Session 24: Distressed Equity as an Option and Acquisition Valuation

Here's a comprehensive summary of the YouTube video transcript, maintaining the original language and technical precision:

Key Concepts

Real Options: The application of option pricing theory to real-world investment decisions, such as the option to delay, expand, or abandon a project.
Financial Flexibility: The ability of a company to adapt to changing circumstances, often by maintaining excess debt capacity.
Optimal Capital Structure: The mix of debt and equity that minimizes a company's cost of capital.
Equity as a Call Option: The concept that equity in a publicly traded company, due to limited liability and residual claims, can be viewed as a call option on the firm's assets.
Distressed Equities: The equity of companies facing financial difficulties, which can be analyzed using option pricing models.
Mergers and Acquisitions (M&A): The process of combining companies, with a critical examination of its value creation and destruction.
Synergy: The concept that the combined value of two entities is greater than the sum of their individual values.
Control Premium: The additional amount paid in an acquisition to gain control of a target company.

Real Options in Capital Budgeting and Capital Structure

The discussion begins by revisiting the three embedded options in capital budgeting: the option to delay, expand, and abandon. The option to abandon is highlighted as a put option, providing flexibility to limit losses.

The lecture then extends the concept of flexibility to capital structure, particularly in the context of debt. While simple bonds are straightforward to value, complexities arise with features like caps, floors, and floating rates, which are often option applications. The focus shifts to the value of financial flexibility in capital structure decisions, especially when a company has excess debt capacity.

The Value of Financial Flexibility

Companies may choose to operate with a debt ratio below their optimal level, citing the value of financial flexibility. This flexibility allows them to:

Weather Recessions: Hold back debt capacity for uncertain economic downturns.
Seize Investment Opportunities: Fund unexpected, high-return projects or acquisitions.

However, the argument for financial flexibility is contingent on several factors:

Company Quality: Companies in good businesses are more likely to have valuable investment opportunities. Companies in bad businesses may not benefit from flexibility as there are no good investments.
Capital Constraints: Flexibility is most valuable when a company faces capital constraints. This can occur if the company is small and capital markets are not amenable, or if it's a large company that wishes to avoid equity dilution by issuing shares.

Valuing Financial Flexibility as an Option

The lecture proposes structuring financial flexibility as an option. The normal reinvestment needs of a company are treated as the strike price. If actual reinvestment needs exceed this strike price, excess debt capacity (the option) allows the company to fund these projects. The cost of the option is the higher cost of capital incurred by not being at the optimal debt ratio.

Case Study: Disney (1997)

Actual Debt Ratio: 18%
Optimal Debt Ratio: 40%
Cost of Capital at Actual Ratio: 12.22%
Cost of Capital at Optimal Ratio: 11.64%
Annual Cost of Not Being Optimal: 58 basis points (0.58%)

To quantify the value of flexibility, a simplified option pricing model is applied:

S (Actual Reinvestment Needs): 5.3% of firm value (average of net capex and change in working capital over 5 years).
Sigma (Standard Deviation of Reinvestment Needs): 375 (standard deviation of the natural log of year-to-year changes).
Strike Price (Internal Cash Flow Generation): 4.8% of firm value.

The calculated option pricing value of flexibility for Disney was 1.6092%. After considering the excess return Disney earned (6.47% over cost of capital), the annual value of flexibility was estimated at 0.85% of firm value. Since 0.85% > 0.58%, the argument for Disney being underlevered due to flexibility is supported.

Implications for Valuing Financial Flexibility:

Capital Constraints: More capital-constrained companies value flexibility more.
Company Size: Small companies value flexibility more than large companies.
Ownership Structure: Private businesses value flexibility more than public companies due to limited access to capital markets.
Market Development: Companies in emerging markets value flexibility more than those in developed markets.
Unpredictability of Reinvestment Needs: Companies with volatile reinvestment needs value flexibility more.
Business Quality: Companies in good businesses have a stronger case for valuing financial flexibility.

Equity as a Call Option

The lecture then shifts to viewing equity in a publicly traded company as a call option. This perspective is driven by two key features:

Limited Liability: Shareholders cannot lose more than their initial investment.
Residual Claim: Equity holders receive whatever is left after all other claims (debt holders) are satisfied.

Valuing Distressed Equities

This framework is particularly useful for valuing distressed equities.

Simplified Example:

Firm Asset Value (S): $100 million
Standard Deviation of Firm Value (Sigma): 40%
Debt: One 10-year zero-coupon bond with a face value (K) of $80 million.
Time to Maturity (T): 10 years
Risk-Free Rate: 10%

Using an option pricing model (similar to Black-Scholes), the equity value is calculated as $75.94 million. The implied interest rate on the debt is 12.77% (a default spread of 2.77%).

Key Insights from the Model:

Bankruptcy Probability: Calculated as 1 - N(d2), which is approximately 37% in this example. This aligns with the methodology used by companies like KMV to estimate default probabilities.
Resilience of Equity: Even when the firm's value drops significantly (e.g., to $5 million), equity can retain value as long as there is time and hope for a turnaround. This is because equity holders are not obligated to pay off the debt if the firm's value is insufficient.
Importance of Volatility: Volatility is crucial for the value of distressed equity. In stable firms, equity is less likely to have significant upside potential when distressed.
Time and Hope: The longer the maturity of the debt and the greater the uncertainty, the more valuable the equity option becomes.

Application to Real-World Scenarios:

Distressed Company Debt: Real-world distressed companies have complex debt structures (multiple issues, different maturities), making the "single zero-coupon bond" simplification challenging but necessary for initial modeling.
Estimating Inputs:
- Firm Value (S): Can be estimated from discounted cash flow (DCF) valuations of existing assets (excluding growth potential) or by summing market values of tradable assets.
- Variance in Firm Value: Can be estimated using industry averages for traded companies or by combining stock and bond price volatilities.
- Value of Debt (K): Can be approximated by replacing multiple debt issues with a single zero-coupon bond of equivalent value and duration.

Case Study: Euro Tunnel

Firm Value (DCF): £2.3 billion
Total Debt: £8.865 billion
Weighted Average Debt Duration (T): 10.93 years
Variance in Firm Value: 0.0335

Despite a firm value significantly lower than its debt, the option pricing model yielded an equity value of £122 million. This highlights how equity can retain value as an option even when intrinsic value models suggest zero.

Conflict of Interest: Equity vs. Lenders

The option perspective reveals conflicts between equity holders and lenders:

Equity Holders (Option Holders): Seek higher risk to increase the potential upside of their call option.
Lenders: Seek to be repaid and prefer lower risk.

Example: Taking a Negative NPV Project

A company with equity as a call option might take a risky, negative NPV project if it increases the firm's volatility. This can transfer wealth from lenders to equity holders. Banks lending to distressed companies must account for this by charging higher interest rates or having a say in management decisions.

M&A and the Option Perspective

The lecture critiques M&A, arguing that acquirers often overpay and fail to realize promised synergies. The option perspective offers insights:

Risk Transference: Acquirers may incorrectly assume they can make a target company safer.
Debt Subsidies: Acquirers with cheap debt may effectively subsidize target shareholders by overpaying.
Control Premium: The value of control should be based on the difference between the company run optimally and its current state, not an arbitrary percentage.
Synergy Valuation: Synergies must be rigorously valued, not used as a "plug variable" to justify premiums.

Synergy Valuation:

Synergy can be:

Operating Synergy: Economies of scale, cost savings, growth synergies (higher returns, higher reinvestment rates, sustainable excess returns).
Financial Synergy: Primarily tax-related (asset write-ups, NOL utilization, interest on capital in Brazil) or debt-related (increased borrowing capacity). Diversification is generally a poor reason for public company mergers but can be valid for private ones.

Valuing Synergy (Three-Step Process):

Value the acquirer and target as standalone entities.
Sum their standalone values.
Value the combined company with synergies incorporated.
The value of synergy is (Step 3) - (Step 2).

Critique of M&A Practices:

Acquirer Overpayment: Acquirers often pay too much upfront.
Unrealized Synergies: Promised synergies are frequently not delivered.
Process Bias: A systemic bias leads to many bad deals.
Lack of Accountability: Mistakes in M&A often go unpunished.

The lecture concludes by emphasizing that while real options are ubiquitous, their economic value depends on exclusivity. The mindset shift from viewing risk as a threat to an ally is a key takeaway from understanding real options.