SMB2F2 1

MBA-0000
Strategic Financial Management
Block
1
INTRODUCTION TO STRATEGIC FINANCIAL
MANAGEMENT
UNIT 1
Strategic Financial Management: An Overview
07
UNIT 2
Firms Environment, Governance and Strategy
20
UNIT 3
Valuing Real Assets in the Presence of Risk
38
UNIT 4
Real Options
56
Expert Committee
Dr. J. Mahender Reddy
Vice Chancellor
IFHE (Deemed University), Hyderabad
Prof. P. A. Kulkarni
Vice Chancellor
Icfai University, Dehradun
Prof. Y. K. Bhushan
Vice Chancellor
Icfai University, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
Icfai University, Nagaland
Dr. Lata Chakravorty

Director
IBS Bangalore
Prof. D. S. Rao
Director
IBS Hyderabad
Prof. P. Bala Bhaskaran

Director
IBS Ahmedabad
Dr. Dhananjay Keskar

Director
IBS Pune
Prof. P. Ramnath
Director
IBS Chennai
Course Preparation Team

Shri T. S. Rama Krishna Rao
Icfai University
Prof. Hilda Amalraj

IBS Hyderabad
Dr. M. Syambabu
Icfai University
Prof. Bratati Ray

IBS Kolkata
Ms. C. Padmavathi
Icfai University
Dr. Vijaya Lakshmi S

IBS Hyderabad
Ms. Sudha
Icfai University
Dr. Vunyale Narender

IBS Hyderabad
Ms. Sunitha Suresh

Icfai University
Prof. Arup Chowdhury

IBS Kolkata
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COURSE INTRODUCTION
This course provides the framework for Strategic Financial Management. Strategic
financial management helps in framing the possible strategies capable of maximizing an
organization's net present value, the allocation of scarce capital resources among the
competing opportunities, and the implementation and monitoring of the chosen strategy
so as to achieve the organizational objectives. This course will help students gain an
understanding of financial statement analysis, business environment, and framing
business strategy. It also gives an insight into strategic capital structure theories,
formulating financial incentives, and managerial decision models. This course will help
the readers manage corporate risks appropriately and also in taking timely decisions to
hedge them.
The course has been divided into the following blocks:
This introductory block gives an overview of strategic financial management,

business environment, corporate governance, and strategy. This block also covers
investment options.
The second block entitled Strategic Capital Structure gives an overview of costs of
capital, various factors affecting capital structure, and the theories of capital
structure. It covers dividend decisions of a firm and the various models that
explain the dividend policy. It also deals with allocating capital, corporate strategy
and restructuring.
The third block containing strategic environment analysis which involves the
framework of analysis of industry, firm and financial policies. This topic gives an
insight into managerial incentives and various decision support models.
The fourth block on Financial Statement Analysis deals with changes in the price
levels in accounts, working capital management, and strategic cost management.
This gives a lot of information on financial statement analysis and framing cost
structure for production to capture the competitive advantages in the market.
The fifth block on Strategic Risk Management includes Corporate Risk

Management, Risk Management and Corporate Strategy, and the practice of
Hedging. It also covers Organization Architecture and Security Design. It gives a
detailed note on Enterprise Risk Management.
The course contains five blocks.
BLOCK 1
INTRODUCTION TO STRATEGIC
FINANCIAL MANAGEMENT
This is the introductory block for Strategic Financial Management. It briefly reviews the
basic concepts of strategic financial management. It discusses about business
environment, government, and strategy. It will help the readers to identify the
investment opportunities. This block consists of four units.
The first unit discusses about maximizing an organizations net present value which is
the main objective of any firm. Identification of the possible strategies and allocation of
scarce capital resources among the competing opportunities and the implementation and
monitoring of the chosen strategy are the insights of strategic financial management.
This unit also covers Agency theory, financial and non-financial objectives of a firm,
and framing of strategy.
Unit 2 covers the elements of a firms business environment and observations of it
affects the internal structures and operations of the firm. It depicts the process of capital
budgeting and the firms production function. It also discusses about the basic pillars of
a firms financial structure.
Unit 3 deals with the valuation of investment opportunities which consists of estimation
of cash flows and their present value. Finding of expected rate of return depends on the
valuations of investment opportunity. It must be valued at the presence of risk.
Unit 4 gives an insight into valuation and analysis of real options. There are number of
options to invest the scarce financial resources. One of them is real options. The unit
covers Comparing Financial and Real Options, types of real options, and the valuation
models.
UNIT 1
STRATEGIC FINANCIAL
MANAGEMENT:
AN OVERVIEW
Structure
1.1
Introduction
1.2
Objectives
1.3
Financial Objectives of a Company
1.4
Non-financial Objectives of a Company
1.5
Agency Theory
1.6
Conflict of Interests in a Firm
1.7
Financial Planning and Strategic Planning
1.8
The Relationship between Short-term and Long-term Financial Planning
1.9
Summary
1.10
Glossary
1.11
Suggested Readings/Reference Material
1.12
Suggested Answers
1.13
Terminal Questions
1.1 INTRODUCTION
Maximizing the present value is the main objective of any firm, but in addition to this, it
has to fulfill the social responsibilities and adopt shot-term and long-term survival
strategies. Hence, Strategic Financial Management plays a crucial role. One of the
popular definitions of strategic financial management as per the official terminology of
the CIMA is, the identification of the possible strategies capable of maximizing an
organizations net present value, the allocation of scarce capital resources among the
competing opportunities and the implementation and monitoring of the chosen strategy,
so as to achieve stated objectives. So, it can be said that, strategy depends on the stated
objectives or targets. In this unit, we shall discuss agency theory, goal congruence,
financial planning and strategic planning.
1.2 OBJECTIVES
After going through the unit, you should be able to:
Understand the financial and non-financial objectives of a company;
Know the Agency Theory;
Identify the primary reasons for conflicts of interest; and
Get an idea of the classification of financial planning and strategic planning.
1.3 FINANCIAL OBJECTIVES OF A COMPANY

It is needless to say that one of the most important objectives of a company is
maximizing the wealth of its shareholders. It is to be kept in mind that a company is
financed by its ordinary shareholders, preference shareholders, loan stock holders and
other long-term and short-term creditors. The entire fund that is surplus, belongs to the
legal owners of the company, and its ordinary shareholders. Any retained profits are the
undistributed wealth of these equity shareholders. The non-financial objectives do not
ignore financial objectives altogether, but they point towards the fact that the simple
theory of company finance which postulates that the primary objective of a firm is to
maximize the wealth of ordinary shareholders, is too simplistic. In essence, the financial
objectives may have to be compromised in order to satisfy non-financial objective.
VALUE ENHANCEMENT IN THE BUSINESS PARLANCE
When the prices of the shares of a company that are traded on a stock market rises, the
wealth of the shareholders tends to get increased. The price of a companys share goes
up when the company is expected to make attractive profits, which it plans to pay as
dividends to its shareholders or re-invest in the business to achieve future profit growth
and dividend growth. However, it is also to be kept in mind that in order to increase the
price of the share, the company should achieve its profits without taking business risks
and financial risks which might worry its shareholders.
1.4 NON-FINANCIAL OBJECTIVES OF A COMPANY

Having discussed the financial objectives of the firm at length, let us now look into
some of the non-financial objectives. The non-financial objectives of a firm can be as
follows:
a.
General welfare of the employees, which includes providing the employees with
good wage, salaries, comfortable and safe working conditions, good training and
career developments and good pensions.
b.
Welfare of the management which includes providing them with the better
salaries and perquisites though it will be at the cost of the companys
expenditure.
c.
Welfare of the society as a whole. For example, the oil companies confront with
the problem of protecting the environment and preserving the earths dwindling
energy resources.
d.
Fulfillment of responsibilities towards customers and suppliers.
e.
Leadership in research and development.
1.5 AGENCY THEORY

Agency theory is often described in terms of the relationships between the various
interested parties in the firm. The theory examines the duties and conflicts that occur
between parties who have an agency relationship. Agency relationships occur when one
party, the principal, employs another party, called the agent, to perform a task on their
behalf. Agency theory is helpful in explaining the actions of the various interest groups
in the corporate governance debate. For example, managers can be seen as the agents of
shareholders, employees as the agents of managers, managers and shareholders as the
agents of long and short-term creditors, etc. In most of these principal-agent
relationships conflicts of interest is seen to exist. It has been widely observed that the
conflicts between shareholders and managers and in a similar way the objectives of
employees and managers may be in conflict. Although the actions of all the parties are
united by one mutual objective of wishing the firm to survive, the various principals
involved might make various arrangements to ensure their agents work closer to their
own interests. For example, shareholders might insist that part of management
8
Strategic Financial Management:

An Overview
remuneration is in the form of a profit related bonus. The agency relationship arising
from the separation of ownership from management is sometimes characterized as the
agency problem. For example, if managers hold none or very little of the equity shares
of the company they work for, what is to stop them from: Working inefficiently? Not
bothering to look for profitable new investment opportunities? Giving themselves high
salaries and perks?
One power that shareholders possess is the right to remove the directors from office.
But shareholders have to take the initiative to do this, and in many companies, the
shareholders lack the energy and organization to take such a step. Even so, directors will
want the companys report and accounts, and the proposed final dividend, to meet with
shareholders approval at the AGM. Another reason why managers might do their best
to improve the financial performance of their company is that managers pay is often
related to the size or profitability of the company. Managers in very big companies, or
in very profitable companies, will normally expect to earn higher salaries than managers
in smaller or less successful companies. Perhaps the most effective method is one of
long-term share option schemes to ensure that shareholder and manager objectives
coincide. Management audits can also be employed to monitor the actions of managers.
Creditors commonly write restrictive covenants into loan agreements to protect the
safety of their funds. These arrangements involve time and money both in initial set-up,
and subsequent monitoring, these being referred to as agency costs.
STAKEHOLDER GROUPS AND STRATEGY
The actions of stakeholder groups in pursuit of their various goals can exert influence on
strategy. The greater the power of the stakeholder, the greater the influence will be.
Each stakeholder group possesses different expectations about what it wants, and the
expectations of the various groups conflicts with each other. Each group, however,
tends to influence strategic decision-making. The relationship between management and
shareholders is sometimes referred to as an agency relationship, in which the managers
act as agents for the shareholders, using delegated powers to run the affairs of the
company in the shareholders best interests.
Self-Assessment Questions 1
a.
What are the non-financial objectives of a firm?

.
.
.
b.
Describe the relationship between management and shareholders.

.
.
.
9
1.6 CONFLICT OF INTERESTS IN A FIRM

MAXIMIZATION OF SHAREHOLDER WEALTH
Although most of the financial management theory is developed keeping in mind the
assumed objective of maximizing shareholder wealth, it is, at the same time, important
to note that in reality, companies may be working towards other objectives. The other
parties that share interests in the organization (e.g., employees, the community at large,
creditors, customers, etc.) have objectives that differ to those of the shareholders. As the
objectives of these other parties might conflict with those of the shareholders, it will be
impossible to maximize shareholder wealth and satisfy the objectives of other parties at
the same time. In such situations, the firm faces multiple, conflicting objectives, and
satisfying of the interested parties objectives becomes the only practical approach for
management. If this strategy is adopted, then the firm seeks to earn a satisfactory return
for its shareholders while at the same time (for example) is able to pay reasonable
wages to its workforce.
GOAL CONGRUENCE
Goal congruence is the term which describes the situation when the goals of different
interest groups coincide. A way of helping to achieve goal congruence between
shareholders and managers is by the introduction of carefully designed remuneration
packages for managers which would motivate managers to take decisions which were
consistent with the objectives of the shareholders. Agency theory sees employees of
businesses, including managers, as individuals, each with his or her own objectives.
Within a department of a business, there are departmental objectives. If achieving these
various objectives also leads to the achievement of the objectives of the organization as
a whole, there is said to be goal congruence.
ACHIEVING GOAL CONGRUENCE
Goal congruence can be achieved, and at the same time, the agency problem can be
dealt with, providing managers with incentives which are related to profits or share
price, or other factors such as:
a.
Pay or bonuses related to the size of profits termed as profit-related pay.
b.
Rewarding managers with shares, for example, when a private company goes
public and managers are invited to subscribe for shares in the company at an
attractive offer price.
c.
Rewarding managers with share options. In a share option scheme, selected

employees are given a number of share options, each of which gives the right
(after a certain date) to subscribe for shares in the company at a fixed price. The
value of an option will increase if the company is successful and its share price
goes up. For example, an employee might be given 10,000 options to subscribe
for shares in the company at a price of Rs.30,000 (by buying Rs.50,000 worth
shares for Rs.20,000).
Such measures might encourage management in the adoption of creative accounting

methods which will distort the reported performance of the company in the service of
the managers own ends. However, creative accounting methods such as off-balance
sheet finance present a temptation to management at all times given that they allow a
more favorable picture of the state of the company to be presented than otherwise, to
shareholders, potential investors, potential lenders and others. An alternative approach
10

An Overview
is to attempt to monitor managers behavior, for example, by establishing Management

audit procedures, to introduce additional reporting requirements, or to seek assurance
from managers that shareholders interests will be foremost in their priorities.
EXTERNAL CONSTRAINTS AND FINANCIAL STRATEGY
Economic Influences
Aggregate Demand and Inflation
A growth in aggregate demand can have either or both of the following consequences:
a.
An increased production by the firms.
b.
Inability on the part of the firms to produce more to meet the demand, due to
limitations, resulting in the increase in the price.
The impact of the rate of price inflation in the economy has the following affects:
a.
Costs of production and selling prices.
b.
Interest rates.
c.
Foreign exchange rates.
d.
Demand in the economy (high rates of inflation seem to put a brake on real
economic growth).
Let us now try to understand each of the above factors in detail.

Interest Rates
Interest rates exert the following economic influences:
a.
Interest rates in a country influence the foreign exchange value of the countrys
currency.
b.
Interest rates act as a guide to the return that a companys shareholders might
want, and changes in market interest rates will affect share prices.
A positive real rate of interest enhances an investors real wealth to the income he earns
from his investments. However, when interest rates go up or down, perhaps due to a rise
or fall in the rate of inflation, there will also be a potential capital loss or gain for the
investor. In other words, the market value of interest-bearing securities will alter.
Market values will fall when interest rates go up and vice versa. Let us see the following
illustration.
Illustration 1
When a government issues long-term gilts at a coupon interest rate of, say,
10 percent and the market rate of interest is also 10 percent, the market value of the
securities will be Rs.100 which is also the face value of the stock.
a.
Now if nominal interest rates in the market subsequently rise to, say,
14 percent the re-sale value of the gilts will fall to:
100
10%
= Rs.71.43 per Rs.100 face value of the stock
14%
An investor in the gilts will make a capital loss of Rs.28.57 percent

(plus selling costs) if he decides to sell the securities.
11
b.
If nominal interest rates subsequently fall to, say, 8 percent, the re-sale value of
the gilts will rise to:
Rs.100
10%
= Rs.125
8%
An investor could then sell his asset for a capital gain of 25 percent (less selling costs).
Interest Rates and Share Prices
When interest rates change, the return expected by investors from shares also tends to
change. For example, if interest rates fall from 14 percent to 12 percent on government
securities, and from 15 percent to 13 percent on company debentures, the return
expected from shares (dividends and capital growth) would also fall. This is because
shares and debt are alternative ways of investing money. If interest rates fall, shares
become more attractive to buy. As demand for shares increases, their prices too rise, and
so the dividend return gained from them falls in percentage terms.
Interest Rates are Important for Financial Decisions by Companies
Interest rate is important for financial decisions by companies. The incidence of the
interest rates can have the following effects:
a.
b.
When interest rates are low, it might be beneficial:

i.
To borrow more, preferably at a fixed rate of interest, and so increase the

companys gearing,
ii.
To borrow for long periods rather than for short periods, and
iii.
To pay back loans which incur a high interest rate, if it is within the
companys power to do so, and take out new loans at a lower interest rate.
When interest rates are higher:

i.
A company might decide to reduce the amount of its debt finance, and to
substitute equity finance, such as retained earnings,
ii.
A company which has a large surplus of cash and liquid funds to invest
might switch some of its short-term investments out of equities and into
interest bearing securities, and
iii.
A company might opt to raise new finance by borrowing short-term funds

and debt at a variable interest rate (for example, on overdraft) rather than
long-term funds at fixed rates of interest, in the hope that interest rates
will soon come down again.
Interest Rates and New Capital Investments

When interest rates go up, consequently the cost of finance to a company also goes up;
the minimum return that a company will require on its own new capital investments also
goes up. A companys management is supposed to give close consideration, when
interest rates are high, keeping investments in assets, particularly unwanted or
inefficient fixed assets, stocks and debtors, down to a minimum. This activity of the
company is done in order to reduce the companys need to borrow. At the same time,
the management also needs to bear in mind the deflationary effect of high interest rates
that deters spending by raising the cost of borrowing.
12

An Overview
a.
What is meant by Goal congruence?

.
.
.
b.
When a government issues long-term gilts of Rs. 1,000 at a coupon interest

rate of 10 percent and the market rate of interest is 8 percent, What will be the
market value of the securities?
.
.
.
1.7 FINANCIAL PLANNING AND STRATEGIC PLANNING

FINANCIAL PLANNING
The management function of planning requires the development, definition and
evaluation of the following:
a.
The organizations objectives.
b.
Alternative strategies for achievement of these objectives.
The objectives of business activity are invariably concerned with money, as the
universal measure of the ability to command resources. Thus, financial awareness
probes into all business activities. Nevertheless, finance cannot be managed in isolation
from other functions of the business and, therefore, financial planning will be
undertaken within the framework of a plan for the whole organization, i.e., a corporate
plan.
THE STRATEGIC PLANNING APPROACH TO DEVELOP A BUSINESS
PLAN
Strategic planning is a systemic approach to decisions about the basic directions and
purposes of a business and the development of plans to achieve that purpose. It may
involve interpretation of policy, applying strategies, establishing corporate objectives
and generally ensuring that a company develops in a planned, rather than haphazard,
fashion.
The period to be covered by a strategic plan will vary between different types of
business. In general terms, the minimum period for a long-term plan will be that
necessary for the implementation of decisions on matters such as:
a.
Development of new facilities (building, plant or equipment and the materials

and manpower necessary to utilize them);
b.
Development of new products or services; and
c.
Entry into a new field of marketing for existing products.

13
For control purposes, a strategic business plan may be broken down into the shorter
term plans normally represented by annual budgets. Thus it can be said that the process
of strategic planning falls into the following six steps:
Step
Action
1.
2
Business review and assessment (including appraisal of corporate strengths

and weaknesses)
Establishment of objectives
Choice of strategies and their evaluation
Detailed evaluation of the strategic plan (sometimes referred to as a

strategic budget)
Establishment of annual or other short-term budgets

Implementing the plan and monitoring results.
1.8 THE RELATIONSHIP BETWEEN SHORT-TERM AND

LONG-TERM FINANCIAL PLANNING
The process of financial planning must begin at the strategic level, where the
corporate strengths and weaknesses are reviewed and long-term objectives are
identified. It is to be kept in mind that business review should enable a forecast to be
made of future changes in sales, profitability and capital employed. When this
forecast is compared with the results desired by the corporate objectives, a gap may
be identified which must be made good by developing new strategies. Senior
management must negotiate with middle management, until a single strategic plan for
the whole company is agreed. From this strategic plan, tactical plans must be drawn
up (e.g., pricing policies, personnel requirements, and production methods) and a
medium-term plan established. This medium-term plan can be broken down into a
series of short-term financial plans at a later point of time.
POTENTIAL CONFLICTS BETWEEN SHORT-TERM AND LONG-TERM
OBJECTIVES
Companies are often accused of favoring short-term profitability at the expense of longterm prosperity. For example, an investment in the latest technology in production
machinery might be postponed because of fear of increasing the depreciation charge,
although longer-term profitability will be improved by the investment.
Planning Systems
Let us now define two possible types of planning system. In a top-down system senior
management announces instructions which filter their way down through the
organization structure. In a bottom-up system information gathered from the lower
levels of the business is consolidated until a summary is produced for the board. An
ideal planning system contains elements of both systems, with decisions passing up and
down the organization structure. Certainly all managers must be involved in the
planning of their own activities, or else they feel no responsibility to meet the targets
given to them. Equally long-term strategic decisions are ultimately the responsibility of
the senior management.
Successful conglomerate companies delegate as much responsibility as possible to their
subsidiaries, while the main board ensures that the group remains focused on a
particular direction. The balance between control and autonomy of a conglomerates
subsidiaries is another area for academic research in recent years.
14

An Overview
TYPES OF LONG-TERM STRATEGY

The different types of long-term strategies can be better understood with the help of the
following flow chart:
Figure 1: Types of Long-term Strategies

Survival Strategies
Non-growth Strategies
A non-growth strategy refers to that strategy where there is no growth in earnings. This
does not necessarily mean no turnover. A company might pursue a non-growth strategy
if it saw its non-economic objectives as more important than its economic objectives.
The primary reasons for adopting a non-growth strategy may include,
Pressure from public opinion;
Maintain an acceptable quality of life;
Lack of enough additional staff with sufficient expertize and loyalty;
Enable the owner-manager to retain personal control over operations; and
Diseconomies of scale of the particular production set-up.
In certain cases, there could even be negative growth, by paying out dividends larger
than current earnings, so that shareholders are effectively receiving a refund of their
capital investment, and there is a net fall in assets employed. A negative growth strategy
can be adopted in pursuit of an objective to increase the percentage return to the
shareholders if the company pulls out of the least profitable areas of its operations
first, it will increase its overall return on investment, although the total investment will
be less. The negative growth strategy consists of an orderly, planned withdrawal from
less profitable areas, and while the shareholders dividend may eventually decline, his
return can rise since the capital invested also falls. If the company simply runs down,
his return will also fall.
Corrective Strategies
A non-growth strategy certainly does not mean that the company can afford to be
complacent. A considerable amount of management time should be devoted to
consider the actions needed to correct its overall strategic structure to achieve the
optimum. This involves seeking a balance between its overall strategic structures to
achieve the optimum. This involves seeking a balance between different areas of
operations and also seeking the optimum organization structure for efficient
operation.
15
Thus, although there is no overall growth (or negative growth occurs) the company will
shift its product market position, employ its resources in different fields and continue to
search for new opportunities. In particular, the company will aim to correct any
weaknesses which it has discovered during its appraisal. For this reason the term
corrective strategy is also used. A non-growth strategy is bound to be a corrective
strategy, but a corrective strategy can also be used in conjunction with, or as one
component of, a growth strategy.
Risk-reducing Contingency Strategies
A company faces risk because of its lack of knowledge of the future. The extent of the
risk it faces can be revealed by the use of performance-risk gap analysis, where
forecasts of the outcome in n years time takes into account not only the likely return
but also the risk involved. While on the subject of risk, it should be remembered that
although it is desirable to reduce risk, risk is inevitably involved in any business. In fact
there are different ways of looking at risk:
Risk which is inevitable in the nature of the business; this risk should be
minimized as above.
Risk which an organization can afford to take. In general, high return involves
higher risk and a company which is in a strong position might be prepared to
take a higher risk in the hope of achieving a high return.
Risk which an organization cannot afford to take. A company cannot afford to

commit penny (and perhaps an overdraft as well) to a risky project. In the event
of failure it would be left in an extremely vulnerable position and could even
face winding up.
Risk which an organization cannot afford not to take. Sometimes a company is

forced to take a risk because it knows that its competitors are going to act and if
it does not follow it could be seriously left behind.
Long-term Strategies
Search for Opportunities
Growth in the size of an organization can be measured in many ways: profit, turnover,
earnings share, manpower, etc. but the real aim of a growth strategy is growth in profits.
The pursuit of increased turnover is not an end in itself but is only worthwhile if it leads
to higher profits. Organization had decided that it does need growth in order to achieve
its economic objectives. Its search for new opportunities must be particularly active.
The Relationship of Investment Decisions to Long-term Planning
Investment decisions are an important part of the long-term planning process, covering
internal investment decisions (committing funds to new projects within the existing
business and withdrawing from such projects if they turn out to be unsatisfactory),
external investment decisions (merging with or acquiring new companies), and
divestment decisions (selling part of the business, such a company no longer producing
satisfactory profits).
16

An Overview
1.9 SUMMARY
The objective of decision-making in corporate finance is to maximize firm value/stock
prices.
The company also needs to be socially desirable by fulfilling its non-financial objectives
like welfare of employees, management, customers, and suppliers and to the society at large.
There is a conflict of interest between stockholders and managers. The important
agency relationship exists between the stockholders and managers, between managers
and debtholders and between managers, stockholders and debtholders in times of
financial distress.
An agency problem in this context refers to conflict between the principle and the agent.
For instance, managers might fix for themselves higher salary, obtain large stock option,
at the expense of the stockholders.
An agency costs refers to the monitoring costs incurred by the principles over their
agents in making them act in the interests of the former.
Financial planning refers to the managerial function of developing, defining and
evaluating the organizational objective and devising strategies in fulfilling these
objectives.
The long-term objectives of the company might include survival or growth of the firm.
The company might need to balance the long-term profitability with the short-term gains.
1.10 GLOSSARY
Strategic financial management is the identification of the possible strategies capable
of maximizing an organizations net present value, the allocation of scarce capital
resources among the competing opportunities and the implementation and monitoring of
the chosen strategy, so as to achieve stated objectives.
Agency theory explains the relationships between the various interested parties in the
firm. For example, the management, shareholders etc.
Investment refers to deploying money in some return generating asset. The returns may
be in the form of regular income or capital appreciation. Investment may be for a long
period or for a short period, depending on the constraints and objectives of the investor.
Return is the gain or loss from an investment over a particular period. Returns may be
in the form of income or capital appreciation. Generally, risk and return go hand-inhand, i.e., more risk gives more return and low risk gives low return.
Strategy is a plan of action resulting or intended to accomplish a specific goal.
1.11 SUGGESTED READINGS/REFERENCE MATERIAL
Mark Grinblatt, and Sheridan Titman. Financial Markets and Corporate

Strategy. 2nd ed. Tata Mcgrawhill, 2002.
Aswath Damodaran. Corporate Finance Theory and Practice. Tata Mcgrawhill,

2000.
Eugene F. Brigham, and Phillip R. Daves. Intermediate Financial Management.

7th ed. Thomson, 2004.
Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

Companies Inc., 2000.
1.12 SUGGESTED ANSWERS

17
a.
b.
The non-financial objectives of a firm are as follows:

i.
General welfare of the employees, which includes providing the

employees with good wage, salaries, comfortable and safe working
conditions, good training and career developments and good pensions.
ii.
Welfare of the management which includes providing them with the

better salaries and perquisites though it will be at the cost of the
companys expenditure.
iii.
Welfare of the society as a whole. For example, the oil companies

confront with the problem of protecting the environment and preserving
the earths dwindling energy resources.
iv.
Fulfillment of responsibilities towards customers and suppliers.
v.
Leadership in research and development.
The actions of stakeholder groups in pursuit of their various goals can exert
influence on strategy. The greater the power of the stakeholder, the greater the
influence will be. Each stakeholder group possesses different expectations about
what it wants, and the expectations of the various groups conflicts with each
other. Each group, however, tends to influence strategic decision-making. The
relationship between management and shareholders is sometimes referred to as
an agency relationship, in which the managers act as agents for the shareholders,
using delegated powers to run the affairs of the company in the shareholders
best interests.
a.
Goal congruence is the term which describes the situation when the goals of
different interest groups coincide. A way of helping to achieve goal congruence
between shareholders and managers is by the introduction of carefully designed
remuneration packages for managers which would motivate managers to take
decisions which were consistent with the objectives of the shareholders.
b.
If the coupon interest rate is 10% and nominal interest rate is 8 percent, then the
market value of gilts will be:
Rs. 1,000 x 10%/8%= Rs.1,250
1.13 TERMINAL QUESTIONS

A. Multiple Choice
1.
2.
18
Which of the following is not included in strategic management?

a.
Providing and organizing the resources required.
b.
Analyzing companys options by matching its resources with external

environment.
c.
Identifying the most desirable strategy.
d.
Setting long-term objectives.
e.
Developing a company profit that reflects its internal conditions and

capabilities.
Which of the following will not come under immediate external environment?

An Overview
3.
4.
5.
a.
Competitors.
b.
Technological developments.
c.
Resources.
d.
Government agencies.
e.
Suppliers.
What prepares the organization and its individuals to define and achieve success
by facilitating self-development?
a.
Strategic planning.
b.
Strategic decision making.
c.
Management development.
d.
Training.
e.
Strategic analysis.
Which of the following reveals a firms financial risk?

a.
Leverage ratios.
b.
Liquidity ratios.
c.
Activity ratios.
d.
Profitability ratios.
e.
None of the above.
Which of the following processes, puts strategies and policies into action through
program budgets and procedures?
a.
Environmental approach.
b.
Strategic formulation.
c.
Strategic implementation.
d.
Evaluation and control.
e.
Strategy planning.
B. Descriptive
1.
What is the essence of agency theory?
2.
Describe the relationship between interest between the share price?
3.
What are the survival strategies?
These questions will help you to understand the unit better. These are for your
practice only.
19
UNIT 2
FIRMS ENVIRONMENT,
GOVERNANCE AND
STRATEGY
Structure
2.1
Introduction
2.2
Objectives
2.3
Firms Business Environment
2.4
Operational Structure
2.5
Financial Structure
2.6
Long-term Performance Plans
2.7
Summary
2.8
Glossary
2.9
2.10
Suggested Answers
2.11
Terminal Questions
2.1 INTRODUCTION
A business firm is not isolated one, but it is a part of society. Several factors affect the
earnings power of the firm. Those factors are known as business environment.
Environmental dynamism is a widely-explored construct in the organization theory and
strategic management literature. This construct has a growing importance according to
the degree of instability or turbulence of such key operating concerns as market and
industry conditions as well as more general technological, economic, social, and
political forces. The ability of an organization to adapt to changing environmental
circumstances is a key to organizational survival while effectiveness of the adaptive
response is dependent on aligning the response to the environmental circumstances
faced by the organization. It is clearly important for any business to be able to respond
positively to such interest. In this unit we will discuss the elements of a firms business
environment and also see as to how it affects the internal structures and operations of
the firm.
2.2 OBJECTIVES
Identify the components of business environment;
Define the operational structure;
Understand the basic pillars of a firms financial structure; and
Develop long-term performance plan for a company.
2.3 FIRMS BUSINESS ENVIRONMENT

There are various components of business environment which affect the earnings of the
firm. For example the level of inflation effects the interest rates which is again effect the
weighted average cost of the company. Here, we will discuss the important components
of business environment.
Firms Environment,
Governance and Strategy
STATE OF THE ECONOMY

The state of the economy both in the current as well as the predicted future plays a
significant role on the firms businessmen strategies, as well as its operational and
financial structures and its risks, performance and contingencies. These issues can be
addressed based on the business environment that the US had experienced since the
Second World War. From the time of end of the Second World War, till the early 1980s,
the firms encountered not only the problem of high rates of taxes but also increased
government regulations, antitrust restrictions on mergers and acquisitions and several
other allocated problems. Coupled with these were the problems of high inflation rates,
and high volatility rates. Further there was also the problem of economic recession.
Though recession has always proved to be disastrous for individuals as well as
businessmen firms, but the issue of consistent below par economic performance has
been even more devastating. The American Economy went through such period during
1974 to 1982. In contrast the economic condition between the years 1983 to 2001
proved to be much more stable. There was a positive signal for interest rates, inflation
and regulation as imposed by government. There was strengthening of the technological
advancements that included both the external as well as internal corporate governance
structures.
Let us now try to answer one intriguing question as to whether the observed average
aggregate returns on stocks corresponds to the markets example expected return. This
has always been an important issue to the managers, because the markets ex ante
required expected return on equity corresponds to the cost of equity capital of the firm.
So one can say that if at all the average returns match with the expected returns, then the
expected returns on the stocks and the cost of equity capital, will vary to a large extent
on a period of time, and perhaps even with the state of the economy. Then in brief it can
be said that, the manager of the firm should keep himself updated with the state of the
macro economy for two reasons (i) to enable himself to predict future economic
conditions, and (ii) to affect the profitability of capital investment projects. Added to
this it may also be stated that the unexpected changes in the economic conditions can
attribute to a major risk factor. The other reason being that the state of the economy
affects a firms overall Weighted Average Cost of Capital (WACC), by having an
influence on both the equity as well as the duelist capital of the firm.
RESOURCES AVAILABLE TO THE FIRM
The dependence of a firms ability to operate in its chosen product and service market to
that of its ability to secure resource equitably on its business strategy need not be
overemphasized. These resources take into account real estate and property plant and
equipment, talented labor and management personnel, cost effective technologies, and
low cost product and service providers. It is important for the firm to continuously seek
out for resources at lower cost, so as to secure and maintain a fair level of competitive
advantage. The increased level of technology in the industrial front has given way for
enhanced profit for a firm. This can be explained from the fact that increased
technology has resulted in the increased productivity of both the labor and capital
inputs. In the long run, the betterment of technology results in the evolution of new
firms and the death of the older firms which fail to keep themselves at pace with the fast
moving technological changes. For any firm that is carrying out its business, it has to
procure a lot of products and services from the product and service providers. These
may include labor, electricity, transportation, distribution and legal services. To procure
21
these services, one needs to attain the economies of scale. On a holistic manner, the
firms management should be able to manage between the vast nexus of contracts with
the stakeholders. Any firm can be characterized as having three types of financial
markets. They are equity markets, debt markets and derivatives market. As it is
commonly said that, having a liquid public market is essential to a firm for its equity.
The reason being, the liquid market enhances the value of the shares, as well as it
provides with a better accent to raise finance to external equity and debt finance. In any
firm, there exists a separation in ownership and control. This issue gives rise to the
fundamental problem that has been constantly addressed as the principal-agent conflict
and information asymmetry. As a result of these, several structures, contracts and
operations of a public firm are designed so as to lessen these problems and their costs,
keeping in mind the benefits accrued out of public equity. It is the equity investors that
estimate the final measure of management performance, which is the stock of the firm.
Here the investors are those who not only own a firms shares but also to those potential
investors who keep a constant watch on the price movement of the stocks and
consistently compare those stocks market prices with that of their true value. Further,
they also include those investors who might be in a position to take a short position in a
stock they consider to be overpriced. And finally it may also include other firms, and
other major investors in the market who continuously question the efficacy of the firms
management. They even stand ready to take control of the firm in case it performs
poorly. The importance of the debt markets is also to be cited here. The reliance to the
public firms on the debt markets is due to the externally generated funds. The
proportion of debt fund in the total capital structure is determined by several
characteristic features. It is also to be stated that the derivative instruments include the
forward contracts, and swaps. These are now playing a dominant role in the financial
strategies and policies. These take into account the interest rate risk, hedging of the
businessman risk, and currency risk.
EXTERNAL GOVERNANCE GROUPS
The federal, state and the local governments play a dual role towards the firms. On one
hand, they provide the adequate service and protection to the firms, whereas on the
other hand, they impose taxes, regulations and even restrictions on these firms that
operate within the industry. The primary service that is provided by the government to
its firms is concerned with the establishment of the property rights through proper
legislations and enforcing the legal contracts with the help of its judicial systems. The
latter function deals with the protection of the property rights. As stated earlier, the
government also imposes taxes, regulations as well as restrictions on the various
activities that are carried out by the firms, in order to protect the interest of the social
structure. As a result of this, the government constitutes an external governance group.
This group can be described as a group of outsiders that is responsible to keep a
constant vigil on the activities of the firm by exerting external control and constraints
over the firm. Another external group can be considered to be the one that is composed
of the creditors. This is because the creditors to a firm also impose constraints on the
firms activities by the use of covenants in debt contracts as well as constant
monitoring. The main purpose of having these two types of creditor governance
mechanism is to find a proper and adequate solution to the problem that arises due to
the existing conflict of interest between the firm and its creditors. There also exists a
third external governance group. This group comprises of the various professional
business analysts and professional commentators. The media plays an important role in
22
Firms Environment,
communicating any information that is available, of the firms activities, to the general
public. The general public refers to the investors and the ultimate consumers. Added to
this, there is also another group of financial analysts that is constantly analyzing the
strategies of the different activities as carried out by almost all the publicly traded firms.
They carry out the activity of estimating the values of these companies shares and
comparing them with their market values. Thus it can be safely said that the firms
financial performance is not guided by the periodic financial statements that are
submitted by these firms to the securities exchange commission, rather the estimation of
the true value of the firm is the result of the constant effort of the analyst and the media.
If studied in detail, it can be seen that the monitoring done by the media and the analysts
results in two important implications. The first being that the information that is
generated by these analysts and the media helps in lessening the information disparity
between the firm and its investors. This can be explained from two points, one being
that the reduction in the information asymmetry helps in increasing the liquidity and
efficiency of the market for the firms stock. At the same time, with more information
being made available by the media and the analysts it will be very difficult for the firm
to maintain those valuable information that it wants to keep private. This is of greater
significance because in order to maintain good competitive advantage, a firm needs to
keep some of its valuable information within its four walls. The other important
implication being that the financial analysts and the commentators provide an enhanced
picture of the firms management which, in turn, creates a better image of the company
in the minds of its shareholders. It is always seen that the analysts and the commentators
are very prompt in pointing out to the management that involves in the excessive
consumption of the perquisites, not performing their duties to the best of their capacities
or even involving in self engaging empire building. Thus one can firmly conclude that
the above stated external governance groups play an important role in reducing the
agency cost that goes with managerial discretion.
INTERNAL GOVERNANCE AND BUSINESS STRATEGY
Let us now study in detail about various elements of the firms internal governance
structure and its business strategy. It has been always an issue of argument that the
firms governance structure is of greater importance than its business strategy. As a
result of which, the former should always be placed on a higher cadre over the latter.
But as it is the case with most of the firms, the promoters of the firms decide upon the
predetermined product and service markets. Further, the role that is to be played by the
firms board of directors is dependent on the firms business strategy to a large extent.
At the same time, the senior managers of the firm in association with the board of
directors, works out on the firms business strategy and at the same time its operational
and financial structures on a constant basis. Keeping these considerations in mind one
has to keep the firms governance structure and the business strategy on an equal basis.
Internal Governance
The internal governance structure of a firm is made of shareholders, the board of
directors and the firms managerial hierarchy as well as its internal capital markets. For
a publicly traded non-financial American firm, there can be four major classes of
shareholders. The insiders, the mutual funds, the pension funds and the outsiders that
comprise the individuals as well as the other outside firms. It is to be noted that the
common stockholders have the voting right of one vote per share if at all they are
allowed to vote. These shareholders vote on the issues of elections for the board of
23
directors. They also vote on the issues of mergers, acquisitions and the sale of the
various assets. One being the proxy contests and the other being the shareholder initiated
proposal. Proxy contests take into account the campaign among the competing groups for
the right to cast the shareholders vote on their behalf. In other words, the process calls for
casting proxy votes for the shareholders. Let us now take a look into the shareholder
initiated proposals. This proposal generally calls for some changes in the firms internal
governance structure. This may include the structure and composition of the firms board
of directors, say for example, proposal to increase the number of outsiders in the
currently existing board of directors. After the decline of the takeover activity in the
1980s, the shareholder initiated proposals gained prominence. The primary objective for
framing these proposals was to increase upon the performance of the companies and to
provide them with a positive market value. Thus they find their applications more in
those firms that are found to perform poorly. Several studies done on these relevant
subjects have thrown some light on the conflicts of interest between the shareholders
and the management. Such studies have found out a negative correlation between the
percentage of votes cast in favor of the proposals and the percentage of stocks held by
the corporate insiders and the non-management members of the board of directors. At
the same time, these studies have also shown positive correlation between the votes that
have been cast for proposals and the management members of the board. Another study
done by Karpoff et al on the shareholder initiated corporate governance proposal has
concluded that such proposals have the ability to increase the firms market share
primarily because of two reasons. The first is that even if the proposal turns out to be
unsuccessful, the message may reach the management that the shareholders are unhappy
with their performance. Added to this, the shareholders proposals can also add value if
they help in gaining control of a corporation or tend to exert pressure for specific policy
changes. There is yet another school of thought that is of the opinion that the
shareholder activism seems to impair firm management, degrade the level of
performance, as well as decrease the value of the firm. There is also the possibility that
the public institutions may use the corporate governance proposals so as to gain
influence over the target firms decisions, and to compel the firm to pursue the
politically motivated and value decreasing investments. Keeping this in mind, it can
be concluded that the corporate governance proposals that are sponsored by the public
institutions will have a tendency to decrease the value of the firm as well as its
operating performances. There has been enough evidence to justify the fact that the
voting of the shareholder and the reaction of the stock market is dependent on several
issues that are considered in a proposal as well as the identity of the proposed sponsor
himself. Those proposals that are sponsored by the individual investors bring fewer
votes and at the same time they tend to impact the stock price to a very lesser extent
as compared to those proposals that are sponsored by the institutional investors. They
receive a larger share of votes and at the same time they tend to have a negative
impact on the stock prices. Further, the outcome of the voting has shown that though
the percentage of votes cast in favor of the proposal averaged less than the majority of
the casted votes, this percentage never showed any sign of increase over a sample
period.
Let us now shift our focus towards the corporate boards. The corporate boards generally
have a membership of around 6 to 12 people. The primary functions that are carried on
by the board involve the hiring, compensating as well as firing the senior management,
voting on the major management proposals, voting on the issues relating to stocks and
24
Firms Environment,
bonds, the payment of dividends, decisions regarding the repurchase of companys

stocks and finally providing the senior management with the much needed strategic
information and advice. One of the important factors of the board is the ratio of the
number of outsiders to that of the number of insiders that constitute the members of the
board. An insider to a board is the one who has been in the employment of the firm for a
long time, and who has shown the ability to rise on the corporate hierarchy. Any
employee to the firm who has got employment because of having any family
relationship with the senior management may also be referred to as the insider to the
board. On the other hand, the outsiders are those who have not been in the employment
of the firm and did not have any long-term relationship with the top boss of the
company. But the bottom-line is pretty clear, that the optimal structure of the board will
comprise of both the insiders as well as the outsiders to the firm. The insiders to the
board carry along with them a lot of experience, perspective and insights which they
have gained during their long tenure of employment. Whereas the outsiders to the board
bring along their experiences that they have gained while working in other firms. It is
worthwhile to mention here that the outsiders can express a more free opinion about the
performance of the CEOs as and when they feel like doing so.
a.
Why does Government constitute as external governance group of a firm?
b.
What is the internal governance structure of a firm?
Management Hierarchy and Internal Capital Markets

For any typical firm, the management hierarchy starts at the top level with the firms
President, the Board Chairman and the Chief Executive Officer. It may also happen that
all these three positions are being held by one single individual. The ultimate
responsibilities of the company are vested with that of the chief executive officer. This
may involve major capital budgeting decisions that may include the strategic and
logistical planning of capital investments and divestitures as well as decisions relating
to the financial structures, including financial planning, issuance of debt and their
retirements, issue of equity as well as the concerns involving their repurchase of shares,
dividend policies and compensation policies. Due to the increasing work pressure,
certain firms may also hire a Chief Financial Officer (CFO) for the smooth running of
their business. Larger firms may also have a broader span of management hierarchies.
Say, for example, they may be having regional and divisional managers who shoulder
the responsibilities of firms operations within their sphere.
25
Business Strategy
The business strategy of a firm can be said to have three essential elements. They are:
Targeting the specific products or the service markets.
Establishing the goals in terms of the market shares and profits.

Developing an effective competitive strategy against its competitors within the
industry.
2.4 OPERATIONAL STRUCTURE

Let us now discuss some of the most important aspects of a firms operational structure.
CAPITAL BUDGETING PROCESS
The capital investment decisions are unarguably the most important decisions that a
firm has to make. This is mainly due to the reason that these decisions ultimately result
in the shareholders value creation. The basic rules of capital budgeting takes into
account the concept of net present value (NPV), it further teaches us that a project
should be accepted only if it yields a positive value of NPV, where the estimation of the
NPV is done by discounting the projects expected cash flows at the rate of the firms
WACC. In an ideal capital market a firm shows an indifferent approach while raising
funds it needs to pursue for a positive NPV. This required fund can be procured by the
issuance of equity or debt or by using the retained earnings. The indifference nature of
the firm can be attributed to the fact that in an ideal capital market all the securities are
sold at a fair price and all the capital structure yields the same level of WACC. Thus one
can say that the capital budgeting and the financing decisions are exclusive in nature.
Based on this platform, the focus of the capital governance is towards the monitoring of
the managements ability to identify the positive NPV projects, because the financing
decisions are obligatory in nature. As it has been stated earlier, the cost that is
associated with the principal-agent conflicts and information disparity can negatively
effect the capital investment and the financial decisions of the firm. Say for example, in
the case of a self serving manager, there may be cases where the project is accepted
though it has a negative NPV, because he is more concerned with building his own
empire. There may also be cases of firms having risky debts outstanding in their
balance, but still it may go for increasing the riskiness of the firms operations as a
means of expropriating wealth from the creditors. Finally there may even be cases
where a firm may sacrifice a positive net present value if only its creditors derive
benefit out of it.
The problem of delegation has always been a cause of concern for many firms,
especially in a multidivisional firm. The problem may be of the form that the divisional
manager may have better information about the profitability of the project than the
senior management of the firm. Coupled with this if the divisional manager has a self
serving incentive to build his or her own division, he/she may indulge in the practice of
showing a better picture about the quality of the proposed project so as to garner greater
capital funds from the companys headquarters. Thus it is the duty of the senior
managers to plan out incentive compatible contracts so that such problems can be
avoided.
ADVANTAGES OF BEING LARGE
The very fact that the larger firms are generally more profit making than the smaller and
the lesser ones need not be mentioned. But perhaps no absolute answer can be given to
as why certain firms grow large and earn more profits whereas others do not. But it can
26
Firms Environment,
be said that towards the way to success, most of the firms have treaded on a similar
path. Successful firms possessed innovative, strategy wise founders who were
succeeded by the equally competent CEOs. Further it has been seen that almost all these
firms had a well developed market structure where it could supply its products. These
firms enjoyed the benefits of being the first mover in the market and as a result of this
they could capture at least temporary profits and were able to exploit the opportunities
effectively following an initial public offering. This provided them with greater access
to the debt and equity markets so that they could raise additional funds when required.
With the increase in the number of these firms, they could reap the benefits of the
economies of scale which in turn helped them in generating extra profits and to force
the competitors out of the existing markets. Finally it can be mentioned here that as far
as the firms financial policies and the strategies are concerned, they go for funding the
expansions using the internal equity. As per the pecking order hypothesis, this is always
a preferred method of financing growth under the conditions of asymmetric information
which considers the element of external capital, especially the external equity capital, to
be costly. Thus here it can be said that the profitable firms have an added advantage in
financing growth.
FIRMS PRODUCTION FUNCTION
For any firm, the balance between the capital and the labor intensities depend on the
industry within which the firm operates. Certain firms that are engaged in the
transportation and the utilities industries have larger scale of operations and as such they
are the most capital intensive industry in the American market. Other large and
manufacturing firms such as the general motors are also highly capital intensive. Thus
for such firms, there is a close relation between the economies of scale or in other words
their profitability, and their capital intensive nature. On the other hand, certain firms
such as Microsoft that falls in the service industry characterizes labor intensiveness.
INTERNAL AUDITING: QUALITY AND COST CONTROL
The birth of a capital investment project begins when the board gives its approval for
the expenditures that are to be made. The procedure of developing the intricacies of a
marketing strategy is a long drawn process. It is the policy of many firms to engage an
internal auditing team that will oversee the entire product development process. The
internal auditing team provides the firm with valuable information that may include
information pertaining to whether all the parties involved in the project are working on a
consensus basis, whether all workings are done according to the plans and if any further
changes are required in those plans. Whether the company is complying with the quality
and cost controls and finally whether the reports on all the activities are accurate. Here it
should be noted that the internal auditing and the cost control procedures are major
aspects of any firms operations especially for a firm that is operating in a highly
competitive product or service market.
2.5 FINANCIAL STRUCTURE

Let us now discuss about the basic pillars of a firms financial structure.
a.
Ownership structure.
b.
Financial planning and leverage.
c.
Executive compensation policies.
Let us now discuss each of these elements in detail.

27
OWNERSHIP STRUCTURE
The optimal structure may widely vary across firms due to the factors that affect the
trade offs that exist between the advantages of diffused ownership and cost of
managerial discretion. One particular way by which one can study the trade off as stated
above is by examining the effect of incentive alignment devices on a firms market
value. There have been several studies done so as to focus on the importance of such
devices. One of such devices has been the executive stock ownership. These studies
focused on the relationship of the fraction of the firms shares that is held by the
executives and the market value of the firm. Studies relating to this have shown that
with the increase of the stock ownership from about zero to about three to five percent,
the value of the firm as measured by the Tobins Q simultaneously increases as
expected. But once the ownership of the stocks increases beyond this level, the firms
value no longer increases. Another way by which the trade off can be seen is to relate
the top executive turnover with that of the firms ownership structure. It has been
further found out that if the top executives own a substantial amount of the firms share
then they can establish themselves despite the firms poor performance. But, on the
other hand, they may find it rather difficult to do so in case a majority of the firms
shareholding is with outside investors. This aspect can at least to some extent explain
the absence of positive relationship between the insider share ownership and the
performance of the firm, when such an ownership becomes substantial. A secondary
trade off can also be brought into the picture, if the outside shareholders need to reduce
the adverse value effects of the management entrenchment, it will be always at the cost
of the less diffused ownership and its associated benefits.
FINANCIAL PLANNING AND LEVERAGE
Let us here discuss some of the factors that affect the firms leverage.
Financial Planning
Financial planning mainly takes into account two major aspects, one being the
predictions regarding the timings and the future capital expenditures on the projects and
the future earnings that the company will produce. And the other issue being how the
firm will finance its capital expenditures, debt payments, dividends and stock
repurchases over the period of time. The main purpose of the financial planning
analyses is to reveal the expected future needs of the firm as far as the external debt or
equity funds is concerned. Thus in a nutshell it can be said that the primary purpose of
the financial planning process is to strike a balance between the amount as well as the
timing of the future outflows of the firm with that of the net cash flows that may accrue
from the operations and the proceeds of the debt or equity issues. Say as an example, the
leverage of a firm may depend on whether the firm has recently gone for raising debt
funds for its capital investments because it faced lack of sufficient internal cash.
Leverage, Investments and the Growth of a Fund
There have been several studies that have shown a negative relationship between the
leverage of a firm and its growth. One of the studies that have been conducted puts forth
two competing relationships. In one instance it mentions about the negative relationship
between the growth of the firm and its financial leverage. On the other hand, it seems
strange that a firm that is expected to be highly profitable would face problems in
securing debt financing when the firms current capital expenditures exceed its available
internal funds.
28
Firms Environment,
EXECUTIVE COMPENSATION POLICIES

As it has been stated earlier the incentive devices in executive compensation contracts
play a crucial role in determining and linking the shareholders and the managers
interest. These incentives generally include the portion of the firms share that is held by
the management, those annual bonuses that are tied up to the firms earnings, the grants
of the restricted stock or the stock options that provide compensation that is a function
of the future performance of the stock price. Let us now delve into the problems that are
generally confronted with the standard incentive devices in executive compensation
contracts, the recent developments that have taken place in alternative incentive devices,
and long-term performance plans. Further, we will also discuss some evidences relating
to the compensation devices in brief.
Problems with Incentive Devices
It is to be borne in mind that there cannot be any perfect incentive device. The primary
problem is from the firms point of view. It can be said that, an executives personal
portfolio is not well diversified and is exposed to the firms risk to a great extent. In
contrast, a typically diversified shareholder is only exposed to the firms systematic or
diversified risk. As a result of which, an executive who is risk adverse in nature
personally motivates himself so as to reduce the firms business risk and financial risk.
As far as reducing the business risk is concerned, he tries to reduce the firms operating
leverage or taking on only the low risky projects. With regard to the financial leverage,
he tries to reduce the firms leverage below its optimal level if at all such a level does
exist. Further, as explained by Shleifer and Vishny, there can also be the potential for
the performance indentures to boomerang. Let us now explain this in more detail. The
serious problem that one can associate with the high powered incentive contracts is that
they result in creating avenues for self dealing managers. The problem can be even
more serious, if those contracts are negotiated with poorly motivated board of directors
rather than with larger blocks of investors. In such situations, the managers may
negotiate for their vested interest, because they know that the earnings or stock prices
are likely to go up, or they may even indulge in manipulating the accounting numbers
and investment policies so as to increase upon their pay. To site an example, Yermack
(1997) found out that managers tend to receive stock option grants shortly before any
announcement of good news and they tend to delay such grants until after any
announcement of bad news. The results he found out are suggestive of the fact that,
option may not always be so much an incentive device as some what canceling
mechanism of self dealing. Any how, the strengths of incentive devices in executive
compensation contracts is associated with their importance and to their positive net
worth. But it is also to be noted here, that the observed cross sectional variations in
incentive devices and their complexity shows that it is rather difficult to bring together
the interests of the senior management and the shareholders through terms in a
compensation contract.
Earnings Based Bonuses Vs Stock Related Grants
The everlasting debate served by placing the managements attention on earnings-stock
price performance. A bonus plan based on earnings may be better off because it is a
reward to the CEO for the realized performance. In contracts, the stocks and the stock
options grant focus directly on the shareholders interest, so as to increase the market
value of the firms equity. But it has been seen that both these kinds of incentive devices
29
are not free from problems. Taking into account, the annual earnings based bonuses, the
problem that arises is that the manager become more concerned on the firms short-term
accounting earnings, which may be of potential harm to the firms long-term
profitability, which is actually the ultimate determining factor of the share value of the
firm. Further, the management can also manipulate accounts of earnings, at least in the
short run. It is of the common practice that managements use accounting methods
according to their convenience. They can do it by switching depreciation methods,
recognizing on delaying the revenues, and writing down assets though the extent to
which they can manipulate accounts is limited as companies have to rise by the
generally accepted accounting principles [GAAP]. The problem that can be associated
with the stock related grants is that, the stock price of the firm depends not only on the
firms performance, but also certain other factors that are beyond the contract of the
manager. They may also include market wide factors that generally affect the stocks
price. There may also be the chances, where management might manipulate the stocks
price. This may be due to the existence of information asymmetry; the markets
valuation of the firms stock price is dependent on the information that comes directly
from the firms management. Say for example, enhancing the profit potential of the
existing or pending projects or price of the firms shares.
Let us now discuss the recent developments that have taken place in alternative forms of
incentive plans, like long-term performance plans.
2.6 LONG-TERM PERFORMANCE PLANS

The development of the long-term performance plans can be partially attributed to the
fact that there existed certain problems with both the annual earnings based bonus plans
and the stock related grants. As a result of which many firms have actually removed
both these forms of incentive plans, and replaced them with the long-term performance
plans that reward the executives according to the firms earnings or stock price
performance over a period of three or five years rather than rewarding annually as it is
the case with earnings based bonuses. A positive aspect of a long-term performance
plan is that, a manager may be of the opinion to hire off a poorly performing asset even
if by doing, it adversely affects the short-term earnings of the firm because of the
writing down. Studies conducted have revealed that the reaction of the market to the
announcement of an asset sale is more favorable if the firms management has a longterm performance plan than if it does not have. The studies have concluded saying that
the long-term performance plans serve as an effective mechanism to motivate managers
to make better decisions. Another study as conducted by Kumar and Sapariwala (1992)
probed into the markets reaction to the announcement of adopting the long-term
performance plans and the subsequent changes in the performance of the adopting firm.
Their studies have reported a considerable positive excess returns around the time when
such plans were adopted. This is consistent with the fact that such plans would result in
the reduction in the agency problems. Further it has also been observed that, there exists
a close allocation between the adoption of long-term performance plans and the
resulting growth in the firms profitability. One last finding in the study was in relation
to the excess returns generated around the announcement of the performance plan
adoptions which showed that such excess return is positively skewed with the
subsequent change in growth of earnings per share, the most commonly used accounting
performance measure.
30
Firms Environment,
Relationship between the Executive Compensation and Firms Financial

Policies and Performance
The relationship between the firms executive compensation and its financial policies is
not that simple. It may happen that the contingencies that are involved in the executive
compensation contract may both effect as well as get effected by other associated
financial variables. Let us now try to understand the relationship of the compensation
plans with some of these variables.
Executive Compensation, Board and Ownership Structures, and Performance
Studies conducted by Tarcker et al. (1999) analyzes the interactions among the
executive compensation, internal governance, and performance. One of their findings
says that, for firms with boards, the executive compensation will be higher and the firm
performance lower, both because the boards of these firms have not resolved the agency
problem of managerial discretion.
Forms of Executive Compensation and Managerial Risk Taking
Studies conducted by Agarwal and Mandellear (1987) have focused on the effects or
provisions in executive compensation contracts on a firms financial policies. The
studies were conducted on the platform that the managers generally have a self serving
incentive so as to decrease the volatility of the firm. Apart from this, they were also of
the opinion that those managers who either hold shares in their firm or have stock
options on the equity of the firm, will then be indulging in risk reducing activities
because their compensation contract better aligns their interest with that of the firms
shareholders. Thus it can be said, that managers who hold the share or stock options will
be more willing to take actions that increase the risk, whereas those managers who do
not hold shares or stock options are more biased towards the risk reducing actions. In
order to test the validity of the hypothesis, the profounders of the theory had identified
the firm that had actually taken one of two types of actions that could change the
volatility of the firm i.e. a capital investment or a change in the leverage. They studied
the change in the variance of returns on the firms stock with the announcement of any
capital investment. Based on this they divided the firms into two categories. One
category belonged to that group that subsequently experienced an increase in the
variance and the other group that subsequently underwent a decrease in variance. The
authors also divided the leverage changing firms into two groups. Those firms that
increased the leverage and those that decreased the leverage. Their ultimate study dealt
with the estimation of the common stock and options holding of managers in each
group. Their findings can be summarized in the following points.
i.
For those firms whose variance in return increases upon an investment

announcement, their managers common stock and the options are larger than
those firms for which the variance in returns decreases upon such
announcements.
ii.
Further, it has been found out that the security holdings of managers of firms
with a debt-equity ratio that increases are larger than those for which the ratio
decreases.
Executive Compensation, Ownership and Governance Structures of Leverage

Study conducted by Mehran (1992) on 170 US manufacturing firms tested the
hypothesis from agency theory about the relationship that existed between the firms
31
leverage and the executive incentive plans, managerial equity investments, monitoring
by the board and the firms major shareholders. The study found a positive relationship
between the firms leverage ratio and the percentage of executives total compensation
in incentive plans, percentage of equity held, the percentage of investment bankers on
the board of equity held, the percentage of investment bankers on the board of directors
and the percentage of equity that is held by individual investors.
Investment Opportunities, Financial Policies and Executive Compensation
Studies conducted by Smith and Watts (1992) speak about the relationships among the
firms investment opportunities, financial policies and executive compensation. Some of
their findings are:
a.
Firms attached with more growth options use stock options more frequently,
because the management in such firms is more difficult to monitor.
b.
Larger proportion of value attributed to growth options is representative of

greater management compensation.
c.
Regulations tend to prohibit the managers investment discretion and reduces the
marginal product of the decision maker.
d.
As a general finding, the larger the proportion of the value of the firm in terms of
growth options, the more it is likely that the firm attaches compensation to the
effect of the firm value.
Evidence on the Pay Performance Relationship

Jensen and Murphy (1990) studied the sensitivity of the chief executive officer
compensation that comprised pay, options and stockholdings on the firms performance.
They found out that, on an average, the wealth of the chief executive officer changes by
0.325% for a change in the shareholders wealth. These results appear to be very
surprising and suggest that the chief executive officer has very little personal incentive
to increase the shareholders wealth. But this fact is pretty surprising, as it rises the
basic rationale behind the compensation plans, as they should contain performance
incentives that actually bring together the managers and the shareholders interest. But
the authors suggest that this argument may fail as the management executives are averse
to risk and thus they may refuse to accept the risk that is associated with such
incentives. But it is to be mentioned that the studies conducted by Jensen and Murphy
may not have yielded accurate results, as it used data on ex post compensation, rather
than the ex ante terms in the executive contracts. This issue was given recognition by
Kole (1997), by examining the shareholders authorized compensation arrangements
that provide a more critical ex ante perspective. He focuses on the flexibility the firms
board has while negotiating a contract with the senior management.
RISKS, PERFORMANCE, AND CONTINGENCIES
Business Risk and Financial Risk as Determinants of Equity Risk
The riskiness of the firms operating earnings, that is, its business risks become well
defined, once the management decides on its business strategy and operational structure.
One of the important ingredients of a firms business strategy that determines its
business risk is the industry in which the firm chooses to operate. There are two aspects
of a firms operational structure that can influence its business risk. One, that a larger
firm is generally more geographically diversified, say in terms of its customers base,
alternative suppliers, employees, plants, etc. The second advantage being, that the firm
32
Firms Environment,
enjoys a semi monopoly status within its industry by the virtue of economies of scale
though this status will not protect the firm from a decline in aggregate demand for the
industry products. As far as the capital intensity is concerned, a traditional debate exists
stating that a firms business risk is positively related to its capital intensity, or in other
words, its operating leverage. The argument states that, any capital intensive firm is
filled with a considerable fixed cost and as a result its operating earnings are more prone
to changes in its revenues. At the same time, the relationship between the capital
intensity and business risk may be difficult to prove empirically, because any typical
capital-intensive firm is larger and so enjoys the business risk-reducing effects of the
large sized firms. Thus, the question still remains unanswered as to which effects
influence in determining a firms business risk. Let us now use empirical evidence on
this issue.
a.
What are the aspects to be covered under financial planning?
..
.
b.
What is the basic rule of capital budgeting under Net Present Value (NPV)
Method?
.
..
.
Business Risk, Financial Risk, Leverage and Equity Risk

It is to be mentioned here that the risk associated with the firms equity is dependent not
only on the firms business risk, but also on the firms financial leverage. This is due to
the fact that the financial leverage works to focus more on the firms business risk on a
smaller equity base. The term financial risk is used in reference to either a firms risk
of bankruptcy or to the effects of leverage on earnings and stock price volatility. Say,
for any given set of risky assets and operations, the firms financial risk increases with
its financial leverage. The business risk and financial leverage work in accordance to
determine the risk of a firms equity, so, the management is concerned with the interest
of the firms equity holders, and the importance of their interest lies in the riskiness of
the firms business risk. Further, one can suppose that the firms that have higher
business risk will tend to have lowest leverages. Let us now take the case, where the
firms management initially decides on its optimal business strategy and its operational
structure, that best explains its business risk and then it considers its leverage. If the
firms management wishes to limit the firms equity risk to some level of tolerance, then
it has to employ less financial leverage when its business risk is higher. Let us now
discuss this in detail.
Cost of Capital, Profitability and Share Value
The traditional capital budgeting identifies projects which have higher expected rate of
return (IRR) than the firms weighted average cost of capital. With few exceptions, this
criterion holds good for all projects. It is worthwhile to mention here, that only such
33
projects are beneficial because they tend to increase the share value. Estimating the IRR
of a project may not be that simple as it seems. Though the initial outlay on the project
may be relatively easier to determine, it is much more difficult to estimate the expected
future cash flows, both in terms of amount and timing. This problem is coupled with the
fact that there exists even the present issue of future contingencies. Say for example,
if the initial results on the projects profitability are favorable, additional capital
expenditures may be called for, whereas, on the other hand, if the cash flows are
adverse, the project may be abandoned and the assets may be liquidated or even
redeployed further estimating the firms WACC may not be always an easy task. The
firms WACC is dependent on both its business risk as well as its capital structure.
Also, at some point of time, the firms WACC will depend on the state of the economy.
Let us now try to answer one peculiar question. Do firms ever adopt projects whose
IRRs exceed their respective WACCs, and if so by what extent? Studies conducted by
French and Tama have concluded that firms generally invest in projects whose IRR
exceeds their WACC, though by a marginal percentage.
Contingencies
Managers generally confront with contingencies as a result of past performances,
irrespective of the fact whether such performance has been good or disappointing. There
are four classes of contingencies:
i.
Growth opportunities.
ii.
Restructuring.
iii.
Merger, acquisition or buyouts.
iv.
Bankruptcy or liquidation.
It is to be remembered that the decisions related to these contingencies, and not the
profitability of firms original projects, determine the majority of the firms future
profitability and the shareholders value. It is mainly for this reason, that the interest of
the shareholders and the management are aligned. If that is not so, then the decisions
related to such contingencies may be suboptimal. Say for example, it may be seen that
many firms are growing, but as a matter of fact, only some of these firms are pursuing
profitable growth opportunities, whereas in other managements, the managers are
engaged in self serving empire building. There have been two milestones in the
development of US firms in 1980s and 1900s.
These are:
34
i.
Internal Corporate Governance.
ii.
Alignment of the interest of the shareholders and the management through the
incentives in the executive compensation contracts. This has led firms to
pursue their core competencies coupled with their growth opportunities.
Another important form of contingency for acquiring firms and targets refer to
the mergers and acquisitions. For a firm that is going to acquit, it may try to
gain critical economies of scale in its existing products market or to pursue a
profitable opportunity in a complementary product market. As far as the target
firm is concerned, it generally is profitable to the shareholders of the acquired
firm. A final contingency deals with the bankruptcy or liquidation element.
Firms Environment,
These types of contingencies after reshuffling its assets and financial structure. In the
case of liquidation, the assets of the firm are sold, and the proceeds are distributed to its
claimholders may be of the last resort, for any company that is in financial distress.
Once a firm declares bankruptcy, it gets protection from its creditors and also an
opportunity to remerge, based on priority, and the firm ceases to exist.
2.7 SUMMARY
The business environment of the firm consists of the state of the economy, resource
availability, external governance groups (media, government and the creditors), internal
governance groups (The shareholders, Board of Directors, managerial hierarchy and the
internal capital markets).
The operational structure of the firm consists of (a) The capital budgeting decisions.
(b) Decision regarding the size of the company. (c) Decision regarding the production
function (capital/labor-intensive operations). (d) Internal audit consisting of the cost
and the quality audit. (e) Decision regarding the financial structure of the company.
The financial structure decisions typically comprises of the ownership structure,
financial leverage, dividend and stock repurchase policies and the executive
compensation policies.
The designing of the executive compensation policies is a difficult task as the interests
of the managers and that of the stakeholders tends to clash. It thus views executive
compensation not only as an instrument for addressing the agency problem between
managers and shareholders, but also as part of the problem itself.
2.8 GLOSSARY
Economic Recession is a business cycle contraction, a general slowdown in economic
activity over a period of time.
The markets ex ante is the variance efficiency of market benchmarks such as the S&P
CNX nifty or sensex Index.[v1]
Debt fund capital is the proportion of capital raised in the form of debentures or longterm loans.

Strategy.
2nd ed. Tata Mcgrawhill, 2002.

2000.

Brealey Myers. Principles of Corporate Finance. 6th edition. US: Mcgraw-Hill


a.
The government plays a dual role towards the firms. On one hand, it provides the
adequate service and protection to the firms, whereas on the other hand, it
imposes taxes, regulations and even restrictions on these firms that operate
within the industry. The primary service that is provided by the government to its
35
firms is concerned with the establishment of the property rights through proper
legislations and enforcing the legal contracts with the help of its judicial systems.
The latter function deals with the protection of the property rights. The
government also imposes taxes, regulations as well as restrictions on the various
activities that are carried out by the firms, in order to protect the interest of the
social structure. As a result of this, the government constitutes an external
governance group. This group can be described as a group of outsiders that is
responsible to keep a constant vigil on the activities of the firm by exerting
external control and constraints over the firm.
b.
The internal governance structure of a firm is made of shareholders, the board of

directors and the firms managerial hierarchy as well as its internal capital
markets.
a.
Financial planning mainly takes into account two major aspects, one being the
predictions regarding the timings and the future capital expenditures on the
projects and the future earnings that the company will produce. And the other
issue being how the firm will finance its capital expenditures, debt payments,
dividends and stock repurchases over the period of time. The main purpose of
the financial planning analyses is to reveal the expected future needs of the firm
as far as the external debt or equity funds is concerned.
b.
The basic rules of capital budgeting takes into account the concept of net present
value (NPV), under this a project should be accepted only if it yields a positive
value of NPV, where the estimation of the NPV is done by discounting the
projects expected cash flows at the rate of the firms WACC.

A. Multiple Choice
1.
2.
36
The business environment of the firm does not consist of which of the following
statements?
a.
Internal governance and business strategy.
b.
External corporate groups.
c.
Internal capital markets.
d.
Ownership structure.
e.
Management hierarchy.
A projects profitability index of 0.87 indicates that:

a.
The present value of benefits is 87% greater than the projects costs
b.
The projects NPV is greater than zero
c.
The project returns 87 paise in present value for each rupee invested
d.
The payback period is less than one year
e.
The ratio of NPV to the initial investment is 87%.
Firms Environment,
3.
4.
5.
All these are part of Porters competitive forces in industry analysis except:
a.
Potential entry of new competitors
b.
Bargaining power of suppliers
c.
Development of substitute products
d.
Bargaining power of unions
e.
Threat of substitutes.
Manager takeover defenses include

a.
Greenmail, poison pills, and white knights
b.
White knights, golden parachutes, and poison pills
c.
Poison pills, dark knights, and golden parachutes
d.
Golden parachutes, greenmail, and poison pills
e.
Dark knights, poison pill and greenmail.
Which of the following is not recommended for effective board governance?

a.
Highly diverse background of board members.
b.
Establishment of formal processes for the boards performance

evaluation.
c.
Ensure the CEO is also designated at the position of board chair.
d.
Strengthen internal management and accounting control systems.
e.
Giving ESOPs to the executives as incentives.
B. Descriptive
1.
What are the basic three pillars of a companys financial structure?
2.
Write the relationship between executive compensation and companys financial

policies.
3.
How does state of economy affects the earnings power of a firm?
practice only.
37
UNIT 3
VALUING REAL ASSETS IN

THE PRESENCE OF RISK
Structure
3.1
Introduction
3.2
Objectives
3.3
Tracking Portfolios and Real Asset Valuation
3.4
Risk Adjusted Discount Rate Method (RADR)
3.5
Using Beta to Estimate the Cost of Capital in all Equity Firms
3.6
Debt and Equity Financing
3.7
Computation of the Cost of Capital Using the Dividend Discount Models
3.8
Multiperiod Risk Adjusted Discount Rates
3.9
The Certainty Equivalent Approach
3.10
The Scenario Analysis
3.11
Capital Rationing
3.12
Capital Budgeting and the Strategic Policy
3.13
Summary
3.14
Glossary
3.15
3.16
Suggested Answers
3.17
Terminal Questions
3.1 INTRODUCTION
Valuation of a project under risky conditions calls for a systematic study. Discounted
cash flow methods and risk adjusted discounted rate methods are essential to fix the
minimum rate of return from the investment. The rate at which the future cash flows are
discounted is actually the projects cost of capital. It is the Weighted Average Cost of
Capital (WACC). WACC is used to find the net present value of the future periods
cash flows and to find the risk adjusted discount rate. In this unit, we shall study how to
generate tracking portfolios for which the present value of the tracking error is zero.
3.2 OBJECTIVES
Understand Tracking Portfolios and Real Asset Valuation;
Know Risk Adjusted Discount Rate Method (RADR) ;
Use Beta to Estimate the Cost of Capital in all Equity Firms;
Know valuation under Debt and Equity Financing;
Compute the Cost of Capital using the Dividend Discount Models;
Valuing Real Assets in the

Presence of Risk
Know the application of Multiperiod Risk Adjusted Discount Rates;
Understand the Certainty Equivalent Approach;
Adopt Scenario Analysis for valuation;
Define Capital Rationing; and
Understand Capital Budgeting and Strategic Policy.
3.3 TRACKING PORTFOLIOS AND REAL ASSET VALUATION

The discounted cash flow method in valuation process is actually based on the platform
of tracking portfolio approach. This particular approach applies well to the risk less cash
flows but in case of risky projects it encounters certain problems. The portfolio that is
capable in perfectly tracking the cash flows of risky projects exists only in certain cases.
As in most of the cases, there exists some tracking error which is basically the
difference between the cash flows of the tracking portfolios and the cash flows of the
projects. Tracking error can be defined as the difference in performance of a particular
fund (project) relative to a benchmark portfolio. Tracking error can be calculated easily
by subtracting the total return of the project for a given period (such as one month) from
the total return of the benchmark for the same period. The tracking error provides a
measure of how much the project returns may differ from the benchmark returns.
So valuing the projects in these cases calls for a theory that best describes how to
generate the tracking portfolios for which the present value of the tracking error is zero.
The tracking portfolio approach is one such way by which this can be accomplished.
ASSET PRICING MODELS AND THE TRACKING PORTFOLIO APPROACH
The use of this approach is relevant for valuation when the present value of the tracking
error is zero. This is possible only when the tracking error consists entirely of
unsystematic or firm specific risks. It is to be always remembered that when a tracking
error with zero systematic risk and zero expected value is generated by a tracking
portfolio for the future cash flows of a project, the market value for the tracking
portfolio is the present value of the projects future cash flows.
Implementing the Approach
Identifying the tracking portfolio that is mean variant efficient makes the valuation task
much simpler. It does not call for the expected return of the market, the risk-free return
or even the expected cash flows for the computation of the present cash flows. But it
becomes very difficult to estimate the correct investment without estimating the
expected future cash flows and the expected return of the market portfolios. Estimating
a tracking portfolio without the knowledge of expected returns or the expected cash
flows can be done in several ways. One such way is when there is perfect or almost
perfect tracking. In these cases the tracking error is zero or very close to zero, which
makes the approach superior to the CAPM and the APT methods. Another way of
estimating the tracking portfolio is by using the market portfolio or factor portfolios.
Actually the use of the market portfolios combined with risk-free assets is needed due to
the presence of the tracking error.
39
3.4 RISK ADJUSTED DISCOUNT RATE METHOD (RADR)

One of the popular ways of estimating the present value of the future cash flows is by
the use of the discount rate method. The rate at which the future cash flows are
discounted is actually the projects cost of capital. The method is generally used in case
where there is a comparison firm or set of firms in the same line of business as the
project. Calculation of the net present value of the future periods cash flows using the
risk adjusted discount rate can be done using the following formula:
PV = E (cf)/{1 + rf + (RT rf )}
Where,
E (cf) denotes expected future cash flows in the next period.
denotes the beta of the return of the project.
rf denotes the risk-free return.
RT denotes the expected return of the tangency portfolio.
USING THE COST OF CAPITAL TO VALUE A NON-TRADED SUBSIDIARY
Company A, a wholly owned subsidiary of company B, has a beta of 1.3 when
computed against the tangency portfolio. The tangency portfolio has an expected return
of 20% per year. The risk-free rate is 8%. The expected value per share of A one year
hence is Rs.12. As per the above formula the companys present value of the share
assuming no dividend payment is:
12 / [1 + 0.08 + 1.3 (0.20 0.08)] = 9.70
In case of the traded securities, the comparison approach is used in identifying the betas
of the stocks. This is done by estimating the betas of the traded stocks of the similar
firms in the industry using some average of their betas as a representative of the
subsidiary companys beta. In fact this comparison approach assumes that the present
value is not negative or zero.
THE EFFECT OF LEVERAGE ON COMPARISON
It is important to note that the beta risk of the equity of the comparison firms is truly
comparable. Further it has been seen that the debt financing in firms has an impact on
the equity betas, so it is also important to make a proper adjustment regarding these beta
risk comparisons. This beta can be very well used to compute the risk adjusted discount
rates (RADR) for the individual projects. This is most suitable in cases where firms
stocks are widely traded and the chances of bankruptcy are minimum.
3.5 USING BETA TO ESTIMATE THE COST OF CAPITAL IN

ALL EQUITY FIRMS
While estimating the cost of capital in an all equity firm the Capital Asset Pricing
Model (CAPM) can be used. The firms cost of capital is the minimum rate of return
that the firms investors require. So for an all equity firm the firms cost of capital is its
40

Presence of Risk
minimum rate of return that the stockholders require. Using the CAPM framework the
minimum expected rate of return required from stock a, will be
Ra = Rf + (Rm Rf) a
Where,
Ra denotes the minimum expected rate of return required from stock a.
Rf denotes risk less interest rate.
Rm denotes market portfolios expected rate of return.
a denotes the beta of stock a.
Now as Ra is the minimum expected rate of return required from stock a, and the firm is
an all equity firm, it can be used as the firms cost of equity. Now if one denotes the
cost of capital by k, and the beta of the firm by b, the above equation looks like:
k = Rf + (Rm Rf)
Example: Stock Holders Corporation, an all equity firm, is considering a new project
with a perpetual cash flow. The initial outlay of the project is Rs.1,00,000, and the beta
of the project is 4. The market portfolios expected rate of return is 14%, and the risk
less interest rate is 3%. The projects minimum rate of return is:
k = 3% + (14% 3%)4 = 47%
3.6 DEBT AND EQUITY FINANCING

Debt financing, also termed as financial leverage, tries to distinguish between the cost
of equity ke, and the financial cost of capital denoted by k. First we will take into
account of a situation where no corporate taxes are present. It can be found out that the
firms cost of capital is actually the weighted average of the specific costs of the debt
and the equity, where the weights are the proportions of the debt and equity of the
firms total financing. The Weighted Average Cost of Capital (WACC) can be
represented as:
WACC = weke + wdkd
Where,
WACC denotes the weighted average cost of capital of the firm.
we denotes the proportion of equity financing.
wd denotes the proportion of debt financing.
ke denotes the cost of equity.
kd denotes the cost of debt.
Here, it is assumed that all the projects have the same level of risk. Thus, it can also be
said that the WACC is equal to the Projects Cost of Capital (PCC) as well as the Firms
Cost of Capital (FCC).
The cost of debt is usually lower than the cost of equity. So it is logical for a firm to
increase on the level of debt financing and thereby reducing its WACC. But as a
practice it is not so. With the increase in debt financing, the stockholders risk increases
41
as the firms have to commit to larger future repayments of debt. This result in the cost
of equity to increase which in turn may increase the WACC in spite of using the cheaper
debt financing. So the firm always seeks for that debt equity mix that minimizes the
WACC. Since the issue of equity every year may prove expensive to the firm it may
think of spacing its issues. Say when the interest rate is relatively high the firm may
decide to issue stock and wait for the interest rate to decline before it goes on for issuing
bonds. At the same time even for a firm that is fully financed by debt, it is advisable for
the firm to use the WACC as its discount rate. So, discounting all the projects by the
WACC avoids the arbitrary decisions based solely on how the firm finances its projects.
Now let us take into account of the situation where there is existence of taxes. This is a
more realistic aspect as taxes do exist, and only the after tax cost of capital is relevant.
The firms after tax cost of capital can be calculated using the following formula:
k = fcc = WACC = weke + wd (1 T) r
Where,
(1T) r denotes the after tax cost of debt kd.
So the above equation can be written as:
k = fcc = WACC = weke + wdkd
Further the after tax cost of equity can be calculated as:
ke= [(1 T) (X rB)]/EL
Where,
ke denotes the cost of equity.
T denotes the tax rate.
X denotes the expected annual pre-tax cash flows.
r denotes the interest rate.
B denotes the amount of debt financing used.
And the after tax cost of debt can be calculated as:
kd= (1 T) r
The notations remain unchanged.
Distinguishing the Risk-Free Debt from the Default-Free Debt
There can be two sources of risks that can be associated with debt. One form is the
interest rate risk which is associated with the general changes in the long-term interest
rates, and the other is the credit risk that is associated with the possibility of default. The
risk-free debts are necessarily short termed; this is true because it cannot have its value
changed by the long-term interest rates. The short-term default-free debts tend to have a
beta near to zero. Here, it is important to mention that the risk-free debt is always a
default-free debt but the converse may not always be true.
42

Presence of Risk
a.
Differentiate Risk-free Debt from the Default-free Debt.

.
.
.
b.
A company has a beta () of 1.5. If the expected future cash flow of the
portfolio is Rs.12 million and the tangency portfolio has an expected return of
15%. The risk free rate of return is 10%. What will be the the present value of
the future period cash flow?
.
.
.
COST OF EQUITY, COST OF DEBT AND THE COST OF CAPITAL AS A

FUNCTION OF LEVERAGE
As long as the firms debt is default-free, the cost of equity capital increases linearly in
the firms leverage ratio. But when the firm is burdened with extreme debt, the expected
return on the risky debt rises as the debt-equity ratio increases. Now as the debtholders
share a part of this risk, the cost of equity rises slower than the debt-equity ratio as
compared with default-free debt.
The following figure best describes the situation:
Figure 1: Functions of Leverage

43
3.7 COMPUTATION OF THE COST OF CAPITAL USING THE

DIVIDEND DISCOUNT MODELS
Though the capital asset pricing model and the arbitrage price theory model are the most
widely used theories in determining the Risk Adjusted Discount Rates (RADR), there
are certain problems that arise out of these two methods. In case of the application of
the CAPM, it is essential to know the value of the covariance of the return of the
investment with the return of the market portfolio along with the estimation of the
expected return of the market portfolio. On the other hand, the APT requires multiple
factors and their corresponding expected returns on multiple factor portfolios. So in
order to overcome these shortcomings, the dividend discount model provides a better
approach.
THE DIVIDEND DISCOUNT MODEL
The dividend discount model takes into account the expected future earnings in order to
determine the required rate of return. This brings into the application of the Gordon
Growth Model that considers the equity of a firm with a dividend stream growing at a
constant rate. The following equation explains the way it can be done:
So= D1/(rE g)
Where,
So denotes the current price of the stock.
D1 denotes the expected dividend of the share in one years time.
rE denotes the market rate of return of the firms stock.
g denotes the expected growth rate in the dividends of the share.
Using the Plowback Ratio Formula to Estimate the Expected Dividend
Growth Rate
From the above formula the expected growth in the dividend can be easily estimated.
This is actually using the analyst forecast in the growth rate estimation. This approach
assumes that the firm pays out a fixed percentage of earnings as dividends. The
expected growth rate in the dividends equals the forecasted growth rate in the earnings.
This growth rate can then be added to the existing dividend in order to get the expected
return on the firms stock. Well, there is an alternative way of computing this growth
rate g, by the use of the plowback ratio formula. This can be done by the use of the
following formula:
g = (b) x (ROE)
Where,
b denotes the plowback ratio (profits retention ratio),
ROE denotes the book return on equity, and
g denotes the growth rate of the dividends.
In this case it is assumed that the book return on the equity represents the growth of the
capital invested in the firm. Here it is to be mentioned that the constant paying of
dividends out of the companys earnings may result in slowing down the companys
44

Presence of Risk
growth rate. But at the same time, as the earnings and dividends are a constant
proportion of the amount that has been reinvested, the growth rate will remain to be the
same as the growth rates of the funds available for the investment in the firm.
Drawbacks of the Dividend Discount Model
The DCM calls for the use of the book return on equity in place of the return on new
investments, but in practice this is much more difficult to calculate. Now if there is a
difference in the returns of the new assets and the old assets, the ROE should be the
return on the new asset investments. In this case if the project has a positive value of
NPV, then the more suitable book return on the equity may exceed the firms cost of
capital. Further, the DCM is based on certain assumptions. Keeping in mind that these
assumptions hold good, this approach may provide with a better understanding and
estimate of the expected rate of return of the firms stock price than that can be
estimated with the CAPM or the APT. Some of these assumptions are:
The expected earnings growth is unbiased.
The growth forecast takes into account of the available information that the
investors possess.
The rates at which the firms earnings and the dividends grow are the same.
USING BETA RISK OF EQUITY

It is important to note that the beta risk of the equity of the comparison firms is truly
comparable. Further it has been seen that the debt financing in firms has an impact on
the equity betas, so it is also important to make a proper adjustment regarding these beta
risk comparisons. This beta can be very well used to compute the Risk Adjusted
Discount Rates (RADR) for the individual projects. This is most suitable in cases where
firms stocks are widely traded and the chances of bankruptcy are minimum.
Pitfalls Using the Comparison Method
There are several pitfalls in using the comparison approach for portfolio valuation.
Some of them are cited below:
Difference in Project Beta and Firm Beta
Generally firms use their own cost of capital as a discount rate for evaluating specific
investment projects. But in most cases such an approach may be inappropriate. New
projects may have a higher project risk than the firms more mature projects. This may
be the case when the project is in its early years and incurs a lot of R&D expenditure.
On the other hand, a project may be less risky than the firms existing projects which
may be due to a lower cost of capital for the project than that experienced by the firm.
But as a matter of fact, a firms market value is determined by both its existing projects
and on the expectations of how a firm can develop new profitable projects.
Growth Opportunities are usually the Source of High Betas
As stated earlier a firms value is seen from the angle of how it can go on in developing
newer projects. This is more commonly referred to as growth opportunities or growth
options. Growth options have an implicit leverage that leads to an increase in the beta,
45
thus they contain a fair amount of systematic risk in them. So it can be said that the
individual projects can differ in their risks from the firm as a whole because they lack
the growth options that are inherent in the firms stock prices.
3.8 MULTIPERIOD RISK ADJUSTED DISCOUNT RATES

In this approach the equity beta from the comparison firm is calculated using the
historical data. Then the expected return is computed with the help of risk expected
return formula using either the CAPM or the APT. The post-tax cost of capital is then
calculated. Finally, the cost of capital is used as a single discount rate for each period.
Drawbacks in Using the Approach
Though it may apparently appear that the use of a single discount rate for the multiple
future cash flows is easier, but actually there may be several drawbacks in using the
approach. The use of a single discount rate may not result in the proper valuation of the
cash flows. This is even more predominant in case of risky cash flows. Say there is a
particular bond that matures in five years time has a rate of 5% attached to it, then the
bond cash flow at the end of year five is to be discounted at this particular rate. Say, on
the other hand, another bond that matures in ten years time has a coupon attached as
10%. So the cash flow of the bond at the end of ten years has to be discounted at this
rate only. Now assume a single rate of discount of 8% is used in both the cases. This
would result in the undervaluation of the near term cash flows and overvaluation of the
future term cash flows.
There is an interesting argument that often comes up while deciding upon whether to
take the long-term risk-free rate or the short-term, while using the capital asset pricing
model or the arbitrage price theory risk expected return relation. Now as a matter of fact
there is no practical basis to select a short-term risk-free rate over a long-term risk-free
rate or vice versa. In practice, the beta of certain cash flows, which is measured over
long-term horizons, is zero and the risk-free rate is the long-term risk less rate. At the
same time, if the authenticity of the CAPM is taken into account, then it is proper to
consider certain long-term cash flows with short-term risk less bonds and the market
portfolio. It is also important to note that while considering short-term intervals of time,
the value of certain cash flows as well as the market portfolio tends to decrease with the
increase in the expected inflation. This may result in the cash flows to have a positive
beta while measured against the short-term beta of the market portfolio. Though
theoretically correct, the short-term CAPM method of valuing a risk-free long-term cash
flow has a certain amount of tracking error. So in order to completely avoid the tracking
error that might exist in the process it is always preferable to use the long-term risk-free
bond as the only instrument in tracking portfolio for any long-term risk less cash flow
and not use the CAPM based approach under any circumstance.
Now let us focus on the dependence of the beta on the chosen time-frame of the cash
flows. As a general practice, while implementing the risk adjusted discount rate method,
the same value of beta is used irrespective of the different cash flows in the cash flow
streams. But following this approach may lead to serious valuation errors. The price of
the comparison stocks acts as a representative of the cash flow streams. But what
46

Presence of Risk
happens if the cash flow pattern of the comparison firms does not match with the
streams of the cash flows that are being valued. This may result in the beta risk of the
comparison firms not providing an appropriate discount rate for the project though there
is no rule of thumb as to how the betas may vary with the cash flow horizons. In some
cases it might happen that the initial cash flows are comparatively safe, but the future
cash flows depend on the market returns. In such cases it is better to use the lower
discount rates for the short-term horizon cash flows. On the other hand, it may also
happen that the long-term cash flows have less of undiversifiable risk than the similar
cash flows of short-term horizons due to many cash flows having a high correlation
with the returns of the traded securities.
3.9 THE CERTAINTY EQUIVALENT APPROACH

In contrast to the RADR approach that involves the adjustments made in the
denominator of the NPV equation, this approach deals with adjusting the numerator of
the equation. In other words, the CE cash flows are discounted at the risk-free interest
rates rather than at risk adjusted discount rates that are done in the case of RADR
approach. The Certainty Equivalent (CE) factor is actually the amount of cash that
someone would require with certainty at a point of time which will make him indifferent
between that certain amount and an amount expected to be received with risk at that
same point of time. Here the risk-free rate and not the firms cost of capital are used as
a discount rate for the estimation of the net present value. This is mainly done because
the companys cost of capital is a risky rate, that reflects the firms average risk and
using this rate may result in double counting of the risk. It is to be kept in mind that the
certainty equivalents range from 0 to 1.0 and the higher the factor the more certain is the
expected cash flow. The CE can be computed in the following way:
t= (certain returns/risky returns)
Further, the net present value can be calculated as:
NPV = NIV(o) + (NCFtt)/(1 + rf)t
Where,
o denotes the CE factor associated with the net initial investment.
t denotes the economic life of the project.
t denotes the CE factor associated with the net cash flows at each period of time t.
rf denotes the risk-free rate.
Now let us take an example.
Year
Expected NCF
(Rs.)
CE factor ()
CE cash flows
PVIF0.08t
Present value cash

flows
(8,000)
1.0
(8,000)
1.00
(8,000)
6,000
0.9
5,400
0.926
5000.4
5,000
0.8
4,000
0.857
3428
10,000
0.7
7,000
0.794
5558
7,000
0.6
4,200
0.735
3087
3,000
0.5
1,500
0.681
1021.5
CE = 10094.9
47
Discussion of the Problem

Let us consider the certainty equivalent cash flow for the year 1, the CE cash flow is
calculated as Rs.5,400 which implies that the decision maker is indifferent between
receiving the promised risky 6,000 a year from now or receiving 5,400 with certainty at
the same time. The CE cash flows at the end of each year are calculated by multiplying
the expected net cash flows with the CE factor. The risk-free rate taken in the above
problem is 8%.
Advantages of the Approach:
Each periods cash flow can be adjusted separately to account for the specific
risk of those cash flows.
The approach provides a clear basis for making decisions, because the decision
makers can introduce their own risk preference directly into the analysis.
The APT and the Certainty Equivalent Method

The certainty equivalent in one factor APT can be calculated as follows:
E(C) (1b1+ 2b2+ 3b3)
Where,
E(C) denotes the expected future cash flows,
b denotes the factor loading of the future cash flows, and
denotes the risk premium of the factor.
Further the CE net present value can be calculated as:
PV = [E(C) (1b1+ 2b2++ 3b3)]/(1+rf)
Where,
rf denotes the risk-free rate at which the cash flows are discounted.
3.10 THE SCENARIO ANALYSIS

This is another technique that can be used to assess the risk of an investment project.
This approach involves the simultaneous changes in the key variables, and their impact
on the project. While using the approach, the various estimates of the projects net
present value is called for. This might involve both the optimistic as well as the most
pessimistic estimates of the projects value. The former may be defined in terms of the
most optimistic values of each of the input variables whereas the pessimistic scenario
can be explained as the pessimistic values of the inputs used in the project. Further there
will also be the existence of the probabilities of these different situations of the project
Outcome
48
Net Present Value (NPV)
Probability (p)
Pessimistic
(15,00,000)
0.20
Most likely
10,00,000
0.60
Optimistic
12,00,000
0.20

Presence of Risk
The net present value of the project can be calculated as follows:

NPV = 0.20(15,00,000) + 0.60(10,00,000) + 0.20(12,00,000) = 5,40,000
Sigma =
[(15 5.4)2 . 2 + (10 5.4)2 x .6 + (12 5.4)2 x .2]1/2

=
(83.232 + 12.696 + 8.712)1/2
(104.64)1/2
10.2293 or 10.23
0 NPV
0 54000
=
= 0.527892 or 0.53
Sigma
10.22937
.5 .2019 = .2981 or 29.81% Negative (NPV)
Advantages of the Risk-Free Scenario Method

In the risk-free scenario, the investors expect the stocks to appreciate at the given riskfree rate. In a moderately pessimistic scenario, the manager finds it easier in estimating
the future cash flows of the project than in estimating the expected value over all
scenarios.
Certainty Equivalents from Prices in Financial Markets
In certain conditions the prices from the financial markets can be used to project the
future cash flows. It is a common practice to estimate the future spot prices of the
different currencies and the commodities using the forward prices. Whenever there is
the availability of the forward prices for estimating the future cash flows it is preferable
to use the certainty equivalent method. Such forward prices conveniently translate the
data from the risky cash flows to the risk-free cash flows.
a.
The market value of Blue Star Companys equity is Rs.15 lakh, and the
market value of its risk-free debt is Rs.5 lakh. If the required rate of return on
the equity is 20% and that on the debt is 8%, calculate the companys cost of
capital.
.
.
.
b.
What are the advantages of the risk-free scenario method?

.
.
.
49
IMPLEMENTING THE RISK-FREE SCENARIO METHOD IN A MULTIPERIOD

SETTING
Let us assume that the yields on one year, five year and ten year risk-free zero coupon
bonds are respectively 5, 6, and 7 percent. Now in order to estimate the present value of
the future three cash flows, it is important to estimate the cash flows occurring at the
end of these three years. Take year one into account. In a risk-free situation say all the
assets, along with the dividends, are reinvested at the end of year one. Now these are
expected to grow by a 5% level given that the one year risk-free rate is 5%. Now
suppose that the security is trading at Rs.100, then at the end of year one it will trade at
Rs.105, given that the risk-free rate is 5%. Similarly over a period of five years the
stock will trade at Rs.133.82, given that the stock appreciates at the five year risk-free
rate, 6% per year. In ten years time the stock will trade at Rs.196.72, if it appreciates at
the 10-year risk-free rate, 7% per year. It is assumed that the companys manager
believes that the operating system is expected to generate a cash equal to 10 million
times than the stock price of the firm. Thus the stock is expected to generate Rs.1.05
billion at the end of year 1, if the stock with dividend is reinvested it is then selling at
Rs.105 per share, Rs.1.3382 billion at the end of year 5 if the stock sells for Rs.133.82
at that point, and Rs.1.9672 billion at the end of year 10 if the stock sells for Rs.196.72
at that point.
Numerically it can be written as:
PV = Rs.1.05/1.05 + Rs.1.3382/(1.06)5 + Rs.1.9672/(1.07)10 = Rs.3 billion.
3.11 CAPITAL RATIONING

Certain firms develop capital budgets based on a predetermined availability of
investment funds. Capital rationing is used to describe such a situation and the process
may involve modification of internal budgeting procedures so that the projects that are
selected collectively add value to the market value of the company. Let us introduce the
concept of profitability index in the following example.
Project
Initial Investment
(000)
PV Cash Inflows
(000)
NPV
(000)
Profitability Index
(PI)
1.6
12
15
1.25
10
1.43
1.75
30
90
60
3.0
The profitability index is actually calculated as:

PI = PVcash inflows/PVcash outflows
The profitability index actually measures the projects contribution to the market value
of the company per rupee of the capital invested in that project. Now based on the above
PI the projects can be ranked and decision can be taken on which one of their
combinations should be selected.
50

Presence of Risk
Project
PI
Initial Investment
NPV
Cumulative
Cumulative NPV
(000)
(000)
Investments (000)
(000)
3.00
30
60
30
60
1.75
34
63
1.60
39
66
1.43
46
69
Investment = 30 + 4 + 5 + 7 = 46,000
So Rs.1,00,000 can be show as Rs.50,000
So it can be said that with a budget of 50,000 one can invest in four projects, namely E,
D, A and C with a total value addition of Rs.69,000.
Though the capital rationing seems to be a practical approach in project appraisal, it is at
the same time not devoid of certain shortcomings. These may include the situations in
which the capital budgeting constraints may creep up in future years and in cases where
the projects may be mutually exclusive. On the whole it may seem that capital rationing
is a sensible way of discouraging the divisional and the product line managers from
submitting the net present value analysis that is based on an optimistic cash flow
forecast. But at the same time it is important to note that there is the existence of
opportunistic costs associated with the capital rationing. These costs result due to not
truly undertaking the positive NPV projects.
3.12 CAPITAL BUDGETING AND THE STRATEGIC POLICY

The strategic policy of a company describes the mission of the company and the way by
which the company plans to achieve that mission, subject to the firms market, political
and the cultural environment. These strategies actually call for high amount of capital
expenditures. The value of the firm is actually its market value, and the financial
valuation models do consider this particular fact. At the same time the managerial
strategies that are derived from the financial models are in essence the managerial
strategies for owner wealth maximization.
On the contrast, the strategic planning models are primarily concerned with the survival
of the firm. These are the normative strategies that consider the firm as an organic entity
that is more interested in self preservation. Now this concept of self preservation at the
expense of the stock holders has been a challenge to financial economists while trying
to solve it. As a matter of fact, capital budgeting is more concerned with the allocation
of the financial resources to the ongoing as well as the proposed projects on the basis of
what the proposers of the project have to say about their future cash flows. In this
process if the use of capital budgeting is not done in a proper way, it may lead to
improper allocation of funds. The senior management of the firm involves in deciding
upon the future of the firm. These actually mean developing the new markets and the
new research and development. These activities in turn call for a lot of funds in carrying
them out. So it can be safely said that the senior management is actually looking for
various options for the future of the firm. Till recently, the financial economists were
51
lacking proper procedures in valuing these options. This was more importantly relevant
in case of real investments which is the major focus in capital budgeting. As a result
capital budgeting was rarely used for strategic planning. In todays world, several
methods have evolved to price the options and these are extensively used for pricing of
the financial assets and their derivatives.
3.13 SUMMARY
There are basically two methods for computing the market values of the future cash
flows of risky investment projects the certainty equivalent approach and the RiskAdjusted Discount Rate (RADR) method.
The RADR method, which obtain the discount rates (i.e. the cost of capital) from widely
used theories of risk and return (such as the CAPM and APT) is impractical when the
betas of the comparison firms are difficult to estimate.
In cases where the comparison firms do not exist and scenarios are required to estimate
risk, practical considerations require that certaintity equivalent approach is a better
valuation tool.
Tracking error refers to the difference between the cash flows of the tracking portfolios
and the cash flows of the projects.
The tracking portfolio approach seeks to develop tracking portfolios for which the
present value of the tracking error is zero.
Whenever a tracking portfolio for the future cash flows of a project generates tracking
error with zero systematic (or factor) risk and zero expected value, the market value of
such a tracking portfolio is equal to the present value of the projects future cash flows.
To compute the present value of the next periods cash flow using RADR,
Compute the future period cash flow.
Compute the beta () of the return from the project.
Compute the expected return of the project by substituting the beta (calculated
above) with the tangency portfolio risk-expected return equation (RT).
PV =
Future period expected CF

1+ rf + (R T - rf )
Cost of equity is given by

re = rA + D/E (rA rD)
Where,
re increases as the firms leverage ratio (D/E) increases.
It increases linearly if the debt is default-free and if rA (the expected return of the
assets) does not change as the leverage rises.
52

Presence of Risk
The certainty equivalent present value formula is given by

PV
(CF) (R T rf )
(1 + rf )
Where,
CF =
Expected future CF.
Beta of the future CF.
RT =
Risk of the tangency portfolio.
It is possible to estimate the expected future CF of an investment or project under a

scenario where all securities are expected to appreciate at risk-free rate of return. The
PV of the CF is then computed by discounting the expected CF for risk-free scenario at
risk-free rate.
Capital rationing in a process of developing capital budgets on the basis of predetermined availability of funds.
3.14 GLOSSARY
Tracking error is the difference in performance of a particular fund relative to a
benchmark portfolio.
Cost of Capital is the minimum rate of return the firm must earn on its investments in
order to satisfy the expectations of investors who provide the funds to the firm. It is
often measured as the weighted arithmetic average of the cost of various sources of
finance tapped by the firm.
Cost of Debt is the rate that has to be received from an investment in order to achieve
the required rate of return for the creditors.[v1]

Net Present Value (NPV) is a method for evaluating investment proposals. NPV is
defined as the present value of benefits minus present value of costs.

Systematic Risk is the risk that cannot be diversified away. It is also referred to as
market risk or non-diversifiable risk.

Unsystematic Risk is the risk that can be diversified away. It is also referred to as
unique risk, specific risk, residual risk, or diversifiable risk.

Strategy. 2nd ed. Tata Mcgrawhill, 2002.
Aswath Damodaran. Corporate Finance Theory and Practice. Tata Mcgrawhill, 2000.

Brealey Myers. Principles of Corporate Finance. 6th ed. US: Mcgraw-Hill

53

a.
There can be two sources of risk that can be associated with debt. One form is
the interest rate risk which is associated with the general changes in the longterm interest rates and the other is the credit risk that is associated with the
possibility of default. The risk-free debts are necessarily short termed; this is true
because it cannot have its value changed by the long-term interest rates. The
short-term default-free debts tend to have a beta near to zero.
b.
PV
= E (cf)/{1 + rf + (RT rf )}
PV
= 12\[1 + 0.1 + 1.5(0.15 0.10)]

= 10.21 million.
a.
Total capital of the company = M.V. of debt + M.V of equity

= 5 + 15 = 20 lakh
Kc= [(15\20) x 20] + [(5\20) x 8]
= 17%.
b.
In the risk-free scenario, the investors expect the stocks to appreciate at the given
risk-free rate. In a moderately pessimistic scenario, the manager finds it easier in
estimating the future cash flows of the project than in estimating the expected
value over all scenarios.

A. Multiple Choice
1.
2.
54
The market required rate of return depends on _____________.

a.
The present value of future cash flows
b.
The yield to maturity
c.
The markets perceived level of risk associated with the individual security
d.
The valuation of the financial asset
e.
The WACC.
The standard deviation ________________.

a.
Is the square root of variance
b.
It can be used to compare investments with the same expected return
c.
It measures dispersion or variability around the mean or expected value
d.
Both (a) and (c) of the above
e.
All (a), (b) and (c) of the above.

Presence of Risk
3.
4.
5.
Projects that increase the overall risk level of the firm _________________.
a.
Will have a low standard deviation
b.
Should be discounted at a rate higher than that of the cost of capital
c.
Should be discounted at the firms cost of capital
d.
Should not be undertaken
e.
Both (b) and (c) of the above.
A decision tree analysis ______________.

a.
Should be the sole input for the decision making process
b.
Is more accurate than simulation technique
c.
Is a form of simulation analysis
d.
Lays out the sequence of decisions and presents a graphical comparison
e.
Should be used in conjunction with the simulation technique.
According to the Capital Asset Pricing Model (CAPM), a well-diversified

portfolios rate of return is a function of ______________.
a.
Unique risk
b.
Reinvestment risk
c.
Market risk
d.
Unsystematic risk
e.
None of the above.
B. Descriptive
1.
What are the pitfalls of dividend discount model?
2.
Explain the scenario analysis.
3.
How does capital budgeting become strategy policy?
practice only.
55
UNIT 4
REAL OPTIONS
Structure
4.1
Introduction
4.2
Objectives
4.3
Definition of Real Options and Difference with Financial Options

4.3.1 Comparison of Real Options with Financial Options
4.4
Types of Real Options

4.4.1 Growth Options
4.4.2 Abandonment Option
4.4.3 Flexibility Options
4.4.4 Investment Timing Options
4.5
Valuing Real Options
4.6
Using the Black-Scholes Model for a Call Option
4.7
Applications of Real Options

4.7.1 Exploring for Oil
4.7.2 Applications of the Real Options in the Drug Industry
4.8
Drawbacks of Using Real Options Analysis
4.9
Summary
4.10
Glossary
4.11
4.12
Suggested Answers
4.13
Terminal Questions
4.1 INTRODUCTION
Investment of financial resources is very crucial to the success of a business firm. There
are so many investment opportunities available. In one way, the investment
opportunities are termed as options.[v1] These options are of two types, viz., financial
options and real options. Investments in financial assets like shares and bonds are
known as financial options whereas investments in real assets like land and realty are
termed as real options. Investing money in available options is not a simple activity or
decision. It is a process which affects the short-term as well as long-term solvency of
the firm. This unit discusses the various approaches that the managers have to adopt to
manage strategic investments.
4.2 OBJECTIVES
Define real options and differentiate them from financial options;
Know the types of real options;
Understand the valuation of real options; and
Know the application of real options.
Real Options
4.3 DEFINITION OF REAL OPTIONS AND DIFFERENCE WITH

FINANCIAL OPTIONS
A real option is an option that arises naturally in the course of business activities rather
than one purchased on a financial market. A common example of a real option is early
investment in a technology, which will enable a firm to exploit the new technology
should it prove successful. In a narrower sense, the real options approach can be viewed
to be an extension of the financial option theory. In case of the real options the
underlyings are real assets unlike financial assets in the case of financial options. The
difference lies in the fact that the financial options are detailed in their contract; the real
options that are embedded in strategic investments must be identified and specified. The
real option approach provides the managers with opportunities for the way they have to
plan and manage strategic investments.
4.3.1 Comparison of Real Options with Financial Options

The basic difference that exists between a financial option and a real option lies in its
underlying. The underlying that exists in case of the former is a security such as a share
of a common stock or a bond, whereas the underlying for the latter is a tangible asset,
say for example, a business unit or a project. It is to be noted that both types of options
give the right but not the obligation to take an action. Financial options are written on
traded securities, whose price is usually observable and one can estimate the variance
of its rate of return. In the case of real options, the underlying risky asset is usually
not a traded asset, thus one estimates the present value of the underlying without
flexibility by using traditional net present value techniques. A further difference
exists between the two. Most financial options are not issued by the companies on
whose shares they are contingent, but rather by the independent agents who write
them and buy those that are not written. As a result of which, the agent that issues a
call option has no influence and control of the company and its share price. The real
options are different in this aspect because here, the management controls the
underlying real assets on which they are written. As an example, a company might
have the right to refer a project and it may choose to do so if the present value of the
project is low.
Now if the company comes up with an innovative idea that has the potential to enhance
the NPV of the project, the value of the right to refer may fall and the company may
decide not to defer. As a matter of fact, the act of enhancing the underlying real assets
value also increases the value of the option. A point of similarity that exists between a
financial option and a real option is that in both cases, the uncertainty of the underlying,
i.e., the risk is assumed to be exogenous. The uncertainty concerning the rate of return
on a share of a stock, is beyond the control and influence of individuals, who are the
actual traders of the stock. In case of real options, the actions of the company that own it
may influence the action of its competitors, and consequently the nature of uncertainty
that the company faces.
4.4 TYPES OF REAL OPTIONS

The very first step in valuing a project lies in identifying the options that are embedded
within the project. It may happen that though two projects are exactly identical, there
may be the presence of several types of real options.
57
4.4.1 Growth Options

A growth option lets a company to increase its capacity of operation if the market
conditions are better than expected. They may be of different types. In one type of
growth option, a company may resort to increase the capacity of an existing product
line. Another type allows a company to expand into new geographic markets. The third
type may deal with the opportunity to add new products that even includes the
complementary products and successive generations of the original product.
4.4.2 Abandonment Option

There may be many projects that contain abandonment options. When one goes for
evaluating a potential project, the standard DCF method is used. The DCF assumes that
the assets that are involved in the project will be used over a specified economic life.
Though it is correct to say that some projects can be operated over their full economic
life, though the market conditions can get adverse and lower the expected cash flows,
there may be other projects that may be abandoned. Say for example, some contracts
between the automobile manufacturers and their suppliers mention the quantity and the
price of the parts that must be delivered. If the labor cost of the supplier increases, then
he might as well lose money on each part he ships. Thus the inclusion of the option to
abandon such a contract might be quite valuable.
4.4.3 Flexibility Options

There are many projects that offer flexibility options which allow the firm to alter
operations depending on how the conditions change during the life of the project. It may
happen that either the inputs or the outputs can be changed. The electric power plants
provide a good example of the input flexibilities.
4.4.4 Investment Timing Options

The conventional type of Net Present Value (NPV) analysis is based on the implicit
assumption that the project will either be accepted or rejected. This has a simple
implication, that a project will be undertaken now or never. Though in practice,
companies may even go in for a third choice. They have the option to relay the
decisions until at a later point of time when more information is available. Such
Investment Timing Options (ITO) result in altering the projects, estimated profitability
and risk.
Say for example, a particular company has plans to introduce an innovative mobile set
with a lot of added features. Your company may be left with two alternatives:
To immediately start of with providing the services that are compatible with the
mobile sets.
To delay the investments in the projects until one gets a better idea of the size of
the market for the innovative mobile sets.
Well, here one should prefer in delaying the investment on the project implementation.
It should be borne in mind that the option to delay will only be valuable if it more than
compensates any harm that might arise from delaying. It might happen that if one
delays, any other company may take advantage of it and create a strong loyal customer
base that in turn might make it difficult for the company to enter the market at a later
point of time. The option to delay projects is usually most valuable to the firms with
proprietary technology, patents, licenses or other barriers to entry, because these factors
58
Real Options
tend to lessen the threats of competition. Further it is also valuable when the market
demand is uncertain, at the same time it is also valuable during periods of volatile
interest rates, since the ability to wait aids in allowing the firms to delay the raising of
its capital for the projects until the interest rates are lower.
4.5 VALUING REAL OPTIONS

Let us now try to focus on the valuation of real options. Let us first consider a simple
project that consists of a single risk-free cash flow that is due one year from today. The
pure DCF value of the project can be calculated as follows:
DCF value of the project =
Cash flow
1+ k RF
Where,
kRF denotes the risk-free rate of return at which the cash flow is discounted.
The inputs are the cash flow and the risk-free rate that help in accurate estimation of the
projects DCF.
In contrary, valuing real options calls for a greater level of judgments in areas of both
formulating the model as well as in estimating the values of the inputs. This implies that
the value of the project using real options will not be as accurate as it had been stated in
a simpler DCF model for valuation. There can be five possible procedures that can be
used in order to deal with real options. They are:
a.
Use of DCF valuation and ignoring any real option, with the assumption that
their values are zero.
b.
Using the DCF valuation and including a qualitative recognition of any real
options value.
c.
Use of decision tree analysis.
d.
Using a standard model for a financial option.
e.
Developing a unique, project specific model with the help of techniques in

financial engineering.
Let us now try to understand each of these with the help of some examples.
Opportunistic India Ltd. is considering a project for an innovative set up device that will
enable cable users to view satellite channels according to their own wish. The total
estimated cost of the project is Rs.5 crore, but the future cash flows of the project
depend on the demand of the Conditional Access System (CAS) that is to be provided
by the government, which is not very certain. The company feels that there lies a 25
percent chance that the demand for the new set up device is very high, in which case the
project will be able to generate a cash flow of Rs.3.3 crore for each of the following
three years. It also feels that there lies a 50 percent chance for the demand to be average
with subsequent generation of cash flows that will amount to Rs.2.5 crore per year,
along with that the chances that the demand will be low is 25 percent in which case the
cash flow generation will be only 50 lakh. A basic analysis reveals that the project is
somewhat riskier than any other average project, as a result of which the cost of capital
that would be used to discount its cash flow is 14 percent.
59
Opportunistics India Ltd. enjoys patent rights on the devices core modules, so instead
of implementing the project immediately, it can also choose to delay the decision until
the coming year. The cost of the project will still amount to Rs.5 crore if it waits, and
the project will still generate the expected cash flows that have been stated earlier. But
each of the expected cash flows will be delayed by one year. It should be remembered
that if the company waits, it will be able to know which of the demand conditions, and
in return which of the set of cash flows, will exist. Thus on delaying the project it will
go in for investments only if the demand is sufficient enough to provide a positive value
of net present value.
Demand for the
Device
Probability
(Pi)
Annual Cash
Flows (cf) (crore)
Expected Cash Flows

(Pi x cf) (crore)
High
0.25
3.3
0.825
Average
0.50
2.5
1.250
Low
0.25
0.5
0.125
2.200
Type 1: Using DCF Valuation and not Considering any

Real Option by Assuming that their Values are Nil
So, as calculated above, the expected annual cash flow per year is Rs.2.2 crore.
If we do not take into account the investment timing option, then the traditional value of
the net present value will be
NPV = Rs.5 crore +
2.2 cr.
2.2 cr.
2.2 cr.
+
+
+10,80,000 (approx. value)
(1+ 0.14) (1+ 0.14) 2 (1+ 0.14)3
= 10,80,000
So, based on the discounted cash flow method, the company should go in for the
project. It is to be noted here, that if the expected cash flow had been slightly lower, say
for example Rs.2.15 crore, the NPV would have been negative and this would have
resulted in rejection of the project.
Further, the project is risky, as there lies 25 percent chance that the demand for the
devices may be low, in which case the net present value would turn out to be a negative
Rs.3.84 crore.
Type 2: Using the DCF with Qualitative Recognition of the Real Options Value
As it is suggested by the discounted cash flow analysis, the project should be barely
accepted, and it ignores the existence of a possible value of real option. If the company
goes in for immediate implementation of the project, it gains the expected cash flow of
0.108 crore but at the cost of the risk that is involved with the chances of its low
demand. Nevertheless, accepting the project now implies that it is also foregoing the
option of waiting for some more time to gain more market information before it makes
any commitments. So, the decision has to be made on whether the company would be
sacrificing worth that is more or less than Rs.0.108 crore. If it is worth more, then it
should not go in for immediate implementation of the project and defer it for some point
of time later, and it would do just the opposite in case it is worth less than this value.
This brings us to another point of discussion: Should the company go ahead with the
project now or wait for sometime? While considering this decision, one should note that
the value of an option is higher if the current value of the underlying asset is high
relative to its exercise price, other things remaining unchanged. Say, for example, a call
60
Real Options
option with an exercise cost of Rs.50 on a stock with the current price of Rs.50 is
definitely worth more if its value were Rs.20. The DCF valuation is also suggestive of
the fact that the underlying value of the asset will be closer to the exercise price, as a
result the value of the option will be valuable.
It is also known that the value of the option increases with the increase in its time to
expire. In our example, the option has life of one year, which is fairly a long time for an
option. This too implies that the option is valuable. Finally, it is to be said that an
options value increases with the risk of an underlying asset. Here, it is seen that the
project is quite risky, which again suggests that the option is valuable.
Thus based on this qualitative approach, it is advisable to delay the project, though the
NPV would result in earning Rs.108 crore on immediate implementation.
Type 3: Use of Decision Tree Analysis
Let us here take two ways of using the decision tree analysis. One being the scenario
analysis, and the other being the other decision tree. The scenario analysis can be
used in the following way.
Case 1
Scenario analysis on immediate implementation of the project

2003
High
Average
Low
2004
0.25
0.5
0.25
2005
3.3
2.5
0.5
2006
3.3
2.5
0.5
3.3
2.5
0.5
NPV of this
Scenario
2.661
0.804
3.839
Prob
0.25
0.50
0.25
1.00
Prob x
NPV
0.665
0.402
0.960
Expected NPV = (0.665) + (0.402) + (0.960) = 0.107

In the above diagram, each possible outcome is shown as a branch on the tree. The
branch resembles the cash flows and the probability of the individual scenarios. As is
evident from the above example, in the high demand scenario, the NPV of the project is
2.661 crore, for analysis demand scenario it is 0.804 crore, whereas in case of low
demand, the project yields a negative NPV of 3.839 crore. So, the company will suffer a
loss to this extent in case of low demand, and as there is a 25 percent chance of the
demand being weak, the project can be considered to be a highly risky one.
The expected NPV of the project is the weighted average of the three possible
outcomes, with the weight for each outcome being its probability. The expected NPV
comes to 0.108 crore, same as one estimated using the DCF valuation. Let us now see
the decision tree analysis in valuing the project.
Case 2
Decision tree analysis project implementation in the next year if optimal.

2003
High
Wait
Average
Low
2004
2005
2006
2007
NPV of this
Scenario
Prob
Prob x
NPV
0.25
3.3
3.3
3.3
2.335
0.25
0.584
0.5
2.5
2.5
2.5
0.705
0.50
0.353
0.25
0.25
1.00
Expected NPV of the Project = (0.584) + (0.353) + (0) = 0.937

61
The above diagram can be viewed similar to that of the scenario analysis, the only
difference being that the company delays the decision and implements the project only
if demand turns out to be high or average. Say if the cost is incurred in the year 2003,
then the only action that can be taken is to wait. Then, if the demand turns out to be
average or high, the company may spend around 5 crore in 2004 and receive either 3.3
crore or 2.5 crore per year for each of the following three years.
Say, if the demand is low, the company will spend nothing in the year 2004, and will
receive no cash flows in the following years. The NPV of the high demand situation is
2.335 crore and that of the average demand situation is 0.705 crore.
Now, as all the cash flows under the low demand situation is zero, the resulting NPV
will also be zero. So, if the company delays the project, the expected NPV comes to
0.936 crore. This clearly shows that the expected value of the project will be much
higher if the company delays the project than if it implements the project immediately.
Added to this, as there is no possibility of losing money under the option to delay, this
decision also lowers the projects risk. This clearly indicates that the option to wait is
definitely volatile, so Opportunists India Ltd. should wait till 2004 before taking any
decision to proceed with the investment.
Case 3
What if, a different discount rate is taken, other than 14 percent?

In both the cases (case 1 and case 2) above, we have used the same cost of capital i.e. 14
percent. But this may not be advisable and feasible to do so, mainly because of the
following reasons:
a.
As there seems to be any possibility of losing money if the company delays the
project, the investment under the plan is clearly less risky than if it charges ahead
today.
b.
The cost of capital of 14 percent may be appropriate for the risky cash flows, yet
the investment of the project in the year 2004 in case 2 is known with certainty.
May be then one should discount it at the risk-free rate.
c.
The cash inflows of the project are different in the second case because of the
elimination of the low demand cash flows. This is suggestive of the fact that if
14 percent is the appropriate cost of capital in the first case, some lower rate may
be appropriate in the latter one. So, let us take the discount rate to be 6 percent
and estimate the expected NPV.
2003
Wait
2004
2005
2006
2007
NPV of this
Scenario
Prob
NPV
Prob x
High
0.25
3.3
3.3
3.3
2.004
0.25
0.501
Average
0.50
2.5
2.5
2.5
0.379
0.50
0.187
Low
0.25
0.00
0.25
0.00
Expected NPV = (0.501) + (0.187) + (0) = 0.688

Using 6 percent as the cost of capital, increase the present value of the cost at 2003, and
lower the NPV from 0.936 crore to 0.688 crore.
62
Real Options
a.
Narrate the examples of growth option.

.
.
.
b.
How do you calculate the value of real option?

.
.
.
Valuing the Standard Model of Financial Option the Black-Scholes Model
Till this point of time, one can safely say that the decision tree analysis, coupled with
the sensitivity analysis, is to be a good provider of information for a good decision. But
let us try to value the option using an option pricing model. In order to do this, one
needs to identify a standard financial option that resembles the projects real option. The
companys option to delay the project is comparable to a call option, hence the BlackScholes option pricing model can be used. Following are the inputs required for the
model:
i.
Risk-free rate
ii.
Time until the option expires
iii.
Exercise price of the option
iv.
Current stock price
v.
Variance of the stocks rate of return.
Let us assume that the rate on a 92-day treasury bill is 6 percent, this rate can be used as
the risk-free rate to discount the cash flows. Let us further assume that the company
must decide within a year whether or not to implement the project so that there is still a
year before the project expires. A further assumption is that, it will cost Rs.5 crore to
implement the project, so the 5 crore value can be used as an exercise price. It is also to
be assumed that there is a need of a proxy for the value of the underlying asset, which in
the Black-Scholes model is the current price of the stock. It is to be noted here that a
stocks current price is the present value of its expected future cash flows. So, as a
proxy for the stock price, one can use the present value of the projects cash flows.
A final assumption in the model is that the variance of the projects expected return can
be used to represent the variance of the stocks return in the Black-Scholes model.
Estimating the Inputs for Stock Price in the Option Analysis of the
Investment Timing Option (Millions of Dollars)
Future Cash Flow
2003
Wait
2004
2005
2006
2007
NPV of this
Scenario
Prob
Prob x
NPV
High
0.25
3.3
3.3
3.3
6.721
0.25
1.680
Average
0.50
2.5
2.5
2.5
5.091
0.50
2.546
Low
0.25
0.5
0.5
0.5
1.018
0.25
0.255
1.00
Expected value of the present values = (1.680 + 2.546 + 0.255) = 4.480

63
The above calculations show the estimation of the present value of the projects cash
flows. One needs to find the current price of the underlying asset, which in this
condition, is the project.
In case of a stock, the current price is the present value of the expected future cash
flows, inclusive of those that are not expected even if one does not exercise the call
option. In case of the real option, the underlying asset is the delayed project, and its
current price is the present value of all its future expected cash flows. Similar to that of
the stock, the present value of the project also contains all its possible future cash flows.
Further, as the price of the stock is not affected by the exercise price of a call option,
one can ignore the projects exercise price, of cost, while estimating its present value.
The present value of the cash flows as of today (2003) is 4.480 crore, and this is the
input one should use for the current price in the Black-Scholes model. The final input
for the model is the variance of the projects return.
Variance of the Projects Return = ln(CV2 + 1) / t
Where,
CV
Coefficient of Variation
Time of expiry of the project
Variance
ln(0.472 + 1)/t = 0.20 = 20 percent

Calculation for Co-efficient of Variation (CV)
Wait
2003
2004
2005
2006
2007
PV in 2004 in
this Scenario
Prob.
Prob x
NPV
High
0.25
3.3
3.3
3.3
7.661
0.25
1.915
Average
0.50
2.5
2.5
2.5
5.804
0.50
2.902
Low
0.25
0.5
0.5
0.5
1.161
0.25
0.290
1.00
Expected Value of PV (2004) = (1.915 + 2.902 + 0.290) = 5.108

Standard Deviation of PV (2004) = 2.402
Co-eff of Variation of PV (2004) = 0.47
Type 4: Calculation of the Value of the Investment Timing Option using a
Standard Financial Option
KRF =
Risk-free rate
Time (in years) until the option expires 1
Cost of project implementation
Current projects value

[as calculated in (i)]
64
6 percent
Rs.5 crore
Rs.4.48 crore
Annualized standard deviation of returns on the underlying asset, i.e.

volatility measures
Variance of the projects return
d1
{l (P/X) + [KRF + (2/2)] + T}/(
T)
20 percent
0.112
Real Options
d2
d1
0.33
N (d1)
0.54
N (d2)
0.37
P [N(d1)] N(d2) = 0.704
As it is seen from the above calculations, the value of the option to defer investment in
the project is 0.704 crore. This is significantly higher than 0.108 crore under immediate
implementation, as the option should be forfeited. If the company implements it
immediately, one can conclude that the company should defer the final decision until
more information is gathered.
Type 5: Financial Engineering Technique
It might sometimes happen that the decision analysis in valuing a real option may not
always give satisfactory results, as it becomes difficult to find a standard financial
option that corresponds to a real option. In such a situation the only other way is to
develop a unique model that corresponds to the specific real option being analyzed,
which in other words, is called financial engineering. Here we use the technique of riskneutral valuation.
RISK-NEUTRAL VALUATION OF REAL OPTIONS
As we discussed in the chapter, decision trees will always give an inaccurate estimate of
a real options value because it is impossible to estimate the appropriate discount rate.
In many cases, there is an existing model for a financial option that corresponds to the
real option in question. Sometimes, however, there is no such model, and financial
engineering techniques must be used. Many financial engineering methods are
extremely complicated and are best left for an advanced finance course. However, one
method is reasonably easy to implement with simulation analysis. This method is riskneutral valuation. It is similar to the certainty equivalent method in that a risky variable
is replaced with one that can be discounted at the risk-free rate. We show how to apply
this method to the investment timing option that we discussed earlier in the chapter.
Murphy software is considering a project with uncertain future cash flows. Discounting
these cash flows at a 14 percent cost of capital gives a present value of $51.08 million.
The cost of the project is $50 million. So it has an expected NPV of $1.08 million.
Given the uncertain market demand for the software, the resulting NPV could be much
higher or much lower.
However, Murphy has certain software licenses that allow it to defer the project for a
year. If it waits, it will learn more about the demand for the software and will implement
the project only if the value of those future cash flows is greater than the cost of $50
million. As the text shows, the present value of the projects future cash flows is $44.80
million, excluding the $50 million cost of implementing the project. We expect this
value to grow at a rate of 14 percent, which is the cost of capital for this type of project.
However, we know that the rate of growth is very uncertain and could either be much
higher or lower than 14 percent. In fact, the text shows that the variance of the growth
rate is 20 percent.
Given a starting value ($44.80), a growth rate (14 percent), and a variance of the growth
rate (20 percent), option pricing techniques assume that the resulting value at a future
date comes from a lognormal distribution. Because we know the distribution of future
65
values, we could use simulation to repeatedly draw a random variable that has this
distribution. For example, suppose we simulate a future value at Year 1 for the project
and it is $75 million. Since this is above the $50 million cost, we would implement the
project in this random draw of the simulation. The payoff is $25 million, and we could
find the present value of the payoff if we knew the appropriate discount rate. We could
then draw a new random variable and simulate a new value at Year 1. Suppose the new
value is $44 million. In this draw of the simulation, we would not implement the
project, and the payoff is $0. We could repeat this process many thousands of times and
then take the average of all the resulting present values, which is our estimate of the
value of the option to implement the project in one year.
Unfortunately, we do not know the appropriate discount rate. This is where we turn to
risk-neutral valuation. Instead of assuming that the projects value grows at an expected
rate of 14 percent, we would assume that it grows at the risk-free rate of 6 percent. This
will reduce the resulting project value at Year 1, the time we must exercise the option.
Suppose we did this, and our first simulation run has a value of $55, based on the
$44.8 starting value, a 20 percent variance of the growth rate, and a 6 percent growth
rate instead of the true 14 percent growth rate. The payoff is only $5 ($55 $50 = $5).
However, we now discount this at the risk-free rate to find the present value. Note that
this is analogous to the certainty equivalent approach in which we reduce the value of
the risky future cash flow but then discount at the risk-free rate. We can repeat the
simulation many times, finding the present value of the payoff when discounted at the
risk-free rate. The average present value of all the outcomes from the simulation is the
estimate of the real options value.
We used the risk-neutral approach to simulate the value of the real option. With 5,000
simulations, our average present value was $7.19 million. With 200,000 simulations, the
average value was $6.97 million. As the text shows, the true value of the real option in
this example is $7.03 million.
One disadvantage of the risk-neutral approach is that it may require several hundred
thousand simulations to get a result that is close to the true value. Also, risk-neutral
valuation requires that you know the current value and variance of the growth rate of the
underlying asset. For some real options, the underlying source of risk is not an asset,
and so you cannot apply risk-neutral valuation.
However, risk-neutral valuation offers many advantages as a tool for finding the value
of real options. The example we showed had only one embedded option. Many actual
projects have combinations of embedded real options, and simulation can easily
incorporate multiple options into the analysis. Personal computers are now so powerful
and simulation software so readily available, we believe that within ten years, riskneutral valuation techniques will be very widely used in business to value real options.
Let us now try to understand more about the growth option and the abandonment
option. Similar to the framework of investment timing option, these two can also be
categorized under the five different approaches. Let us here try to understand each of
this with the help of an illustrative example.
THE GROWTH OPTION: AN ILLUSTRATION
Grow well Corporation designs and produces products aimed at the rural market. Most
of its products have a very short life, given the rapidly changing tastes of the rural
population. Grow well is now considering a project that will cost Rs.3.0 crore. The
66
Real Options
companys management believes there is a 25 percent chance that the project will take
off and generate operating cash flows of Rs.3.4 crore in each of the next two years,
after which rural tastes will change and the project will be terminated. There is a 50
percent chance of average demand, in which case cash flows will be Rs.2 crore annually
for two years. Finally, there is a 25 percent chance that the rural population will not like
the product at all, and it will generate cash flows of only Rs.2 crore per year. The
estimated cost of capital for the project is 14 percent.
Based on its experience with other projects, the company believes it will be able to
launch a second-generation product if demand for the original product is average or
above. This second-generation product will cost the same as the first product, Rs.3.0
crore, and the cost will be incurred in 2005. However, given the success of the firstgeneration product, it believes the second-generation product will be just as successful
as the first-generation product.
THE MODEL
The growth option for the project resembles a call option on a stock, since it gives Grow
well corporation the opportunity to purchase a successful follow-on project at a fixed
cost if the value of the project is greater than the cost. Otherwise, it will let the option
expire by not implementing the second-generation product. The following sections
apply the first four valuation approaches: (a) DCF, (b) DCF and qualitative assessment,
(c) decision-tree analysis, and (d) analysis with a standard financial option.
Approach 1
DCF Analysis Ignoring the Growth Option
Based on probabilities for the different levels of demand, the expected annual operating
cash flows for the project are Rs.1.875 crore per year:
0.25 (Rs.3.4) + 0.50 (Rs.2.0) + 0.25 (Rs.0.2) = Rs.1.900 crore
Ignoring the investment timing option, the traditional NPV is Rs.0.129 crore:
NPV = Rs. 0.3 +
Rs.1.970
(1+0.14)1
Rs.1.970
(1+0.14) 2
= Rs.0.129
Based upon this DCF analysis, the company should accept the project.
Approach 2
DCF Analysis with a Qualitative Consideration of the Growth Option
Although the DCF analysis indicates that the project should be accepted, it ignores a
potentially valuable real option. The options time to maturity and the volatility of the
underlying project provide qualitative insights into the options value. Grow wells
growth option has two years until maturity, which is a relatively long time, and NPV
(calculated on case 2). The cash flows of the project are quite volatile. Taken together,
this qualitative assessment indicates that the growth option should be quite valuable.
Approach 3
Decision Tree Analysis of the Growth Option
Table 1 shows a scenario analysis for Grow wells project. The coefficient of variation
of the project is 14.54, indicating that the project is very risky.
67
Table 2 shows a decision tree analysis in which Grow well undertakes the secondgeneration product only if demand is average or high. In these scenarios, shown on the
top two branches of the decision tree, the company will incur a cost of Rs.3.0 crore in
2005 and receive operating cash flows of either Rs.3.4 crore or Rs.2.0 crore for the next
two years, depending on the level of demand. If the demand is low, shown on the
bottom branch, it has no cost in 2005 and receives no additional cash flows in
subsequent years. All operating cash flows, which do not include the cost of
implementing the second-generation project in 2005, are discounted at the WACC of 14
percent. Because the Rs.3.0 crore implementation cost is known, it is discounted at the
risk-free rate of 6 percent. As shown in Table 2, the expected NPV is Rs.0.470 crore,
indicating that the growth option is quite valuable.
(Rs. in crore)
Future Cash Flows
2003
3.0
2004
2005
NPV of this
Scenario
Probability
Probability x
NPV
High
0.25
3.4
3.4
2.599
0.25
0.650
Average
0.50
2.0
2.0
0.293
0.50
0.147
Low
0.25
0.2
0.2
2.671
0.25
0.668
1.00
Expected value of NPVs
Standard deviation
Coefficient of variation
0.129
1.870
1.454
Table 1: Scenario Analysis and Decision Tree Analysis for

the Grow well Project Scenario Analysis of First-Generation Project
(Rs. in crore)
Future Cash Flows
3.0
NPV of this
Scenario
Probability
Probability x
NPV
2003
2004
2005
2006
2007
High
0.25
3.4
0.4
3.4
3.4
4.237
0.25
1.059
Average
0.50
2.0
1.0
2.0
2.0
0.157
0.50
0.079
Low
0.25
0.2
0.2
2.671
0.25
0.668
Expected value of NPVs =
0.470
Standard deviation
2.462
0.524
Table .2: Decision Tree Analysis of the Growth Option

Approach 4
Valuing the Growth Option with Black-Scholes Option Pricing Model
The fourth approach is to use a standard model for a corresponding financial option. As
we noted earlier, Grow well corporations growth option is similar to a call option on a
stock, and so we will use the Black-Scholes model to find the value of the growth
option. The time until the growth option expires is two years. The rate on 91-day
Treasury bill is 6 percent, and this provides a good estimate of the risk-free rate. It will
cost Rs.3.0 crore to implement the project, which is the exercise price.
68
Real Options
(Rs. in crore)
Future Cash Flows
2003
High
Average
Low
2004 2005
0.25
0.50
0.25
2007
NPV of this
Scenario
Probability
2006
Probability
x NPV
3.4
2.0
0.2
3.4
2.0
0.2
4.308
2.534
0.253
0.25
0.50
0.25
1.00
1.077
1.267
0.063
Expected value of NPVs
Standard deviation
2.407
=
1.439
0.060
Table 3: Estimating the Input for Stock Price in the Growth Option
Analysis of the Investment Timing Option
The input for stock price in the Black-Scholes model is the current value of the
underlying asset. For the growth option, the underlying asset is the second-generation
project, and its current value is the present value of its cash flows. The calculations in
Table 3 show that this is Rs.2.407 crore. Because the exercise cost of Rs.3.0 crore is
greater than the current price of Rs.2.407 crore, the growth option is presently out of
the money.
Future Cash Flows
2003
High
Average
Low
2004
2005
0.25
0.50
0.25
2006
2007
3.4
2.0
0.2
3.4
2.0
0.2
PV in 2003 for this Probability Probability PV

Scenario
2003
5.599
3.293
0.329
0.25
0.50
0.25
1.00
Expected value of PV2005

Standard deviation PV2005
Coefficient of variation PV2005
1.400
1.647
0.082
= 3.129
= 1.870
= 0.060
Table 4: The Value and Risk of Future Cash Flows

at the Time the Option Expires
Table 4 shows the estimates for the variance of the projects rate of return. We use an
initial estimate of 15.3 percent in our initial application of the Black-Scholes model,
shown in Table 5.
Real Option
KRF
Risk-free interest rate
6 percent
Cost to implement the project
Rs.3.000 crore
Current value of the project
Rs.2.407 crore
Variance of the projects rate of return
15.3 percent
d1
{ln(P/X) + [KRF + (2/2)]t}/( t )
0.096
d2
d1 t
0.46
N(d1)
0.54
N(d2)
0.32
Rs.4.34
P[N(d1)] Xe KRFt [N(d2)]
Table 5: Value of a Call Option Using The Black-Scholes Model
69
4.6 USING THE BLACK-SCHOLES MODEL FOR A CALL

OPTION
Table 5 shows a Rs.0.434 crore value for the growth option. The total NPV is the sum
of the first-generation projects NPV and the value of the growth option: Total NPV =
Rs.0.129 + Rs.0.434 = 0.563 crore, which is much higher than the NPV of only the firstgeneration project. As this analysis shows, the growth option adds considerable value to
the original project.
Expected price at the time the option expires = Rs.31.29
Standard deviation of expected price at the time the option expires = 18.70
Coefficient of Variation (CV) = 0.60
Time (in years) until the option expires (t)
= 2Variance of the projects expected return

= ln(CV2 + 1)/t = 15.3 percent
THE ABANDONMENT OPTION: AN ILLUSTRATION
Web World Systems produces a variety of switching devices for computer networks at
large corporations. It is considering a proposal to develop and produce a wireless
network targeted at homes and small businesses. The required manufacturing facility
will cost Rs.2.6 crore. Web World can accurately predict the manufacturing costs, but
the sales price is uncertain. There is a 25 percent probability that demand will be strong
and the company can charge a high price. Table 5 shows a detailed projection of
operating cash flows over the four-year life of the project. There is a 50 percent chance
of moderate demand and average prices, and a 25 percent chance of weak demand and
low prices. The cost of capital for this project is 12 percent.
Web World can sell the equipment used in the manufacturing process for Rs.1.4 crore
after taxes in 2004 if customer acceptance is low. In other words, the company can
abandon the project in 2004 and avoid the negative cash flows in subsequent years.
The Model
This abandonment option resembles a put option on stock. It gives Web World the
opportunity to sell the project at a fixed price of Rs.1.4 crore in 2004 if the cash flows
beyond 2004 are worthless than Rs.1.4 crore. If the cash flows beyond 2004 are worth
more than Rs.1.4 crore, it will let the put option expire and keep the project.
Expected Operating Cash Flows for Project At Web World
(Rs. in crore)
Demand
Probability
2004
2005
2006
High
25
1.8
2.3
2.8
3.3
Average
50
0.77
0.8
0.9
1.0
Low
25
0.9
1.0
Expected operating
cash flow = 0.600
0.8
0.750
Table 6: Operating Cash Flow
70
2007
0.900
1.025
1.2
Real Options
Approach 1
DCF Analysis Ignoring the Abandonment Option
Using the expected cash flows from Table 6 and ignoring the abandonment option, the
traditional NPV is Rs.0.174 crore.
NPV = Rs.2.6 +
0.600
0.750
0.900
+
+
= Rs.0.174.
(1 + 0.12) (1 + 0.12) 2 (1 + 0.12)3
Based only on this DCF analysis, Web World should reject the project.
Approach 2
DCF Analysis with a Qualitative Consideration of the Abandonment Option
The DCF analysis ignores the potentially valuable abandonment option. Qualitatively,
one would expect the abandonment option to be valuable because the project is quite
risky, and risk increases the value of an option. The option has one year until it expires,
which is relatively long for an option. Again, this suggests that the option might be
valuable.
Approach 3
Decision Tree Analysis of the Abandonment Option
Table 6 shows a scenario analysis for this project. There is a 25 percent chance that
customers will accept a high price for the product, with the cash flows shown on the top
line. There is a 50 percent chance that it can charge a moderately high price, and the
cash flows of this scenario are in the middle row. However, if customers are reluctant to
buy this product, the company will have to cut prices, resulting in the negative cash
flows on the bottom row. The sum in the last column in Table 2 shows the expected
NPV of Rs.0.174 crore, which is the same as the traditional DCF analysis as calculated
in Approach 1 above.
Table 5 shows a decision tree analysis in which the company undertakes project in the
low-price scenario. In particular, if the company has the Rs.0.8 crore operating cash
flow in 2004 and the prospect of even bigger losses in subsequent years, it will abandon
the project and sell the equipment for Rs.1.4 crore. Note that the company will not
abandon the project in the average-demand scenario, even though it has a negative
expected NPV as seen above. This is because the original investment of Rs.2.6 crore is a
sunk cost. Only the future cash flows are relevant to the abandonment decision, and they
are positive in the average-demand scenario. Therefore, the company will abandon the
project only in the low-demand scenario.
All operating cash flows, which do not include the salvage value in the low-demand
scenario of 2004, are discounted at the WACC of 12 percent. The salvage value is
known with a high degree of certainty, so it is discounted at the risk-free rate of 6
percent. As shown in Table 3, the expected NPV is 0.704 crore, indicating that the
abandonment option is quite valuable. In fact, the option to abandon is so valuable that
it should accept the project.
The option itself alters the risk of the project, which means that 12 percent may not
probably be any longer the appropriate cost of capital. In addition, the estimated Rs.14
crore salvage value is relatively certain, but there is a slight chance that it might be
either higher or lower.
71
(Rs. in crore)
Future Cash Flows
Rs.26
2003
2004
2005
2006
2007
NPV for
this
Scenario
Probability
Probability
x NPV
High
0.25
1.8
2.3
2.8
3.3
4.031
0.25
1.233
Average
0.50
0.7
0.8
0.9
1.0
0.061
0.50
0.031
Low
0.25
0.8
0.9
1.0
1.2
5.506
0.25
1.377
1.00
Expected value of NPVs =
0.174
Standard deviation
3.692
= 2.117
Table 7: Scenario Analysis of the Project (Ignoring the Option to Abandon)

(Rs. in crore)
Future Cash Flows
Rs.2.6
Probability Probability x
NPV
2003
2004 2005
2006
2007
NPV for this

Scenario
High
0.1
1.8
2.8
3.3
3.3
4.931
0.25
Average
0.50
0.7
0.8
1.0
1.0
0.061
0.50
0.031
Low
0.25
0.6
0.0
0.0
0.0
1.994
0.25
0.498
1.233
1.00
Expected value of NPVs = 0.704
Standard deviation
= 2.565
= 0.364
Table 8: Scenario Analysis of the Project

(Ignoring the Option to Abandon)
Approach 4
Valuing the Abandonment Option with a Financial Option
The fourth procedure for a real option valuation is to use a standard model for an
existing financial option. As we have noted earlier, the companys abandonment option
is similar to a put option on a stock. We can use the Black-Scholes model for the value
of a call option, VCall, in order to determine the value of a put option, VPut:
VPut = VCall P + Xe-kRFt
(1)
where the symbols have usual meanings.

Before we can apply the put formula to determine the value of Web Worlds project
with an embedded abandonment option, we must break the original project into two
separate projects plus an option to abandon the second project. Figure H shows Project A,
which is a one-year project that includes the initial cost and first-year operating cash flows
of Web Worlds project. Table 9 shows Project B, which begins in 2005, the year after
Project A ends. Project B has no cash flows in 2003 or 2004, but has the networking
projects operating cash flows in the subsequent years. Note that combining Projects A
and B gives the same cash flows as Web Worlds networking project. Project A has an
NPV of Rs.2.064 crore (shown in the last column in Table 8) and Project B has an NPV
72
Real Options
of Rs.1.890 crore. The combination of the two projects has an NPV of Rs.2.064 +
Rs.1.890 = Rs.0.174 crore, the same NPV shown for Web Worlds networking project.
But the company also has an option to abandon Project B, which gives it the right to sell
Project B for Rs.1.4 crore. In other words, it can invest in Project A by paying the initial
cost of Rs.2.6 crore, which also gives it the ownership of Project B. But in addition to
owning Projects A and B, it also has the right to sell Project B for Rs.1.4 crore.
(Rs. in crore)
Future Cash Flow
2003
Rs.2.6
2004
NPV of this
Scenario
Probability
Probability x
NPV
High
0.25
1.8
0.993
0.25
0.248
Average
0.50
0.7
1.975
0.50
0.988
Low
0.25
0.8
3.314
0.25
0.829
1.00
Expected value of PVs = 2.064
Standard Deviation
= 0.826
= (0.40)
Table 9: DCF Analysis of Project A that Lasts One Year

(Rs. in crore)
Future Cash Flows
2003
2004
NPV for this
2005
2006
2007
Scenario
2.3
2.8
3.3
5.924
Probability
Probability x
NPV
High
0.25
0.25
1.481
Average
0.50
0.8
0.9
1.0
1.914
0.50
0.957
Low
0.25
0.9
1.0
1.2
2.192
0.25
0.548
1.00
Expected value of PVs
= 1.890
Standard deviation
= 2.869
= 0.152
Table 10: DCF Analysis of Project B that starts in 2005,

in Project A is already in Place
We can use the standard Black-Scholes equation to determine the value of Web Worlds
abandonment option. Note that we need the same five factors to price a put option using
the Black-Scholes model as we do to price a call option: risk-free rate, time until the
option expires, exercise price, current price of the underlying asset, and variance of the
underlying assets rate of return. The rate on a 91-day Treasury bill is 6 percent, and this
provides a good estimate of the risk-free rate. The time until the growth option expires
is one year. Web World can sell the equipment for Rs.1.4 crore, which is the exercise
price.
The underlying asset in this application of the option-pricing model is Project B, since
we have the option to abandon it. Project Bs current price is the present value of its
future cash flows. As the last column in Table 9 shows, this is Rs.1.890 crore.
Table 10 shows the estimates for the variance of Project Bs rate of return using the
method previously described in the analysis of the option to delay.
Table 10 shows an extremely high coefficient of variation, 0.518, reflecting the
enormous range of potential outcomes. As in the previous examples, one can use the
73
indirect method (refer to table 2) to convert the coefficient of variation at the time the
option expires into an estimate of the variance of the projects rate of return:
Expected price at the time the option expires
Standard deviation of expected price at the time the option expires
Coefficient of variation (CV)
Time (in years) until the option expires (t)
Variance of the projects expected return = ln (CV2 + 1)/.t
ln(1.5182 + 1)
1
=
=
=
=
=
Rs.21.17
Rs.32.14
1.518
1
119.5%
= 1.195 = 119.5 %
Table 11: Indirect Method: Use the Scenarios to Indirectly

Estimate the Variance of the Projects Return
Figure K shows the calculation of the abandonment options value. Using the BlackScholes model for a put option, the resulting value is Rs.0.528 crore. The total NPV of
the project is the sum of the original projects NPV (which is also equal to the sum of
NPVs of Projects A and B) and the value of the option to abandon: Total NPV 0.174 =
0.528 0.354 crore. Given the improvement in NPV caused by the abandonment
option, Web World decided to undertake the project.
(Rs. in crore)
2004
High
Average
Low
0.2
0.50
0.25
Future Cash Flow

2005
2006
2.3
0.8
0.9
2007
2.8
0.9
1.0
3.3
1.0
1.2
PV in 2004
for this
Scenario
6.635
2.144
2.455
Probability
Probability x
PV2004
0.25
0.50
0.25
1.00
1.659
1.072
0.614
Expected value of PV2002

Standard deviation of PV2002
Coefficient of variation of PV2002
= 2.117
= 3.214
= 0.518
Table 12: Find the Value and Risk of Future

Cash Flows at the Time the Option Expires
(Rs. in crore)
Real Option
kRFt
t
X
P
Risk-free interest rate
=
=
=
Time until the option expires =

Salvage value if abandoned =
Current value of the Project B
1
1.400
= 1.890
Variance of Project Bs rate of return
175
{ln(P/X) [kRF + ( /2)]t}/( t )
0.934
d2
=
N(d1) =
N(d2) =
V of Call =
d1 t
=
0.82
0.35
P[N(d1)] Xe kRFt[N(d2)]
1.099
V of Put =
V of Put =
V of Put =
Cal P + Xe (kRFt)
1.099 1.890 + 1.318
0.527
d1
6 percent
0.39
Table 13: Value of a Put Option Using the Black-Scholes Model
74
Real Options
4.7 APPLICATIONS OF REAL OPTIONS

The concept of real options is applicable in actual industry. The application process is
explained here with two industries.
4.7.1 Exploring for Oil

Reliance Petrochemicals has leased a large tract of land somewhere in the Southern
India and was evaluating alternate exploration strategies. The Government of India were
to provide additional information about the amount of oil in the ground, and the drilling
would add information about the amount of oil reserves and could resolve whether the
oil could be produced. Should Reliance begin the exploration? Which exploration
investment strategy should they use?
Following are the risk elements that Reliance was aware of,
Six to fifteen years time is required to get an unexplored tract into production.
There is huge involvement of money in the project, that will amount to crores.
There lies a very small chance, say about 10 percent, for the project to
successfully lead to oil production.
Several earlier attempts to carry out similar projects were futile because the estimated
development costs were supposed to exceed the production profit or because the oil
price fell too low so as to justify more expenditures.
The decision regarding the exploration of oil is made by valuing the tract under each
initial exploration strategy, as well as the other contingent follow on strategies. The
strategy that is able to deliver the highest valued tract is chosen. The tract value is
dependent on three sources of uncertainty:
Oil Prices.
Reserve Size.
Chance of Success (COS).
The current spot price of the oil is observed daily and the volatility of the oil prices is
estimated as the volatility that is implied by the option contract on the oil. The initial
level and the standard deviation of the companies are based on historical experiences in
the region and also the experience with specific geological features. The market priced
risk is easily tracked and the private risks are uncorrelated with any traded asset. This
ratio can be defined as the (Standard deviation after the exploration)/(Standard deviation
before the exploration investment).
This ratio is always less than one, differs by the type of investments, and its value
decreases with the stage of investment. The featuring ratios for the companies with
drilling equals zero, because drilling fully resolves the companies uncertainty. At the
end of the lease, the tract is either developed or abandoned.
THE FINDINGS
The first finding of the problem is the value of the tract that is under each first stage
strategy. When the optional strategy is to delay the project, the same analysis is
repeated after one years time with the changed oil prices and a shorter time to the
expiration of the lease. The optimal strategy will be immediate implementation in case
the payoff resulting from producing oil is so high that the managers are willing to risk
75
abandoning the tract after a sizeable development expenditure. The following figure
shows the optimal first stage exploration investment strategy as a function of the current
estimate of reserve size and of current oil prices, keeping the other inputs constant. The
figure reveals two types of waiting the lower left of the grid power of the optimal
strategy calls for the condition of wait to explore. This is because the oil prices and the
estimate of reserve size is low. The upper right of the grid suggests an optimal strategy
to wait to develop as the estimated reserve size is high but the price of oil is a bit too
low to justify the development. The figure 5.1 actually reflects a very interesting feature
of the oil industry, an increase in the oil price brings tracts out of delay mode and into
exploration, thus creating demand for oil services. This in turn enhances the cost of
further exploration development, thereby reducing the value of the exploration option.
The final deals with the value of the information that is proportionate to the extent of
how much the oil company would be willing to pay to further resolve reserve size or
companys uncertainty. The real option approach of valuing the project shows that the
value of resolving uncertainty depends on the following factors.
Future decision involving exploration.
Current value of oil prices.
Uncertainty type.
Say for example, when the development costs are high, the value of resolving the
companys uncertainty is high and the seismic investments are not very valuable as they
are unable to supply the important piece of information. The use of the real option
aligns the value of the information with financial market valuation.
Seismic
Drill
High
Current
oil price
Strategy space for

oil exploration
i nvestment
Seismic
Drill
Wait to
explore
Wait to
develop
Low
High Estimate Reserve Low Size
Figure 1: Strategy Space for Oil Exploration Investment
4.7.2 Applications of the Real Options in the Drug Industry

The process of developing and marketing a drug is a very costly as well as a lengthy
process. These characteristics make it a very good case for the real option approach in
investment decision making. The development of a drug can be viewed as a learning
investment in which the R&D investment reduces the uncertainty regarding the
remaining costs to complete the development of the drug, and the initial marketing
efforts resolve the uncertainties about the size of the drugs market. During the first year
of drug development there is the birth of the market priced risk. The level of uncertainty
is relatively small as compared to the private risk uncertainty. The real option based
approach to drug development relies more on the evaluation of the consequences of
private risk. Market priced risk is relatively more important in case of oil exploration
strategies and transacted values of reserves. In case of drug development the private risk
is relatively important.
76
Real Options
While valuing a drug development project with the help of real options, certain
questions need to be answered:
What are the roles that private and market priced risks play in the development
of decisions and valuations?
What are the possible implications of the large amount of the private risk?
The drug development process and the marketing process can be modeled as a sequence
of fearing investment and abandonment options. In each of the periods, the firm divides
on whether to make expenditures at a predetermined amount for further development
and marketing or to abandon the development process, the reward that the firm gets by
continuing the next option.
Each of the options contain the opportunity to make a similar decision in future periods
and later garner possible profits in the life cycle of the project. The application of the
real option associates the following sources of uncertainties:
Remaining life cycle costs of drug.
The size of the market for the drug that completes development.
Industry wide evidence of value.
Probability of passing regulatory tests.
THE FINDINGS
The following figure 2(a) shows that as the managers opt for using the option to
abandon the project, the number of drugs that are in the development stage falls by
phase of investments. Figure 2(b) reveals that the value of a surviving drug increases as
it paves the regulatory hurdles along with uncertainty about the remaining costs and size
of the market is resolved. Figure 2(c) shows, how the level of uncertainty about
surviving drug projects decreases by phases until a time comes when all the private risk
is eliminated and the uncertainty of the project is equal to the volatility of the market
priced risk.
(b)
(a)
Real
option
value per
drug
Number
Late
Early
Number of surviving drugs

in development
Early
Late
Number of surviving drugs

in development
(c)
Level
of
uncertainity
Volatility of
market price
risk
Late
Early
Uncertainity about drug value
Figure 2
77
Though the use of a discounted cash flow analysis might show that developing a drug is
a zero NPCE investment, if one considers all the options during the drugs life cycle it
reveals that the correct valuation might be much higher. Using the real option approach,
to manage a portfolio of drugs results in more drugs in the development process to more
drugs to be abandoned.
a.
What are the inputs require to value an option under the Black-Scholes option
pricing model?
.
.
.
b.
What are the findings in the application of real options concept to

Petrochemicals industry?
.
.
.
4.8 DRAWBACKS OF USING REAL OPTIONS ANALYSIS

Though the use of real options had brought in considerable advantages in creating a
project, still there exists some pitfalls in their usage. These pitfalls can broadly be
categorized under the following:
Using the real option analysis when one should not use them.
Framing a wrong model for the purpose of valuation.
Using incorrect data and biased judgments in the model.
Miscalculation in the process of valuation.
Let us now try to discuss each of the drawbacks in brief:

a.
Using real option analysis when one should not
Real option analysis takes into account a number of assumptions. One basic
assumption of real option is that the relevant uncertainities are random walks and
as a result are unforeseeable. Coupled with this, it also states that the consumer is
the price taker, and decision taken by the consumer can change the future course
of the random walk. Such assumptions are in fact violated if there exists a small
number of leading competitors. In this case the decisions may not be random.
Each players action can influence the price of all the players who will take
decisions with full knowledge of what the possible counter moves will be for
every other player. The other assumption the option theory makes is that the
risks of an option can be hedged away. If hedging is feasible the option will be
priced as if it had been hedged, in which case the risk is risk-free. If it is given
that hedging is indeed possible it does not matter whether any one option is
actually hedged or not.
78
Real Options
b.
Using the wrong real option model
It is easy to wrongly assume that the actual decisions pertaining to the project is
Like a given real option model while in reality it is Unlike so. Thus picking
up a wrong model can be disastrous. Say for example, if one has assumed that
the interest rates are fixed, should it change the decisions to a large extent if the
interest rates were truly variable. If one bases his assumption that the prices of
oil and gas are independent of each other, how can it, in any way, influence the
decision if they were linked by some economic mechanism.
c.
Miscalculation in the data inputs
It is important to understand the drivers of the option value in any specific real
option model. One needs to check the model for sensitivity to the associated
variables, try to understand how the errors in the variables could result in based
results. Say for example, the value of the call option is increased in the time to
expiry and the volatility of the underlying asset is increased. As far as this is
concerned it is important to note that one has over- estimated the length of the
available time, or what could be the smallest possible estimate one could use for
volatility?
d.
Getting both the models of the data right, but making mistakes in the
solution
It may sometimes happen, that while using the complete mathematical algorithm,
one can easily miss an important variable. While calculating the option value,
one may notice that the calculated option values are exploding towards plus or
minus infinity, or are oscillating between the two. The results of option valuation
are sometimes in conflict with common sense approach. Nevertheless, it is
important to make as many logical checks as possible to ensure that these results
are commensurate with the economic rationality.
4.9 SUMMARY
Opportunities to respond to changing circumstances are called managerial option as
they give managers a chance to influence the outcome of the project. Such projects are
also called as real options as they deal with real rather than financial assets.
Many projects include a variety of embedded options that can dramatically influence
its NPV. These can be
a.
Investment timing option that allows the firm to delay the project.
b.
Growth option that enable a firm to manage its capacity in response to

changing market conditions.
c.
Abandonment option.
d.
Flexibility options which give flexibility to a firm over its operations.
There are five possible procedures for valuing real options:

a.
DCF only, ignoring the real option.
b.
DCF analysis and qualitative assessment of the real option value.

79
c.
Decision tree analysis.
d.
Analysis with a standard model for an existing financial option.
e.
Financial engineering technique.

The various drawbacks of real option analysis includes,
Using it where it is not applicable,
Framing a wrong model for valuation,
Using incorrect data and biased judgment, and
Miscalculation.
4.10 GLOSSARY
A Real Option is an option that arises naturally in the course of business activities
rather than one purchased on a financial market. A common example of a real option is
early investment in a technology, which will enable a firm to exploit the new
technology should it prove successful.
An Option is a contract that confers the right, but not an obligation to the holder to buy
or sell an underlying asset like stock, currency, commodity, financial instrument or a
futures contract at a price agreed on a specific date or by a specific expiry date.
Net Present Value or NPV is a method for evaluating investment proposals. NPV is
defined as present value of benefits minus present value of costs.
Discounting is the process of finding the present value of a future cash flow or a series
of future cash flows.

Strategy. 2nd ed., Tata Mcgrawhill, 2002.

2000.

7th ed, Thomson, 2004.
Brealey Myers, Principles of Corporate Finance, 6th edition, USA: Mcgraw-Hill


a.
A growth option lets a company to increase its capacity of operation if the

market conditions are better than expected. In one type of growth option, a
company may resort to increase the capacity of an existing product line. Another
type allows a company to expand into new geographic markets. The third type
may deal with the opportunity to add new products that even includes the
complementary products and successive generations of the original product.
80
Real Options
b.
The pure DCF value of the project can be calculated as follows:

DCF value of the project =
Cash flow
1+ k RF
Where,
kRF denotes the risk-free rate of return at which the cash flow is
discounted.
The inputs are the cash flow and the risk-free rate that help in accurate estimation
of the projects DCF.
In contrary, valuing real options calls for a greater level of judgments in areas of
both formulating the model as well as in estimating the values of the inputs. This
implies that the value of the project using real options will not be as accurate as
it had been stated in a simpler DCF model for valuation. There can be five
possible procedures that can be used in order to deal with real options. They are:
Use of DCF valuation and ignoring any real option, with the assumption
that their values are zero.
Using the DCF valuation and including a qualitative recognition of any

real options value.
Use of decision tree analysis.
Using a standard model for a financial option.
Developing a unique, project specific model with the help of techniques

in financial engineering.
a.
To value an option under the Black-Scholes option pricing model, the following
are the inputs required:
b.
i.
Risk-free rate
ii.
iii.
Exercise price of the option
iv.
Current stock price
v.
Variance of the stocks rate of return.
The first finding of the problem is the value of the tract that is under each first
stage strategy. When the optional strategy is to delay the project, the same
analysis is repeated after one years time with the changed oil prices and a
shorter time to the expiration of the lease. The optimal strategy will be
immediate implementation in case the payoff resulting from producing oil is so
high that the managers are willing to risk abandoning the tract after a sizeable
development expenditure. The following figure shows the optimal first stage
exploration investment strategy as a function of the current estimate of reserve
size and of current oil prices, keeping the other inputs constant.
81

A. Multiple Choice
1.
2.
3.
4.
5.
82
The option to include complementary products and services to the existing

product portfolio, when the market condition improves, can be dealt under which
of the real option model?
a.
Investment timing option.
b.
Growth option.
c.
Rainbow option.
d.
Compound option.
e.
Flexibility option.
Which of the following is the risk neutral approach of valuing real options?
a.
Sensitivity analysis.
b.
Decision tree approach.
c.
Simulation analysis.
d.
Discounted Cash Flow (DCF) model.
e.
Black-Scholes model.
An asset with future payoffs that is dependent on the result of an uncertain

development is called:
a.
An option contract
b.
A convertible asset
c.
A contingent claim
d.
A riskless asset
e.
A risky asset.
The difference between the current market value of an option and its intrinsic
value is its
a.
Contingent value
b.
In-the-money value
c.
Option value
d.
Time value
e.
Out of the money value.
The opportunity to defer investing to a later date may have value because
a.
The cost of capital may decline in the near future
b.
Uncertainty may be reduced in the future
c.
Investment costs fluctuate in time
d.
Market conditions may change and increase the NPV of the project
e.
A favorable change in the governmental policies is expected.
Real Options
B. Descriptive
1.
Differentiate between real option and financial option.
2.
How can real option be applied in project involving exploring for oil?
3.
What are the drawbacks of using real option analysis?
practice only.
83
NOTES
84

Block
Unit
Nos.
Unit Title
INTRODUCTION TO STRATEGIC FINANCIAL
MANAGEMENT
1.
Strategic Financial Management: An Overview
2.
Firms Environment, Governance and Strategy
3.
Valuing Real Assets in the Presence of Risk
4.
Real Options
II
STRATEGIC CAPITAL STRUCTURE

5.
Capital Structure
6.
Dividend Policy
7.
Allocating Capital and Corporate Strategy
8.
Financial Distress and Restructuring
III
STRATEGIC ENVIRONMENT ANALYSIS

9.
Industry Analysis, Financial Policies and Strategies
10.
Information Asymmetry and the Markets for Corporate

Securities
11.
Managerial Incentives
12.
Decision Support Models
IV
CORPORATE ACCOUNTING AND BUSINESS

STRATEGY
13.
Financial Statement Analysis
14.
Inflation Accounting
15.
Working Capital Management
16.
Strategic Cost Management
STRATEGIC RISK MANAGEMENT

17.
Corporate Risk Management
18.
Risk Management and Corporate Strategy
19.
Organization Architecture, Risk Management, and

Security Design
20.
The Practice of Hedging
21.
Enterprise Risk Management

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MBA-0000

Strategic Financial Management

Dr. Lata Chakravorty

Prof. P. Bala Bhaskaran

Dr. Dhananjay Keskar

Course Preparation Team

Prof. Hilda Amalraj

Prof. Bratati Ray

Dr. Vijaya Lakshmi S

Dr. Vunyale Narender

Ms. Sunitha Suresh

Prof. Arup Chowdhury

The ICFAI University Press, All rights reserved.

The ICFAI University Press, Hyderabad

This introductory block gives an overview of strategic financial management,

The fifth block on Strategic Risk Management includes Corporate Risk

The course contains five blocks.

Financial Objectives of a Company

Non-financial Objectives of a Company

Conflict of Interests in a Firm

Financial Planning and Strategic Planning

The Relationship between Short-term and Long-term Financial Planning

Suggested Readings/Reference Material

Understand the financial and non-financial objectives of a company;

Know the Agency Theory;

Identify the primary reasons for conflicts of interest; and

Get an idea of the classification of financial planning and strategic planning.

1.3 FINANCIAL OBJECTIVES OF A COMPANY

Strategic Financial Management

1.4 NON-FINANCIAL OBJECTIVES OF A COMPANY

Fulfillment of responsibilities towards customers and suppliers.

Leadership in research and development.

1.5 AGENCY THEORY

Strategic Financial Management:

What are the non-financial objectives of a firm?

Describe the relationship between management and shareholders.

Strategic Financial Management

1.6 CONFLICT OF INTERESTS IN A FIRM

Pay or bonuses related to the size of profits termed as profit-related pay.

Rewarding managers with share options. In a share option scheme, selected

Such measures might encourage management in the adoption of creative accounting

Strategic Financial Management:

is to attempt to monitor managers behavior, for example, by establishing Management

An increased production by the firms.

Costs of production and selling prices.

Foreign exchange rates.

Let us now try to understand each of the above factors in detail.

An investor in the gilts will make a capital loss of Rs.28.57 percent

Strategic Financial Management

When interest rates are low, it might be beneficial:

To borrow more, preferably at a fixed rate of interest, and so increase the

When interest rates are higher:

A company might opt to raise new finance by borrowing short-term funds

Interest Rates and New Capital Investments

Strategic Financial Management:

What is meant by Goal congruence?

When a government issues long-term gilts of Rs. 1,000 at a coupon interest

1.7 FINANCIAL PLANNING AND STRATEGIC PLANNING

The organizations objectives.

Alternative strategies for achievement of these objectives.

Development of new facilities (building, plant or equipment and the materials

Development of new products or services; and

Entry into a new field of marketing for existing products.