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OBJECTIVE
To show how to use finance theory to analyze strategic decisions, such as acquiring or merging with another firm,
spinning off a business unit as a separate firm, and investing in real options.
CONTENTS
17.1 Mergers and Acquisitions
17.2 spin-offs
17.3 Investing in Real Options
This chapter shows how to app1y finance theory to strategic decision making in firms. In chapter 1 we concluded
that both in theory and in practice the criterion for the managers of a firm in evaluating strategic decisions should be
the maximization of the wealth of the company's owners. In chapters 6and 16, we showed how to apply discounted
cash now analysis to estimate an investment's contribution to the wealth of a firm's owners. In this chapter we extend
that analysis in two ways to examine two basic aspects of corporate strategy. First, we analyze corporate decisions
regarding mergers, acquisitions, and spinoffs. Then we show how option theory can be applied to evaluate
management's ability to time the start of an investment project, to expand it, or to abandon it after it has begun.
17.1 MERGERS AND ACQUISITIONS
When one firm acquires a controlling interest in another it is called an acquisition; when two firms join to form a
new firm, it is called a merger. Under the criterion for good management of maximizing current shareholder’s, wealth,
there are essentia1ly three reasons for considering acquiring or merging with another company: synergy, taxes, or
bargains. Let us consider each.
Synergy is said to exist if: by combining two companies, the value of the operating assets of the combined firm
will exceed the sum of the values of the operating assets of the two companies taken separately. Such synergy will
occur if there are economies of scale in the production or distribution of the products of two or more firms. It can also
occur through the elimination of duplicate efforts in management, in technology, or in research and development. In
essence, the value goes up because the factors of production are more efficiently organized in the combined firm.
For example, in 1995in the United States there was a wave of mergers among banks. The mergers were
largely explained by the executives involved and by outside analysts as attempts to realize cost savings through
consolidation of various banking activities and elimination of expensive duplicative technology. This interpretation
was corroborated by the postmerger closing of many branch offices and the elimination of many jobs in the merged
banks.
Another potential source of increased value to shareholders from mergers and acquisitions is a reduction in
the taxes paid to the government by the companies involved in the merger. Even in the absence of opportunities to
reduce production and distribution costs through true operating synergies, corporations can sometimes reduce the
combined present values of their tax payments through a merger. For example, under certain conditions, a
profitable firm may acquire an unprofitable firm and thereby reduce its taxes by exploiting the unprofitable firm's
tax-loss carryforwards.
Unlike mergers motivated by synergies, solely tax-motivated business reorganizations add no net value to
society at large. The market value of a firm reflects its value to the private sector. Because the firm pays taxes (or
may pay taxes in the future), there is an additional value of the firm to society in the form of the present value of its
tax payments. The sum of the market value in the private sector and this “shadow” value is the total value of the firm
to society.
In the case of synergy, the value of the firm to society is increased with a corresponding increase in both the
market and shadow social values of the firm. However, where a reduction in taxes is the sole reason for a merger, the
value of the combined firm to society is just equal to the sum of the values to society of the r firms. This combination
does not increase the total value to society, but it does redistribute the total between the shareholders of the firms and
the tax-paying public.
A third reason for mergers and acquisitions is to take advantage of bargains in the stock market. If the firm to be
acquired has a market value that is less than its intrinsic value, then by acquiring the firm, the management of the
acquiring firm can increase its stockholders’ wealth.
There are two distinct reasons why a firm could be selling for less than intrinsic value. The first is that relative to
the acquiring firm’s information set, the stock market is not efficient in the sense discussed in chapter 7. That is, the
management of the acquiring firm believes that it has information such that if this information were widely known, the
market value of the firm to be acquired would be higher than its acquisition cost. If this is the principal reason for the
acquisition, then the management’s behavior is identical to that of a security analyst whose job it is to identify
mispriced securities.
A second reason why a firm could be selling for less than its intrinsic value is that the firm to be acquired is
currently being mismanaged. That is, through either incompetence or malevolence, the current management is not
managing the firm’s resources so as to maximize the market value of the firm. Unlike the first reason, this reason is
completely consistent with an efficient capital market.
Notable by its absence among the three valid reasons for acquisitions is diversification-the acquisition of another
firm for the sole purpose of reducing the volatility (variance) oft he firm's operations-Although diversification is a
frequently cited reason for an acquisition, it is often not the real reason. More often than not, it will be for one of the
three reasons already given.
However, if diversification is the real reason, then the acquisition route will in general be an inefficient way to
achieve it. Finance theory and a large amount of empirical evidence lead to the following conclusion:
The combined market value d two firms that merge solely in order to achieve diversification of risks is no more than the sum of
the market values of the two separate firms.
In other words, in the area of corporate diversification the whole is worth no more than the sum of its parts.
The argument in favor of corporate diversification is often presented by analogy with an individual investor
where we have seen in chapter 12that diversification is quite important. However, this type of argument simply
illustrates the pitfalls of treating the firm as if it were an individual household with its own preferences rather than as an
economic organization designed to serve specific economic functions.
An intuitive explanation of why the market values of two firms will not be in- creased through a merger even
though the combined firm may have a smaller total risk (variance) than the individual firms is as follows: In order for
investors to be willing to pay a higher price for the combined firm than they were willing to pay for the two firms
separately, the act of combining the two firms must provide a service to the investors that they were previously unable
to obtain.
However, prior to the combination, investors could purchase shares of either or both firms in any mix they want.
In particular, in the case of a merger, investors can purchase the shares of both firms in the same ratio implicit in the
combined firm. Hence, investors could achieve for themselves (prior to the merger) the same amount of diversification
(of the risks of both firms) as is provided by the combined firm. Therefore, the merger provides no new diversification
opportunities to investors. For that reason, investors would not pay a premium for the combined firm. Indeed, in the
absence of diversification benefits, the combined firm should sell for less than the sum of the values of the two separate
firms simply because there are costs to doing the merger.
Firm diversification can also hurt market value by reducing the investment choices available to investors and by
reducing the amount of information available to investors. After consolidation of the two firms, investors have fewer
choices for portfolio construction than they did before consolidation. For example, prior to a merger, investors could
hold any amounts of each of the two merging firms. After the merger, the only way that investors can hold firm 1is to
invest in the combined firm, which means they must also invest in firm 2. Indeed, they can only invest in firm 1 if they
are willing to invest in firm 2in the relative proportions of the postmerger firm. The consolidated accounting and other
public statements of the merged firm will typically contain less total information than was provided to investors in the
individual filings when the companies were separate. Unless this increase in “opaqueness” permits the firm to improve
its profitability, the reduction in information is likely to cause a reduction in firm value.
Note that this negative aspect of firm diversification applies even in a frictionless world of no transactions costs
and where the merger takes place on term where no premium above market value is paid for the acquired firm by the
acquiring firm. In the real world, the acquiring firm must usually pay a premium above the market value to acquire a
firm. The premium can range from 5% to more than 100% with an average somewhere around 20%.A natural question
to ask is: Why do the owners of the firm to be acquired demand a premium for their shares?
Although there are several possible explanations, one that is consistent with our previous analyses is as follows:
If the acquiring firm's management is behaving optimally, then the reason for its making a takeover attempt must be
one of the three reasons discussed at the outset of this section-Because any one of these three reasons will increase the
value of the acquiring firm's shares, the acquired firm's shareholders are demanding compensation for providing the
means for this increase in value.
How this potential increase in value is shared between the acquiring and acquired firms, shareholders cannot be
determined in general (as is the usua1case for bilateral bargaining), but almost certainly, the acquired firm's
shareholders will receive some positive share. Of course, the acquired firm's shareholders do not know what the
acquiring firm's management believes the value of the acquired firm is. Hence, it might appear that no consolidation
could be consummated because whatever price is offered, clearly, the acquiring firm's management believes it is worth
more and, therefore, the acquired firm's shareholders should demand more.
However, the fact that the acquiring firm shareholders believe it is worth more does not mean that it is, indeed,
worth more. Their beliefs may be wrong. Hence, at high enough price above market, the acquired firm's shareholders
will take the sure premium, and let the acquiring firm take the risk (and earn the possible reward) that its information is
sufficiently superior to the market’s that the acquired firm is still a “bargain”.
Whether or not the acquired firm’s shareholders or the acquiring firm’s shareholders come out ahead on these
takeovers is still an open empirical question. However, it is clear that acquiring another firm for the sole purpose of
diversification is a losing proposition for the acquiring firm because it must pay a premium for a firm whose acquisition
promises no increase in market value even if it is purchased without paying a premium over the market price prior to
the announcement of the takeover.
Although the premium paid over market value for the acquired firm is usually the principal cost of an acquisition,
there are other costs as well that can frequently be substantial. In an uncontested merger, there are legal costs and
management’s time that could be spent on other activities. There are uncertainties created for the acquired firm’s
management, employee, supplies, and customers that could affect the operations of that firm during the negotiations
and subsequent transition. Of course, if the merger is contested, then litigation costs will be substantial.
Even if it is decided that firm diversification is warranted, then achieving this diversification through acquisition
is very costly. If it is costly for your shareholders to diversify their portfolios by direct purchase of individual firms’
shares, then this service almost surely can be provided at less cost by mutual funds, investment companies, and other
financial intermediaries. If, because of management risk aversion or debt capacity or supplier concerns, it is decided
that the volatility or total risk of the firm should be reduced, then this can be achieved much more efficiently (i.e., at
lower cost) by simply purchasing a portfolio of equities and fixed-income securities in which no premium is paid over
market and no significant transactions costs are incurred. In general, the risk management objectives of a firm can be
implemented more efficiently by using a growing array of financial technologies and specialized products provided by
financial-service firms.
If diversification is desired simply to provide cash now from these operations to fund growth investments in
current operations, then it is almost certainly less costly to issue securities and raise the funds in the capital markets.
Don't pay $12to $20to acquire $10in cash!
In summary, there are three types of reasons for a firm to consider the acquisition of another firm:
1. synergy
2. taxes
3. the firm to be acquired is a bargain
They all have in common that the acquisition should increase the value of the acquiring firm's current
stockholders' wealth.
The possibility of a takeover of one firm by another is an important check that serves to force managements of
publicly owned firms to pursue policies that are (at least approximately) value maximizing.
Simple diversification by the firm is, in general, not an important objective for the management of the firm.
Hence, if pursued, then a minimum of resources should be used to achieve it. Specifically, the acquisition of another
firm is a costly way to achieve diversification.
Beware: Diversification is frequently given as the reason for acquiring a firm by the acquiring firm's management. If
carefully investigated (most of the time),the meaning of diversification as used is not the one described here, and the
real reasons will be one or more of the three (proper)reasons for making an acquisition.
17.2 SPIN-OFFS
A spin-off occurs when a corporation divests itself of one or more of its business units and creates a separate company
with assets, liabilities, and stock of its own. For example, in 1997Pepsico spun off its restaurant division, giving
it$1billion (at book value) in assets and $12 billion (at book value) in liabilities. What reasons might there be for a
corporation to spin off a business unit?
From the perspective of value maximization it pays to spin off a business unit if the sum of the expected market
values of the separate businesses-often called the firm's “breakup” value-exceeds the firm's value as a single entity. The
reasoning is identical to the reasoning behind a merger or acquisition discussed in section 17.1. If there is no synergy
between the business units comprising a multidivisional firm, then the business units are more valuable as separate
firms.
There is another possible reason for a multidivisional firm to spin off business units into separate firms, even if
the sum of the value of the assets after the breakup does not exceed the value of the firm as a single entity. If the firm
has a lot of long term, fixed-income liabilities, then it may be possible for management to increase the wealth of
shareholders at the expense of the firm's creditors by breaking the firm up into two or more separate firms.
To see how this is possible, let us consider Multicorp, a firm with two divisions, each of which has assets worth
$1 billion. Assume that the returns on each of the separate divisions are quite risky, but that they are perfectly
negatively correlated, so that in combination Multicorp has a riskless return. The riskless rate of interest is 5% per year,
and that is also the expected equilibrium rate of return on each d the two divisions. Assume that Multicorp has $1billion
of long-term debt, which also bears an interest rate of 5% per year.
Before the spin-off, the market value of the debt is $1billion because there is no uncertainty about the firm's
earning a risk-free 5% rate of return. However, sup pose that Multicorp spins off one of its divisions as a new firm,
Unicorp, with$1 billion in assets and $0.5 billion of Multicorp's debt. The combined market value of the two separate
firms is still $2 billion, but the debt will fall in market value because there is now a possibility of default for each of the
separate firms. The decline in the value of the debt accrues to the shareholders of Multicorp, who are now the
shareholders of both Multicorp and Unicorp.
Note that the transfer of wealth from Multicorp's creditors to its shareholder is only with respect to the existing
debt. After the spill-off, lenders would require an interest-rate premium that is large enough to compensate them for the
risk of default.
17.3 INVESTING IN REAL OPTIONS
To this point we have ignored an extremely important aspect of many (if not most) corporate investment
opportunities-the ability of managers to delay the start of project, or once started, to expand it or to abandon it. Failure
to take account of these real options (as contrasted with financial options) will cause an analyst evaluating the project to
underestimate its NPV.
The movie industry provides a good example of the importance of real-option values in evaluating investment
projects. Often a movie studio will buy the rights to a movie script and then wait to decide if and when to actually
produce it. Thus, the studio has the option to wait. Once production starts, and at every subsequent step in the process,
the studio has the option to discontinue the project in response to information about cost overruns or changing tastes of
the movie-going public.
Another very important managerial option in the movie business is the option of the film studio to make
sequels. If the original movie turns out to be a success, then the studio has the exclusive right to make additional
movies with the same title and characters. The option to make sequels can be a significant part of a movie project's
total value.
There is a fundamental similarity between the options in investment projects and call options on stocks: In both
cases the decision maker has the right but not the obligation to buy something of value at a future date.
Recognizing the similarity between call options and managerial options is important for three reasons:
· It helps in structuring the analysis of the investment project as a sequence of managerial decisions over time.
· It clarifies the role of uncertainty in evaluating projects.
· It gives us a method for estimating the option value of projects by applying the quantitative models developed for
valuing call options on stocks.
17.3.1 An Example
An example may help to clarify how the analogy between call options and managerial options can help in
analyzing an investment project. Consider a film studio's decision about whether to purchase the movie rights to a book
currently being written by a best-selling author.
Assume the author charges $1million for the exclusive right to make a movie out of her novel that is scheduled
for publication a year from now. If the novel is a success as a book, then the film studio will make a movie out of it, but
if the book is a commercial failure the studio will not exercise its right to make it into a movie. Figure 17.1shows this
investment project as a decision tree.
The studio's current decision is whether to pay the $1 million price the author demands. This is represented by a
decision box at the bottom of the tree. The top branch coming out of the first decision box corresponds to a decision to
pay the $1million for the movie rights and the right branch to a decision not to pay the $1 million.
The circle attached to the upper decision branch represents an event not under the control of management:
whether the book is a commercial success. There are two branches coming out of this event circle: The upper branch
corresponds to the possibility that the novel is a success, and the lower branch to the possibility that the novel is a
failure. Each has a probability of .5. Analysts at the studio estimate that if the book is a success, then the NPV of the
movie a year from now will be $4 million. If, however, the book is a failure then the NPV of the movie a year from
now will be -$4 million.
Note that attached to the right side of each branch extending from the event circle is another decision box
representing the decision management must make about whether to actually produce the movie. If the project were
analyzed without taking account of management's ability to abandon it a year from now, then the project would be
rejected. This is because the project's expected present value today would be zero at any cost of capital no matter how
low. Management would surely not spend $1million to buy the rights to make a movie that has an expected present
value of zero.
But this is a misspecification of the investment opportunity. Because management has the right and not the
obligation to make the movie, the possible payoffs a year from now are an NPV of $4 million if the book turns out to
be a success and an NPV of 0 if the novel is a failure. This payoff distribution has an excepted value of $2 million. As
long as the cost of capital used to discount this $2 million expected NPV to the present is less than 100% per year, the
project’s expected present value will exceed the $1 million cost of the movie rights to the book. Thus, we see that it is
extremely important in structuring the analysis of the project to take account of management's ability to change course
in the future.
We also learn something about the impact of uncertainty on the project's NPV from thinking about it in terms of
options. For example, suppose the range of possible future NPVs doubled whereas the expected value remained O: $8
million if the book is a success and -$8 million if it is a failure. Because management will not make the movie if the
book is a failure, the worst possible outcome is still only 0 and not -$8million. Because management will choose to
abandon the project if the book turns out to be a failure, the expected NPV a year from now increases from $2million to
$4 million. Thus, the project's expected NPV doubles as a result of the doubling in the range of possible future
outcomes. In this sense, an increase in the uncertainty about the project's future payoffs increases its value.
How important is the value of managerial options as a component of an investment project's total value? The
answer depends on the type of project, but it is difficult to think of any investment project where management has no
discretion to alter its plans once the project has begun. It is especially important to take option value into account when
considering investments in research and development. The use of the financial theory of options in capital budgeting
has been adopted by at least one large pharmaceutical company (see Box 111).I n general, the greater the uncertainty
about future outcomes of the project, the greater the need to account explicitly for any options.
17.3.2 Applying the Black-Scholes Formula to Value Real Options
Now that we have recognized the importance of taking account of the option value in investment opportunities,
how do we quantify that value? One way is to apply the Black-Scholes formula.
For example, suppose that a firm, Rader Inc., is considering acquiring another firm, Target Inc. Let us assume
they are both 100% equity-financed firms; that is, neither firm has any debt outstanding. Each firm has 1 million shares
of common stock outstanding that can be freely bought and sold in a competitive market. The current market value of
Target's assets is $100 million and the standard deviation of the proportional change in its value is20. Suppose that
Target's management offers Rader an option to acquire 100% of Target's shares a year from now for $106 million. Um
riskless interest rate is 6%per year.
If the option costs $6 million, is the investment worthwhile?
From Rader's perspective this is a capital budgeting decision. The initial outlay is the $6 million cost of the
option to acquire Target's assets a year from now. To determine the value of this option we can use the same valuation
models developed in chapter 15to price a European call option on a stock. Applying the Black-Scholes formula:
C N (d1 ) S N (d 2 ) Ee rT
ln( S / E ) (r 2 / 2)T
d1
T
d 2 d1 T
where
C=price of the option
S=price of the stock
E=exercise price
T=time to maturity of the option in years
σ =standard deviation of the annualized continuously compounded rate of return on the stock
Option Price Calculation Table
S E r T d σ Result
100 106 .05 1 0 .2 C = $8 million
The value of the option is approximately $8 million. The NPV of the investment opportunity is $2 million-the
option's value to Rader less its $6 million cost-SO it is worthwhile.
Now let us consider how option theory can help to evaluate an investment opportunity that does not involve the
explicit purchase of an option but does contain a managerial option. Suppose Electro Utility has the opportunity to
invest in a project to build a power-generating plant. In the first phase an initial outlay of $6 million is required to build
the facility to house the equipment. In the second phase, one year from now, equipment costing $106 million must be
purchased. Suppose that viewed from today's perspective the value of the completed plant a year from now is a random
variable with a mean of $112 million and a proportional standard deviation of .2.
Suppose that we do a conventional DCF analysis of this investment opportunity. At a discount rate of k, the
present value of the completed plant is$112 million/(1+k).Because the $106 million investment out lay for
power-generating equipment is known for certain, its present value is computed by discounting at the riskless rate. If
that rate is 6%, then the present value of the outlay is $100 million. In addition, the initial outlay to build the facility is
$6minion.Thus,the project's NPV is given by
NPV=$112 million/(1+k) - $100 million - $6 mill10n
=$112 million/(1+k) - $106 million
The NPV of the project so computed will be negative for any k greater than 5.66%, which is even less than the
riskless rate of interest. For example, if the k is 12%, then the present value of the completed plant is $100 million, and
the project’s computed NPV is-$6.O million.
But to do this is to ignore the important fact that management has the right to abandon the project a year from
now. In other words, management will invest an additional $106 million in the second stage of the project only if the
value of the plant a turns out to be more than $106 minion.
How can we evaluate this investment taking management's flexibility into account? The answer is that we can
apply the same method we just applied in evaluating Rader Inc.’s option to buy Target Inc. Although the circumstances
are somewhat different, the two situations have the same structure and even the same payoffs.
To see this, note that by undertaking the first phase of the project, Electro Utility would in effect be paying $6
million to “buy an option” that will mature in one year. The option is to undertake phase two of the project, and its
“exercise price” is $106 million. The present value of the completed project is $100 million.
The Black-Scholes formula says that this option is worth approximately $8 million. The project, therefore, has
a positive NPV of $2million instead of the negative NPV computed when we ignored management's option to
discontinue the project after the first year.
Our conclusion is that taking management's flexibility explicitly into account increases a project's NPV
Moreover, from the theory of option pricing; we know that the value of flexibility increases with the volatility of the
project.
Again, consider the example of Electro Utility .Suppose that the value of the power-generating plant is actually
more volatile than was at first thought. Instead of the standard deviation being .20, suppose it is .40. This makes the
investment project more attractive. Applying the Black-Scholes formula, we find that the option value is now
$16million-me project's NPV is, therefore, $10minion, rather than the $2 million computed earlier.
Virtually all future investment opportunities can be viewed as call options because firms can almost always wait
before making their initial outlay and can decide not to proceed with it. The amount of time the firm can wait is
analogous to the option's time to expiration; the initial outlay is analogous to the exercise price; and the present value of
the project's expected future cash flows is analogous to the price of the underlying stock-me project's conventionally
computed NPV is, thus-analogous to the option's intrinsic value, that is, what it would be worth if it were expiring
immediately. Conventional NPV understates the value of the project because it ignores the option's time value.
Summary
There are three valid reasons for a merger or acquisition:(1) to reduce operating costs through synergies, (2) to
reduce taxes, and (3) to take advantage of bargains in the stock market.
Diversification of risk is a poor reason for two firms to merge, because in general shareholders can diversify their
portfolios on their own; they do not need the firm to do it for them.
An extremely important feature of investment projects is the ability of managers to delay the start of a project, or
once started, to expand it or to abandon it Failure to take account of these management options will cause an
analyst evaluating the project to underestimate its NPV.
Recognizing the similarity between financial options and real managerial options is important for three
reasons:(1)It helps in structuring the analysts of the investment project as a sequence of managerial decisions over
time,(2)it clarifies the role of uncertainty in evaluating projects, and,(3)it gives us a method for estimating the
option value of projects by applying the quantitative models developed for valuing call options on stocks
