
0.0013
0.0016
0.0019
0.0022
0.0026
0.0030
0.0035
0.0040
0.0047
0.0054
0.0062
0.0071
0.0082
0.0094
0.0107
0.0122
0.0139
0.0158
0.0179
0.0202
0.0228
0.0256
0.0287
0.0322
0.0359
0.0401
0.0446
0.0495
0.0548
0.0606
0.0668
0.0735
0.0808
0.0885
0.0968
0.1056
0.1151
0.1251
0.1357
0.1469
0.1587

d
-1.00
-0.95
-0.90
-0.85
-0.80
-0.75
-0.70
-0.65
-0.60
-0.55
-0.50
-0.45
-0.40
-0.35
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00

N(d)
0.1587
0.1711
0.1841
0.1977
0.2119
0.2266
0.2420
0.2578
0.2743
0.2912
0.3085
0.3264
0.3446
0.3632
0.3821
0.4013
0.4207
0.4404
0.4602
0.4801
0.5000
0.5199
0.5398
0.5596
0.5793
0.5987
0.6179
0.6368
0.6554
0.6736
0.6915
0.7088
0.7257
0.7422
0.7580
0.7734
0.7881
0.8023
0.8159
0.8289
0.8413

d
1.05
1.10
1.15
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
1.60
1.65
1.70
1.75
1.80
1.85
1.90
1.95
2.00
2.05
2.10
2.15
2.20
2.25
2.30
2.35
2.40
2.45
2.50
2.55
2.60
2.65
2.70
2.75
2.80
2.85
2.90
2.95
3.00

N(d)
0.8531
0.8643
0.8749
0.8849
0.8944
0.9032
0.9115
0.9192
0.9265
0.9332
0.9394
0.9452
0.9505
0.9554
0.9599
0.9641
0.9678
0.9713
0.9744
0.9772
0.9798
0.9821
0.9842
0.9861
0.9878
0.9893
0.9906
0.9918
0.9929
0.9938
0.9946
0.9953
0.9960
0.9965
0.9970
0.9974
0.9978
0.9981
0.9984
0.9987

16

Adjusting for Dividends

Ifthedividendyield(y=dividends/Currentvalueoftheasset)ofthe
underlyingassetisexpectedtoremainunchangedduringthelifeofthe
option,theBlackScholesmodelcanbemodifiedtotakedividends
intoaccount.

C=SeytN(d1)KertN(d2)
where, S
2
ln
+ (r y +
)t
K
2
d1 =
t
d2=d1t

Thevalueofaputcanalsobederived:

P=Kert(1N(d2))Seyt(1N(d1))
Aswath Damodaran

17

Problems with Real Option Pricing Models

1.Theunderlyingassetmaynotbetraded,whichmakesitdifficultto
estimatevalueandvariancefortheunderlyingasset.
2.Thepriceoftheassetmaynotfollowacontinuousprocess,which
makesitdifficulttoapplyoptionpricingmodels(liketheBlack
Scholes)thatusethisassumption.
3.Thevariancemaynotbeknownandmaychangeoverthelifeofthe
option,whichcanmaketheoptionvaluationmorecomplex.
4.Exercisemaynotbeinstantaneous,whichwillaffectthevalueofthe
option.
5.Somerealoptionsarecomplexandtheirexercisecreatesotheroptions
(compound)orinvolvelearning(learningoptions)

Aswath Damodaran

18

Option Pricing Applications in

Investment/Strategic Analysis

Aswath Damodaran

19

Options in Projects/Investments/Acquisitions

Oneofthelimitationsoftraditionalinvestmentanalysisisthatitis
staticanddoesnotdoagoodjobofcapturingtheoptionsembeddedin
investment.
Thefirstoftheseoptionsistheoptiontodelaytakingainvestment,when
afirmhasexclusiverightstoit,untilalaterdate.
Thesecondoftheseoptionsistakingoneinvestmentmayallowustotake
advantageofotheropportunities(investments)inthefuture
Thelastoptionthatisembeddedinprojectsistheoptiontoabandona
investment,ifthecashflowsdonotmeasureup.

Theseoptionsalladdvaluetoprojectsandmaymakeabad
investment(fromtraditionalanalysis)intoagoodone.

Aswath Damodaran

20

The Option to Delay

Whenafirmhasexclusiverightstoaprojectorproductforaspecific
period,itcandelaytakingthisprojectorproductuntilalaterdate.
Atraditionalinvestmentanalysisjustanswersthequestionofwhether
theprojectisagoodoneiftakentoday.
Thus,thefactthataprojectdoesnotpassmustertoday(becauseits
NPVisnegative,oritsIRRislessthanitshurdlerate)doesnotmean
thattherightstothisprojectarenotvaluable.

Aswath Damodaran

21

Valuing the Option to Delay a Project

PVofCashFlows
fromProject

InitialInvestmentin
Project
PresentValueofExpected
CashFlowsonProduct
Projecthasnegative
NPVinthissection

Aswath Damodaran

Project'sNPVturns
positiveinthissection

22

Insights for Investment Analyses

Havingtheexclusiverightstoaproductorprojectisvaluable,evenif
theproductorprojectisnotviabletoday.
Thevalueoftheserightsincreaseswiththevolatilityoftheunderlying
business.
Thecostofacquiringtheserights(bybuyingthemorspendingmoney
ondevelopment,forinstance)hastobeweighedoffagainstthese
benefits.

Aswath Damodaran

23

Example 1: Valuing product patents as options

Aproductpatentprovidesthefirmwiththerighttodevelopthe
productandmarketit.
Itwilldosoonlyifthepresentvalueoftheexpectedcashflowsfrom
theproductsalesexceedthecostofdevelopment.
Ifthisdoesnotoccur,thefirmcanshelvethepatentandnotincurany
furthercosts.
IfIisthepresentvalueofthecostsofdevelopingtheproduct,andV
isthepresentvalueoftheexpectedcashflowsfromdevelopment,the
payoffsfromowningaproductpatentcanbewrittenas:
Payofffromowningaproductpatent
=VI
ifV>I
=0
ifVI

Aswath Damodaran

24

Payoff on Product Option

NetPayoffto
introduction

Costofproduct
introduction
PresentValueof
cashflowsonproduct

Aswath Damodaran

25

Obtaining Inputs for Patent Valuation

Input

EstimationProcess

1.ValueoftheUnderlyingAsset

PresentValueofCashInflowsfromtakingproject
now
Thiswillbenoisy,butthataddsvalue.

2.Varianceinvalueofunderlyingasset

Varianceincashflowsofsimilarassetsorfirms
Varianceinpresentvaluefromcapitalbudgeting
simulation.

3.ExercisePriceonOption

Optionisexercisedwheninvestmentismade.
Costofmakinginvestmentontheproject ;assumed
tobeconstantinpresentvaluedollars.

4.ExpirationoftheOption

Lifeofthepatent

5.DividendYield

Costofdelay
Eachyearofdelaytranslatesintoonelessyearof
valuecreating cashflows
Annualcostofdelay =

Aswath Damodaran

1
n

26

Valuing a Product Patent: Avonex

Biogen,abiotechnologyfirm,hasapatentonAvonex,adrugtotreat
multiplesclerosis,forthenext17years,anditplanstoproduceandsell
thedrugbyitself.Thekeyinputsonthedrugareasfollows:
PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion
PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion
PatentLife=t=17yearsRisklessRate=r=6.7%(17yearT.Bondrate)
VarianceinExpectedPresentValues=2=0.224(Industryaveragefirm
varianceforbiotechfirms)
ExpectedCostofDelay=y=1/17=5.89%
d1=1.1362 N(d1)=0.8720
d2=0.8512 N(d2)=0.2076

CallValue=3,422exp(0.0589)(17)(0.8720)2,875(exp (0.067)(17)(0.2076)=$
907million
Aswath Damodaran

27

Patent Life and Exercise

Figure28.4:PatentvalueversusNetPresentvalue
1000
900
800
Exercisetheoptionhere:Convertpatenttocommercialproduct

700

Value

600
500
400
300
200
100
0
17

16

15

14

13

12

11

10

Numberofyearsleftonpatent
Valueofpatentasoption

Aswath Damodaran

Netpresentvalueofpatent

28

Valuing a firm with patents

Thevalueofafirmwithasubstantialnumberofpatentscanbe
derivedusingtheoptionpricingmodel.
ValueofFirm=Valueofcommercialproducts(usingDCFvalue
+Valueofexistingpatents(usingoptionpricing)
+(ValueofNewpatentsthatwillbeobtainedinthe
futureCostofobtainingthesepatents)
Thelastinputmeasurestheefficiencyofthefirminconvertingits
R&Dintocommercialproducts.Ifweassumethatafirmearnsitscost
ofcapitalfromresearch,thistermwillbecomezero.
Ifweusethisapproach,weshouldbecarefulnottodoublecountand
allowforahighgrowthrateincashflows(intheDCFvaluation).

Aswath Damodaran

29

Value of Biogens existing products

Biogenhadtwocommercialproducts(adrugtotreatHepatitisBand
Intron) at the time of this valuation that it had licensed to other
pharmaceuticalfirms.
The license fees on these products were expected to generate $ 50
million in aftertax cash flows each year for the next 12 years. To
valuethesecashflows,whichwereguaranteedcontractually,thepre
taxcostofdebtof7%ofthelicensingfirmswasused:
PresentValueofLicenseFees=$50million(1(1.07) 12)/.07
=$397.13million

Aswath Damodaran

30

Value of Biogens Future R&D

Biogencontinuedtofundresearchintonewproducts,spendingabout
$100milliononR&Dinthemostrecentyear.TheseR&Dexpenses
were expected to grow 20% a year for the next 10 years, and 5%
thereafter.
It was assumed that every dollar invested in research would create $
1.25 in value in patents (valued using the option pricing model
describedabove)forthenext10years,andbreakevenafterthat(i.e.,
generate$1inpatentvalueforevery$1investedinR&D).
Therewasasignificantamountofriskassociatedwiththiscomponent
andthecostofcapitalwasestimatedtobe15%.

Aswath Damodaran

31

Value of Future R&D

Yr Valueof
Patents
1 $150.00
2 $180.00
3 $216.00
4 $259.20
5 $311.04
6 $373.25
7 $447.90
8 $537.48
9 $644.97
10 $773.97

Aswath Damodaran

R&DCost
(at15%)
$120.00
$144.00
$172.80
$207.36
$248.83
$298.60
$358.32
$429.98
$515.98
$619.17

ExcessValue

PresentValue

$30.00
$36.00
$43.20
$51.84
$62.21
$74.65
$89.58
$107.50
$128.99
$154.79

$26.09
$27.22
$28.40
$29.64
$30.93
$32.27
$33.68
$35.14
$36.67
$38.26

$318.30
32

Value of Biogen
ThevalueofBiogenasafirmisthesumofallthreecomponentsthe
present value of cash flows from existing products, the value of
Avonex(asanoption)andthevaluecreatedbynewresearch:
Value=Existingproducts+ExistingPatents+Value:FutureR&D
=$397.13million+$907million+$318.30million
=$1622.43million
SinceBiogenhadnodebtoutstanding,thisvaluewasdividedbythe
numberofsharesoutstanding(35.50million)toarriveatavalueper
share:
Valuepershare=$1,622.43million/35.5=$45.70

Aswath Damodaran

33

Example 2: Valuing Natural Resource Options

Inanaturalresourceinvestment,theunderlyingassetistheresource
andthevalueoftheassetisbasedupontwovariablesthequantityof
theresourcethatisavailableintheinvestmentandthepriceofthe
resource.
Inmostsuchinvestments,thereisacostassociatedwithdevelopingthe
resource,andthedifferencebetweenthevalueoftheassetextracted
andthecostofthedevelopmentistheprofittotheownerofthe
resource.
DefiningthecostofdevelopmentasX,andtheestimatedvalueofthe
resourceasV,thepotentialpayoffsonanaturalresourceoptioncanbe
writtenasfollows:

Aswath Damodaran

Payoffonnaturalresourceinvestment =VX ifV>X

=0
ifVX
34

Payoff Diagram on Natural Resource Firms

NetPayoffon
Extraction

CostofDeveloping
Reserve

Valueofestimatedreserve
ofnaturalresource

Aswath Damodaran

35

Estimating Inputs for Natural Resource Options

Input
1.ValueofAvailableReservesoftheResource
2.CostofDevelopingReserve(Str ikePrice)
3.TimetoExpir ation

4.Varianceinvalueofunderlyingasset

EstimationProcess
Exper testimates(Geologistsforoil..);The
presentvalueoftheaftertaxcashflowsfrom
ther esourcearethenestimated.
Pastcostsandthespecificsoftheinvestment
RelinqushmentPeriod:ifassethastobe
relinquishedatapointintime.
Timetoexhaustinventorybasedupon
inventoryandcapacityoutput.
baseduponvariabilityofthepriceofthe
resourcesandvariabilityofavailablereserves.

5.NetProductionRevenue(DividendYield)

Netproductionrevenueeveryyearaspercent
ofmarketvalue.

6.DevelopmentLag

Calculatepresentvalueofreservebasedupon
thelag.

Aswath Damodaran

36

Valuing an Oil Reserve

Consideranoffshoreoilpropertywithanestimatedoilreserveof50
millionbarrelsofoil,wherethepresentvalueofthedevelopmentcost
is$12perbarrelandthedevelopmentlagistwoyears.
Thefirmhastherightstoexploitthisreserveforthenexttwentyyears
andthemarginalvalueperbarrelofoilis$12perbarrelcurrently
(Priceperbarrelmarginalcostperbarrel).
Oncedeveloped,thenetproductionrevenueeachyearwillbe5%of
thevalueofthereserves.
Therisklessrateis8%andthevarianceinln(oilprices)is0.03.

Aswath Damodaran

37

Inputs to Option Pricing Model

CurrentValueoftheasset=S=Valueofthedevelopedreservediscounted
backthelengthofthedevelopmentlagatthedividendyield=$12*50/
(1.05)2=$544.22
(Ifdevelopmentisstartedtoday,theoilwillnotbeavailableforsaleuntil
twoyearsfromnow.Theestimatedopportunitycostofthisdelayisthelost
productionrevenueoverthedelayperiod.Hence,thediscountingofthe
reservebackatthedividendyield)
ExercisePrice=PresentValueofdevelopmentcost=$12*50=$600
million
Timetoexpirationontheoption=20years
Varianceinthevalueoftheunderlyingasset=0.03
Risklessrate=8%
DividendYield=Netproductionrevenue/Valueofreserve=5%

Aswath Damodaran

38

Valuing the Option

Basedupontheseinputs,theBlackScholesmodelprovidesthe
followingvalueforthecall:
d1=1.0359
d2=0.2613

N(d1)=0.8498
N(d2)=0.6030

CallValue=544.22exp(0.05)(20)(0.8498)600(exp(0.08)(20)(0.6030)=$
97.08million
Thisoilreserve,thoughnotviableatcurrentprices,stillisavaluable
propertybecauseofitspotentialtocreatevalueifoilpricesgoup.

Aswath Damodaran

39

Extending the option pricing approach to value

natural resource firms

Sincetheassetsownedbyanaturalresourcefirmcanbeviewedprimarily
asoptions,thefirmitselfcanbevaluedusingoptionpricingmodels.
Thepreferredapproachwouldbetoconsidereachoptionseparately,
valueitandcumulatethevaluesoftheoptionstogetthefirmvalue.
Sincethisinformationislikelytobedifficulttoobtainforlargenatural
resourcefirms,suchasoilcompanies,whichownhundredsofsuch
assets,avariantistovaluetheentirefirmasoneoption.
Apuristwouldprobablydisagree,arguingthatvaluinganoptionona
portfolioofassets(asinthisapproach)willprovidealowervalue
thanvaluingaportfolioofoptions(whichiswhatthenaturalresource
firmreallyown).Nevertheless,thevalueobtainedfromthemodelstill
providesaninterestingperspectiveonthedeterminantsofthevalueof
naturalresourcefirms.

Aswath Damodaran

40

Inputs to the Model

Inputtomodel

Correspondinginputforvaluingfirm

Valueofunderlyingasset
Valueofcumulatedestimatedreservesofthe
resourceownedbythefirm,discountedbackatthe
dividendyieldforthe
developmentlag.
ExercisePrice
Estimatedcumulatedcostofdevelopingestimated
reserves
Timetoexpirationonoption Averagerelinquishmentperiodacrossallreserves
ownedbyfirm(ifknown)orestimateofwhen
reserveswillbe
exhausted,givencurrent productionrates.
Risklessrate
Risklessratecorrespondingtolifeoftheoption
Varianceinvalueofasset
Varianceinthepriceofthenaturalresource
Dividendyield
Estimatedannualnetproductionrevenueas
percentageof
valueofthereserve.

Aswath Damodaran

41

Valuing Gulf Oil

GulfOilwasthetargetofatakeoverinearly1984at$70pershare(It
had165.30millionsharesoutstanding,andtotaldebtof$9.9billion).
Ithadestimatedreservesof3038millionbarrelsofoilandtheaverage
costofdevelopingthesereserveswasestimatedtobe$10abarrelin
presentvaluedollars(Thedevelopmentlagisapproximatelytwoyears).
Theaveragerelinquishmentlifeofthereservesis12years.
Thepriceofoilwas$22.38perbarrel,andtheproductioncost,taxes
androyaltieswereestimatedat$7perbarrel.
Thebondrateatthetimeoftheanalysiswas9.00%.
Gulfwasexpectedtohavenetproductionrevenueseachyearof
approximately5%ofthevalueofthedevelopedreserves.Thevariance
inoilpricesis0.03.

Aswath Damodaran

42

Valuing Undeveloped Reserves

Valueofunderlyingasset=Valueofestimatedreservesdiscountedbackfor
periodofdevelopmentlag=3038*($22.38$7)/1.05 2=$42,380.44
Exerciseprice=Estimateddevelopmentcostofreserves=3038*$10=$30,380
million
Timetoexpiration=Averagelengthofrelinquishmentoption=12years
Varianceinvalueofasset=Varianceinoilprices=0.03
Risklessinterestrate=9%
Dividendyield=Netproductionrevenue/Valueofdevelopedreserves=5%

Basedupontheseinputs,theBlackScholesmodelprovidesthefollowing
valueforthecall:
d1=1.6548
d2=1.0548

N(d1)=0.9510
N(d2)=0.8542

CallValue=42,380.44exp(0.05)(12)(0.9510)30,380(exp (0.09)(12)(0.8542)=$
13,306million

Aswath Damodaran

43

Valuing Gulf Oil

Inaddition,GulfOilhadfreecashflowstothefirmfromitsoilandgas
productionof$915millionfromalreadydevelopedreservesandthese
cashflowsarelikelytocontinuefortenyears(theremaininglifetimeof
developedreserves).
Thepresentvalueofthesedevelopedreserves,discountedattheweighted
averagecostofcapitalof12.5%,yields:
Valueofalreadydevelopedreserves=915(11.125 10)/.125=$5065.83

Addingthevalueofthedevelopedandundevelopedreserves
Valueofundevelopedreserves=$13,306million
Valueofproductioninplace =$5,066million
Totalvalueoffirm =$18,372million
LessOutstandingDebt
=$9,900million
ValueofEquity
=$8,472million
Valuepershare
=$8,472/165.3 =$51.25

Aswath Damodaran

44

The Option to Expand/Take Other Projects

Takingaprojecttodaymayallowafirmtoconsiderandtakeother
valuableprojectsinthefuture.
Thus,eventhoughaprojectmayhaveanegativeNPV,itmaybea
projectworthtakingiftheoptionitprovidesthefirm(totakeother
projectsinthefuture)providesamorethancompensatingvalue.
Thesearetheoptionsthatfirmsoftencallstrategicoptionsanduse
asarationalefortakingonnegativeNPVorevennegativereturn
projects.

Aswath Damodaran

45

The Option to Expand

PVofCashFlows
fromExpansion

AdditionalInvestment
toExpand
PresentValueofExpected
CashFlowsonExpansion
Firmwillnotexpandin
thissection

Aswath Damodaran

Expansionbecomes
attractiveinthissection

46

An Example of an Expansion Option

AmbevisconsideringintroducingasoftdrinktotheU.S.market.The
drinkwillinitiallybeintroducedonlyinthemetropolitanareasofthe
U.S.andthecostofthislimitedintroductionis$500million.
Afinancialanalysisofthecashflowsfromthisinvestmentsuggests
thatthepresentvalueofthecashflowsfromthisinvestmenttoAmbev
willbeonly$400million.Thus,byitself,thenewinvestmenthasa
negativeNPVof$100million.
Iftheinitialintroductionworksoutwell,Ambevcouldgoaheadwith
afullscaleintroductiontotheentiremarketwithanadditional
investmentof$1billionanytimeoverthenext5years.Whilethe
currentexpectationisthatthecashflowsfromhavingthisinvestment
isonly$750million,thereisconsiderableuncertaintyaboutboththe
potentialforthedrink,leadingtosignificantvarianceinthisestimate.

Aswath Damodaran

47

Valuing the Expansion Option

ValueoftheUnderlyingAsset(S)=PVofCashFlowsfrom
ExpansiontoentireU.S.market,ifdonenow=$750Million
StrikePrice(K)=CostofExpansionintoentireU.Smarket=$1000
Million
Weestimatethestandarddeviationintheestimateoftheprojectvalue
byusingtheannualizedstandarddeviationinfirmvalueofpublicly
tradedfirmsinthebeveragemarkets,whichisapproximately34.25%.
StandardDeviationinUnderlyingAssetsValue=34.25%

Timetoexpiration=Periodforwhichexpansionoptionapplies=5
years
CallValue=$234Million

Aswath Damodaran

48

Considering the Project with Expansion Option

NPVofLimitedIntroduction=$400Million$500Million=$
100Million
ValueofOptiontoExpandtofullmarket=$234Million
NPVofProjectwithoptiontoexpand
=$100million+$234million
=$134million

Investintheproject

Aswath Damodaran

49

The Link to Strategy

Inmanyinvestments,especiallyacquisitions,strategicoptionsor
considerationsareusedtotakeinvestmentsthatotherwisedonotmeet
financialstandards.
Thesestrategicoptionsorconsiderationsareusuallyrelatedtothe
expansionoptiondescribedhere.Thekeydifferencesareasfollows:
Unlikestrategicoptionswhichareusuallyqualitativeandnotvalued,
expansionoptionscanbeassignedaquantitativevalueandcanbebrought
intotheinvestmentanalysis.
Notallstrategicconsiderationshaveoptionvalue.Foranexpansion
optiontohavevalue,thefirstinvestment(acquisition)mustbenecessary
forthelaterexpansion(investment).Ifitisnot,thereisnooptionvalue
thatcanbeaddedontothefirstinvestment.

Aswath Damodaran

50

The Exclusivity Requirement in Option Value

Is the first investment necessary for the second investment?
Not necessary

Pre-Requisit

A Zero competitive
advantage on Second Investment

An Exclusive Right to
Second Investment

No option value
Option has no value

100% of option value

Option has high value
Second investment
has large sustainable
excess return

Second Investment has

zero excess returns
FirstMover

Technological
Edge

Brand
Name

Telecom
Licenses

Pharmaceutical
patents

Increasing competitive advantage/ barriers to entry

Aswath Damodaran

51

The Determinants of Real Option Value

Doestakingonthefirstinvestment/expenditureprovidethefirmwith
anexclusiveadvantageontakingonthesecondinvestment?
Ifyes,thefirmisentitledtoconsider100%ofthevalueoftherealoption
Ifno,thefirmisentitledtoonlyaportionofthevalueoftherealoption,
withtheproportiondeterminedbythedegreeofexclusivityprovidedby
thefirstinvestment?

Isthereapossibilityofearningsignificantandsustainableexcess
returnsonthesecondinvestment?
Ifyes,therealoptionwillhavesignificantvalue
Ifno,therealoptionhasnovalue

Aswath Damodaran

52

Internet Firms as Options

Someanalystshavejustifiedthevaluationofinternetfirmsonthe
basisthatyouarebuyingtheoptiontoexpandintoaverylarge
market.Whatdoyouthinkofthisargument?
Isthereanoptiontoexpandembeddedinthesefirms?
Isitavaluableoption?

Aswath Damodaran

53

The Option to Abandon

Afirmmaysometimeshavetheoptiontoabandonaproject,ifthe
cashflowsdonotmeasureuptoexpectations.
Ifabandoningtheprojectallowsthefirmtosaveitselffromfurther
losses,thisoptioncanmakeaprojectmorevaluable.
PVofCashFlows
fromProject

CostofAbandonment
PresentValueofExpected
CashFlowsonProject

Aswath Damodaran

54

Valuing the Option to Abandon

AirbusisconsideringajointventurewithLearAircrafttoproducea
smallcommercialairplane(capableofcarrying4050passengerson
shorthaulflights)
Airbuswillhavetoinvest$500millionfora50%shareoftheventure
Itsshareofthepresentvalueofexpectedcashflowsis480million.

LearAircraft,whichiseagertoenterintothedeal,offerstobuy
Airbuss50%shareoftheinvestmentanytimeoverthenextfiveyears
for$400million,ifAirbusdecidestogetoutoftheventure.
Asimulationofthecashflowsonthistimeshareinvestmentyieldsa
varianceinthepresentvalueofthecashflowsfrombeinginthe
partnershipis0.16.
Theprojecthasalifeof30years.

Aswath Damodaran

55

Project with Option to Abandon

ValueoftheUnderlyingAsset(S)=PVofCashFlowsfromProject
=$480million
StrikePrice(K)=SalvageValuefromAbandonment=$400million
VarianceinUnderlyingAssetsValue=0.16
Timetoexpiration=LifeoftheProject=5years
DividendYield=1/LifeoftheProject=1/30=0.033(Weare
assumingthattheprojectspresentvaluewilldropbyroughly1/n
eachyearintotheproject)
Assumethatthefiveyearrisklessrateis6%.Thevalueoftheput
optioncanbeestimatedasfollows:

Aswath Damodaran

56

Should Airbus enter into the joint venture?

ValueofPut=Kert(1N(d2))Seyt(1N(d1))
=400(exp(0.06)(5)(10.4624)480exp(0.033)(5)(10.7882)
=$73.23million
Thevalueofthisabandonmentoptionhastobeaddedontothenet
presentvalueoftheprojectof$20million,yieldingatotalnet
presentvaluewiththeabandonmentoptionof$53.23million.

Aswath Damodaran

57

Implications for Investment Analysis

Havingaoptiontoabandonaprojectcanmakeotherwise
unacceptableprojectsacceptable.
Actionsthatincreasethevalueoftheabandonmentoptioninclude
Morecostflexibility,thatis,makingmoreofthecostsoftheprojectsinto
variablecostsasopposedtofixedcosts.
Fewerlongtermcontracts/obligationswithemployeesandcustomers,
sincetheseaddtothecostofabandoningaproject
Findingpartnersintheinvestment,whoarewillingtoacquireyour
investmentinthefuture

Theseactionswillundoubtedlycostthefirmsomevalue,butthishas
tobeweighedoffagainsttheincreaseinthevalueoftheabandonment
option.

Aswath Damodaran

58

Option Pricing Applications in the Capital

Structure Decision

Aswath Damodaran

59

Options in Capital Structure

Themostdirectapplicationsofoptionpricingincapitalstructure
decisionsisinthedesignofsecurities.Infact,mostcomplexfinancial
instrumentscanbebrokendownintosomecombinationofasimple
bond/commonstockandavarietyofoptions.
Ifthesesecuritiesaretobeissuedtothepublic,andtraded,theoptions
havetobepriced.
Ifthesearenontradedinstruments(bankloans,forinstance),theystill
havetobepricedintotheinterestrateontheinstrument.

Theotherapplicationofoptionpricingisinvaluingflexibility.Often,
firmspreservedebtcapacityorholdbackonissuingdebtbecausethey
wanttomaintainflexibility.

Aswath Damodaran

60

The Value of Flexibility

Firmsmaintainexcessdebtcapacityorlargercashbalancesthanare
warrantedbycurrentneeds,tomeetunexpectedfuturerequirements.
Whilemaintainingthisfinancingflexibilityhasvaluetofirms,italso
hasacost;theexcessdebtcapacityimpliesthatthefirmisgivingup
somevalueandhasahighercostofcapital.
Thevalueofflexibilitycanbeanalyzedusingtheoptionpricing
framework;afirmmaintainslargecashbalancesandexcessdebt
capacityinordertohavetheoptiontotakeprojectsthatmightarisein
thefuture.

Aswath Damodaran

61

Determinants of Value of Flexibility Option

Quality of the Firms Projects: It is the excess return that the firm
earnsonitsprojectsthatprovidesthevaluetoflexibility.Otherthings
remaining equal, firms operating in businesses where projects earn
substantially higher returns than their hurdle rates should value
flexibility more than those that operate in stable businesses where
excessreturnsaresmall.
Uncertainty about Future Projects: If flexibility is viewed as an
option,itsvaluewillincreasewhenthereisgreateruncertaintyabout
future projects; thus, firms with predictable capital expenditures and
excess returns should value flexibility less than those with high
variabilityinbothofthosevariables.

Aswath Damodaran

62

Value of Flexibility as an Option

ConsiderafirmthathasexpectedreinvestmentneedsofXeachyear,
withastandarddeviationinthatvalueofX.Theseexternal
reinvestmentsincludebothinternalprojectsandacquisitions.
AssumethatthefirmcanraiseLfrominternalcashflowsandits
normalaccesstocapitalmarkets.(Normalaccessreferstotheexternal
financingthatisusedbyafirmeachyear)
Excessdebtcapacitybecomesusefulifexternalreinvestmentneeds
exceedthefirmsinternalfunds.
IfX>L:Excessdebtcapacitycanbeusedtocoverthedifferenceand
investinprojects
IfX<L:Excessdebtcapacityremainsunused(withanassociatedcost)

Aswath Damodaran

63

What happens when you make the investment?

Iftheinvestmentearnsexcessreturns,thefirmsvaluewillincrease
bythepresentvalueoftheseexcessreturnsovertime.Ifweassume
thattheexcessreturneachyearisconstantandperpetual,thepresent
valueoftheexcessreturnsthatwouldbeearnedcanbewrittenas:
Valueofinvestment=(ROCCostofcapital)/Costofcapital
Thevalueoftheinvestmentsthatyoucantakebecauseyouhave
excessdebtcapacitybecomesthepayofftomaintainingexcessdebt
capacity.
IfX>L:[(ROCCostofcapital)/Costofcapital]Newinvestments
IfX<L:0

Aswath Damodaran

64

The Value of Flexibility

Expected
(Normal)
Reinvestment
Needs that can
be financed
without
flexibility

Use financing flexibility

to take unanticipated
investments (acquisitions)
Payoff: (S-K)*Excess Return/WACC

Cost of Maintaining Financing Flexibility

Excess Return/WACC = PV of excess returns in perpetutity

Aswath Damodaran

Actual
Reinvestment
Needs

65

Disneys Optimal Debt Ratio

DebtRatio
Cost of Equity
0.00%
13.00%
10.00%
13.43%
Current:18%13.85%
20.00%
13.96%
30.00%
14.65%
40.00%
15.56%
50.00%
16.85%
60.00%
18.77%
70.00%
21.97%
80.00%
28.95%
90.00%
52.14%
Aswath Damodaran

Cost of Debt
4.61%
4.61%
4.80%
4.99%
5.28%
5.76%
6.56%
7.68%
7.68%
7.97%
9.42%

Cost of Capital
13.00%
12.55%
12.22%
12.17%
11.84%
11.64%
11.70%
12.11%
11.97%
12.17%
13.69%
66

Inputs to Option Valuation Model

To value flexibility as a percent of firm value (as an annual cost),

thesewouldbetheinputstothemodel:
S=ExpectedReinvestmentneedsaspercentofFirmValue
K=ExpectedReinvestmentneedsthatcanbefinancedwithoutfinancing
flexibility
t=1year
=Varianceinln(NetCapitalExpenditures)

Once this option has been valued, estimate the present value of the
excessreturnsthatwillbegainedbytakingtheadditionalinvestments
bymultiplyingby(ROCWACC)/WACC

Aswath Damodaran

67

The Inputs for Disney

Expectedreinvestmentneedsasapercentoffirmvalue:
Overthelast5years,reinvestment(netcapex,acquisitionsandchangesinworking
capital)hasbeenapproximately5.3%offirmvalue
Iamassumingthatthisistheexpectedreinvestmentneed;thevariancein
ln(reinvestment)overthelast5yearsis0.375

Reinvestmentneedsthatcanbefinancedwithoutflexibility.
Welookedatinternalfunds,afterdebtpaymentsbutbeforereinvestmentneeds,as
apercentoffirmvalueoverthelast5years.(Internalfunds=(NetIncome+
Depreciation)/MarketValueoftheFirm)
Welookedatnetdebtfinancingeachperiod,asapercentoffirmvalue(asa
measureofaccesstoexternalfinancingeachyear).(NewDebtDebt
Repaid)/MarketValueofFirm)
Reinvestmentneedsthatcanbefinancedwithoutflexibility=(NetIncome+
Depreciation+NetDebtIssued)/MarketValueofFirm
Thisnumberhasaveraged4.8%,overthelast5years

Aswath Damodaran

68

Valuing Flexibility at Disney

The value of flexibility as a percentage of firm value can be estimated as
follows:
S=5.3%
K=4.8%
t=1year
=0.375(Varianceinln(ReinvestmentNeeds/FirmValue))
Thevalueofanoptionwiththesecharacteristicsis1.6092%
Disney earns 18.69% on its projects has a cost of capital of 12.22%. The
excessreturn(annually)is6.47%.
ValueofFlexibility(annual)=1.6092%(.0647/.1222)=0.85%ofvalue
Disneyscostofcapitalatitsoptimaldebtratiois11.64%.Thecostitincurs
tomaintainflexibilityistherefore0.58%annually(12.22%11.64%).It
thereforepaystomaintainflexibility.
Aswath Damodaran

69

Determinants of the Value of Flexibility

Capacitytoraisefundstomeetfinancingneeds:Thegreaterthe
capacitytoraisefunds,eitherinternallyorexternally,thelessthe
valueofflexibility.
1.1:Firmswithsignificantinternaloperatingcashflowsshouldvalue
flexibilitylessthanfirmswithsmallornegativeoperatingcashflows.
1.2:Firmswitheasyaccesstofinancialmarketsshouldhavealower
valueforflexibilitythanfirmswithoutthataccess.

Unpredictabilityofreinvestmentneeds:Themoreunpredictablethe
reinvestmentneedsofafirm,thegreaterthevalueofflexibility.
Capacitytoearnexcessreturns:Thegreaterthecapacitytoearn
excessreturns,thegreaterthevalueofflexibility.
1.3:Firmsthatdonothavethecapacitytoearnorsustainexcessreturns
getnovaluefromflexibility.

Aswath Damodaran

70

Option Pricing Applications in Valuation

EquityValueinDeeplyTroubledFirms
ValueofUndevelopedReservesforNaturalResourceFirm
ValueofPatent/License

Aswath Damodaran

71

Option Pricing Applications in Equity Valuation

Equityinatroubledfirm(i.e.afirmwithhighleverage,negative
earningsandasignificantchanceofbankruptcy)canbeviewedasa
calloption,whichistheoptiontoliquidatethefirm.
Naturalresourcecompanies,wheretheundevelopedreservescanbe
viewedasoptionsonthenaturalresource.
Startupfirmsorhighgrowthfirmswhichderivethebulkoftheir
valuefromtherightstoaproductoraservice(eg.apatent)

Aswath Damodaran

72

Valuing Equity as an option

Theequityinafirmisaresidualclaim,i.e.,equityholderslayclaim
toallcashflowsleftoverafterotherfinancialclaimholders(debt,
preferredstocketc.)havebeensatisfied.
Ifafirmisliquidated,thesameprincipleapplies,withequityinvestors
receivingwhateverisleftoverinthefirmafteralloutstandingdebts
andotherfinancialclaimsarepaidoff.
Theprincipleoflimitedliability,however,protectsequityinvestors
inpubliclytradedfirmsifthevalueofthefirmislessthanthevalueof
theoutstandingdebt,andtheycannotlosemorethantheirinvestment
inthefirm.

Aswath Damodaran

73

Equity as a call option

Thepayofftoequityinvestors,onliquidation,canthereforebewritten
as:
Payofftoequityonliquidation =VD
ifV>D
=0
ifVD
where,
V=Valueofthefirm
D=FaceValueoftheoutstandingdebtandotherexternalclaims

Acalloption,withastrikepriceofK,onanassetwithacurrentvalue
ofS,hasthefollowingpayoffs:
Payoffonexercise

Aswath Damodaran

=SK
=0

ifS>K
ifSK

74

Payoff Diagram for Liquidation Option

NetPayoff
onEquity

FaceValue
ofDebt
Valueoffirm

Aswath Damodaran

75

Application to valuation: A simple example

Assumethatyouhaveafirmwhoseassetsarecurrentlyvaluedat
$100millionandthatthestandarddeviationinthisassetvalueis40%.
Further,assumethatthefacevalueofdebtis$80million(Itiszero
coupondebtwith10yearslefttomaturity).
Ifthetenyeartreasurybondrateis10%,
howmuchistheequityworth?
Whatshouldtheinterestrateondebtbe?

Aswath Damodaran

76

Model Parameters

Valueoftheunderlyingasset=S=Valueofthefirm=$100million
Exerciseprice=K=FaceValueofoutstandingdebt=$80million
Lifeoftheoption=t=Lifeofzerocoupondebt=10years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirm
value=0.16
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=
10%

Aswath Damodaran

77

Valuing Equity as a Call Option

Basedupontheseinputs,theBlackScholesmodelprovidesthe
followingvalueforthecall:
d1=1.5994
d2=0.3345

N(d1)=0.9451
N(d2)=0.6310

Valueofthecall=100(0.9451)80exp (0.10)(10)(0.6310)=$75.94
million
Valueoftheoutstandingdebt=$100$75.94=$24.06million
Interestrateondebt=($80/$24.06)1/101=12.77%

Aswath Damodaran

78

The Effect of Catastrophic Drops in Value

Assumenowthatacatastrophewipesouthalfthevalueofthisfirm
(thevaluedropsto$50million),whilethefacevalueofthedebt
remainsat$80million.Whatwillhappentotheequityvalueofthis
firm?
Itwilldropinvalueto$25.94million[$50millionmarketvalueof
debtfrompreviouspage]
Itwillbeworthnothingsincedebtoutstanding>FirmValue
Itwillbeworthmorethan$25.94million

Aswath Damodaran

79

Illustration : Value of a troubled firm

Assumenowthat,inthepreviousexample,thevalueofthefirmwere
reducedto$50millionwhilekeepingthefacevalueofthedebtat$80
million.
Thisfirmcouldbeviewedastroubled,sinceitowes(atleastinface
valueterms)morethanitowns.
Theequityinthefirmwillstillhavevalue,however.

Aswath Damodaran

80

Valuing Equity in the Troubled Firm

Valueoftheunderlyingasset=S=Valueofthefirm=$50million
Exerciseprice=K=FaceValueofoutstandingdebt=$80million
Lifeoftheoption=t=Lifeofzerocoupondebt=10years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirm
value=0.16
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=
10%

Aswath Damodaran

81

The Value of Equity as an Option

Basedupontheseinputs,theBlackScholesmodelprovidesthe
followingvalueforthecall:
d1=1.0515
d2=0.2135

N(d1)=0.8534
N(d2)=0.4155

Valueofthecall=50(0.8534)80exp(0.10)(10)(0.4155)=$30.44
million
Valueofthebond=$50$30.44=$19.56million
Theequityinthisfirmdropsby,becauseoftheoptioncharacteristics
ofequity.
Thismightexplainwhystockinfirms,whichareinChapter11and
essentiallybankrupt,stillhasvalue.

Aswath Damodaran

82

Equity value persists ..

Value of Equity as Firm Value Changes
80

70

Value of Equity

60

50

40

30

20

10

0
100

90

80

70

60

50

40

30

20

10

Value of Firm ($ 80 Face Value of Debt)

Aswath Damodaran

83

Valuing equity in a troubled firm

Thefirstimplicationisthatequitywillhavevalue,evenifthevalue
ofthefirmfallswellbelowthefacevalueoftheoutstandingdebt.
Suchafirmwillbeviewedastroubledbyinvestors,accountantsand
analysts,butthatdoesnotmeanthatitsequityisworthless.
Justasdeepoutofthemoneytradedoptionscommandvaluebecause
ofthepossibilitythatthevalueoftheunderlyingassetmayincrease
abovethestrikepriceintheremaininglifetimeoftheoption,equity
willcommandvaluebecauseofthetimepremiumontheoption
(thetimeuntilthebondsmatureandcomedue)andthepossibilitythat
thevalueoftheassetsmayincreaseabovethefacevalueofthebonds
beforetheycomedue.

Aswath Damodaran

84

The Conflict between bondholders and

stockholders

Stockholdersandbondholdershavedifferentobjectivefunctions,andthis
canleadtoconflictsbetweenthetwo.
Forinstance,stockholdershaveanincentivetotakeriskierprojectsthan
bondholdersdo,andtopaymoreoutindividendsthanbondholderswould
likethemto.
Thisconflictbetweenbondholdersandstockholderscanbeillustrated
dramaticallyusingtheoptionpricingmodel.
Sinceequityisacalloptiononthevalueofthefirm,anincreaseinthe
varianceinthefirmvalue,otherthingsremainingequal,willleadtoan
increaseinthevalueofequity.
Itisthereforeconceivablethatstockholderscantakeriskyprojectswith
negativenetpresentvalues,whichwhilemakingthembetteroff,maymake
thebondholdersandthefirmlessvaluable.Thisisillustratedinthefollowing
example.

Aswath Damodaran

85

Illustration: Effect on value of the conflict

between stockholders and bondholders

Consideragainthefirmdescribedintheearlierexample,withavalue
ofassetsof$100million,afacevalueofzerocoupontenyeardebtof
$80million,astandarddeviationinthevalueofthefirmof40%.The
equityanddebtinthisfirmwerevaluedasfollows:
ValueofEquity=$75.94million
ValueofDebt=$24.06million
ValueofFirm==$100million

Nowassumethatthestockholdershavetheopportunitytotakea
projectwithanegativenetpresentvalueof$2million,butassume
thatthisprojectisaveryriskyprojectthatwillpushupthestandard
deviationinfirmvalueto50%.

Aswath Damodaran

86

Valuing Equity after the Project

Valueoftheunderlyingasset=S=Valueofthefirm=$100million
$2million=$98million(Thevalueofthefirmisloweredbecause
ofthenegativenetpresentvalueproject)
Exerciseprice=K=FaceValueofoutstandingdebt=$80million
Lifeoftheoption=t=Lifeofzerocoupondebt=10years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirm
value=0.25
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=
10%

Aswath Damodaran

87

Option Valuation

OptionPricingResultsforEquityandDebtValue
ValueofEquity=$77.71
ValueofDebt=$20.29
ValueofFirm=$98.00

Thevalueofequityrisesfrom$75.94millionto$77.71million,
eventhoughthefirmvaluedeclinesby$2million.Theincreasein
equityvaluecomesattheexpenseofbondholders,whofindtheir
wealthdeclinefrom$24.06millionto$20.19million.

Aswath Damodaran

88

Effects of an Acquisition

Assumethatyouarethemanagerofafirmandthatyoubuyanother
firm,withafairmarketvalueof$150million,forexactly$150
million.Inanefficientmarket,thestockpriceofyourfirmwill
Increase
Decrease
RemainUnchanged

Aswath Damodaran

89

II. Effects on equity of a conglomerate merger

Youareprovidedinformationontwofirms,whichoperateinunrelated
businessesandhopetomerge.

FirmA FirmB
Valueofthefirm
$100million
$150million
FaceValueofDebt $80million
$50million(Zerocoupondebt)
Maturityofdebt
10years 10years
Std.Dev.invalue
40%
50%
Correlationbetweencashflows 0.4
Thetenyearbondrateis10%.

Thevarianceinthevalueofthefirmaftertheacquisitioncanbecalculatedas
follows:
Varianceincombinedfirmvalue =w1212+w2222+2w1w21212
=(0.4)2(0.16)+(0.6)2(0.25)+2(0.4)(0.6)(0.4)(0.4)(0.5)
=0.154

Aswath Damodaran

90

Valuing the Combined Firm

Thevaluesofequityanddebtintheindividualfirmsandthecombinedfirm
canthenbeestimatedusingtheoptionpricingmodel:
FirmA
FirmB Combinedfirm
Valueofequityinthefirm$75.94 $134.47 $207.43
Valueofdebtinthefirm $24.06 $15.53 $42.57
Valueofthefirm $100.00 $150.00 $250.00
Thecombinedvalueoftheequitypriortothemergeris$210.41millionand
itdeclinesto$207.43millionafter.
Thewealthofthebondholdersincreasesbyanequalamount.
Thereisatransferofwealthfromstockholderstobondholders,asa
consequenceofthemerger.Thus,conglomeratemergersthatarenot
followedbyincreasesinleveragearelikelytoseethisredistributionof
wealthoccuracrossclaimholdersinthefirm.

Aswath Damodaran

91

Obtaining option pricing inputs - Some real

world problems

Theexamplesthathavebeenusedtoillustratetheuseofoption
pricingtheorytovalueequityhavemadesomesimplifying
assumptions.Amongthemarethefollowing:
(1)Therewereonlytwoclaimholdersinthefirmdebtandequity.
(2)Thereisonlyoneissueofdebtoutstandinganditcanberetiredatface
value.
(3)Thedebthasazerocouponandnospecialfeatures(convertibility,put
clausesetc.)
(4)Thevalueofthefirmandthevarianceinthatvaluecanbeestimated.

Aswath Damodaran

92

Real World Approaches to Getting inputs

Input
ValueoftheFirm

EstimationProcess
Cumulatemarketvaluesofequityanddebt(or)
Valuethe
assetsinplace usingFCFFandWACC(or)
Usecumulatedmarketvalueofassets,iftraded.

VarianceinFirmValue

Ifstocksandbondsaretraded,
2firm =we2e2 +wd2d2+2we wd ed ed
wheree2 =varianceinthestockprice
we=MVweightofEquity
d2 =thevarianceinthebondpricew d=MVweightofdebt
Ifnottraded,usevariancesofsimilarlyratedbonds.
Useaveragefirmvaluevariancefromtheindustryinwhich
companyoperates.

ValueoftheDebt

Ifthedebtisshortterm,youcanuseonlythefaceorbookvalue
ofthedebt.
Ifthedebtislongtermandcouponbearing,addthecumulated
nominalvalueofthesecouponstothefacevalueofthedebt.

MaturityoftheDebt

Facevalueweighteddurationofbondsoutstanding(or)
Ifnotavailable,useweightedmaturity

Aswath Damodaran

93

Valuing Equity as an option - Eurotunnel in

early 1998

Eurotunnelhasbeenafinancialdisastersinceitsopening
In1997,Eurotunnelhadearningsbeforeinterestandtaxesof56million
andnetincomeof685million
Attheendof1997,itsbookvalueofequitywas117million

Ithad8,865millioninfacevalueofdebtoutstanding
Theweightedaveragedurationofthisdebtwas10.93years
DebtType
FaceValue
Duration

Aswath Damodaran

Shortterm
10year
20year
Longer
Total

935
2435
3555
1940

0.50
6.7
12.6
18.2

8,865mil

10.93years
94

The Basic DCF Valuation

Thevalueofthefirmestimatedusingprojectedcashflowstothefirm,
discountedattheweightedaveragecostofcapitalwas2,278million.
Thiswasbaseduponthefollowingassumptions

Aswath Damodaran

Revenues will grow 10% a year for the next 5 years and 3% a year in perpetuity
after that.
The cost of goods sold which was 72% of revenues in 1997 will drop to 60% of
revenues by 2002 in linear increments and stay at that level.
Capital spending and depreciation will grow 3% a year for the next 5 years. Note
that the net capital expenditure is negative for each of these years we are
assuming that the firm will be able to not make significant reinvestments for the
next 5 years. Beyond year 5, capital expenditures will offset depreciation.
There are no working capital requirements.
The debt ratio, which was 95.35% at the end of 1997, will drop to 70% by 2002.
The cost of debt is 10% for the next 5 years and 8% after that.
The beta for the stock will be 2.00 for the next five years, and drop to 0.8 thereafter
(as the leverage decreases).

95

Other Inputs

ThestockhasbeentradedontheLondonExchange,andthe
annualizedstddeviationbaseduponln(prices)is41%.
ThereareEurotunnelbonds,thathavebeentraded;theannualizedstd
deviationinln(price)forthebondsis17%.
Thecorrelationbetweenstockpriceandbondpricechangeshasbeen0.5.
Theproportionofdebtinthecapitalstructureduringtheperiod(1992
1996)was85%.
Annualizedvarianceinfirmvalue
=(0.15)2(0.41)2+(0.85)2(0.17)2+2(0.15)(0.85)(0.5)(0.41)(0.17)=0.0335

The15yearbondrateis6%.(Iusedabondwithadurationofroughly
11yearstomatchthelifeofmyoption)

Aswath Damodaran

96

Valuing Eurotunnel Equity and Debt

InputstoModel

Valueoftheunderlyingasset=S=Valueofthefirm=2,278million
Exerciseprice=K=FaceValueofoutstandingdebt=8,865million
Lifeoftheoption=t=Weightedaveragedurationofdebt=10.93years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirmvalue=
0.0335
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=6%

Basedupontheseinputs,theBlackScholesmodelprovidesthefollowing
valueforthecall:
d1=0.8582
d2=1.4637

N(d1)=0.1955
N(d2)=0.0717

Valueofthecall=2278(0.1955)8,865exp(0.06)(10.93)(0.0717)=116million
Appropriateinterestrateondebt=(8865/2162)(1/10.93)1=13.7%

Aswath Damodaran

97

Industry Name
Std Deviation in Equity Std Deviation in Firm Value
Advertising
68.00%
58.86%
Aerospac e/Defense
51.00%
38.14%
Air Transport
50.00%
29.11%
Apparel
54.00%
41.66%
Auto & Truc k
45.00%
22.27%
Auto Parts
61.00%
37.35%
Bank
31.00%
24.63%
Bank (Canadian)
36.00%
32.75%
Bank (Foreign)
29.00%
25.85%
Bank (Midwest)
30.00%
24.60%
Beverage (Alc oholic )
43.00%
37.54%
Beverage (S oft Drink)
35.00%
31.28%
Biotec hnology
104.00%
102.64%
Building Materials
48.00%
37.13%
Cable TV
73.00%
44.99%
Canadian Energy
37.00%
28.47%
Cement & Aggregates
39.00%
29.29%
Chemic al (Basic )
51.00%
39.40%
Chemic al (Diversified)
40.00%
32.06%
Chemic al (S pec ialty)
52.00%
37.19%
Computer & Peripherals
97.00%
89.55%
Computer S oftware & S vc s
105.00%
101.07%
Diversified Co.
45.00%
35.11%
Drug
102.00%
98.47%
E-Commerc e
119.00%
101.77%
Educ ational S ervic es
58.00%
56.72%
Elec tric Util. (Central)
29.00%
15.68%
Elec tric Utility (East)
32.00%
19.15%
Elec tric Utility (West)
35.00%
17.81%
Elec tric al Equipment
85.00%
81.54%
Elec tronic s
81.00%
64.56%
Entertainment
75.00%
62.69%
Entertainment Tec h
78.00%
75.73%
Environmental
69.00%
43.23%
Financ ial S vc s. (Div.)
53.00%
35.88%
Food Proc essing
44.00%
32.71%
Food Wholesalers
60.00%
48.09%
Foreign Elec tron/Entertn
44.00%
33.90%
Foreign Telec om.
49.00%
36.42%
Furn./Home Furnishings
45.00%
35.96%
Gold/S ilver Mining
66.00%
55.99%
Groc ery
44.00%
31.86%
Healthc are Info S ystems
97.00%
87.75%
Home Applianc e
42.00%
30.14%
Homebuilding
45.00%
27.38%
Hotel/Gaming
52.00%
30.49%
Household Produc ts
43.00%
37.57%
Human Resourc es
45.00%
41.37%
Industrial S ervic es
64.00%
50.72%
Information S ervic es
57.00%
51.33%
Insuranc e (Life)
44.00%
39.82%

Aswath Damodaran

Industry Name
Std Deviation in Equity Std Deviation in Firm Value
Insuranc e (Prop/Casualty
42.00%
41.39%
Internet
132.00%
115.85%
Investment Co.
21.00%
14.54%
Investment Co. (Foreign)
34.00%
34.00%
Mac hinery
51.00%
34.41%
Manuf. Housing/Rec Veh
48.00%
37.71%
Maritime
49.00%
25.61%
Medic al S ervic es
84.00%
68.11%
Medic al S upplies
74.00%
70.53%
Metal Fabric ating
51.00%
41.37%
Metals & Mining (Div.)
55.00%
39.37%
Natural Gas (Distrib.)
31.00%
18.63%
Natural Gas (Diversified
49.00%
34.73%
Newspaper
29.00%
22.80%
Offic e Equip & S upplies
55.00%
34.61%
Oilfield S ervic es/Equip.
62.00%
51.37%
Pac kaging & Container
51.00%
27.41%
Paper & Forest Produc ts
40.00%
24.18%
Petroleum (Integrated)
41.00%
36.07%
Petroleum (Produc ing)
66.00%
49.13%
Pharmac y S ervic es
54.00%
47.26%
Power
89.00%
51.20%
Prec ision Instrument
80.00%
70.52%
Publishing
64.00%
54.81%
R.E.I.T.
27.00%
19.50%
Railroad
36.00%
23.35%
Rec reation
60.00%
48.28%
Restaurant
52.00%
43.26%
Retail (S pec ial Lines)
72.00%
61.60%
Retail Building S upply
51.00%
48.81%
Retail S tore
45.00%
36.85%
S ec urities Brokerage
57.00%
33.16%
S emic onduc tor
100.00%
94.65%
S emic onduc tor Cap Equip
80.00%
75.73%
S hoe
55.00%
48.86%
S teel (General)
51.00%
32.41%
S teel (Integrated)
52.00%
27.05%
Telec om. Equipment
103.00%
89.76%
Telec om. S ervic es
85.00%
57.92%
Textile
62.00%
28.23%
Thrift
33.00%
29.55%
Tire & Rubber
53.00%
32.41%
Tobac c o
50.00%
38.64%
Toiletries/Cosmetic s
51.00%
44.93%
Truc king/Transp. Leasing
47.00%
36.74%
Utility (Foreign)
37.00%
22.83%
Water Utility
29.00%
17.73%
Wireless Networking
132.00%
94.72%
Market
57.10%
44.94%

98