The Smith Company: a case on capital budgeting and real options

The Smith Company: a case on capital budgeting and real options 1. Introduction The Smith Company, an energy technology company, has grown over the years through its internal operations, as well as through acquisitions. Most of these endeavors have been very successful, but more recently the Board of Directors (BOD) of Smith has begun to question why the senior managers of Smith did not acquire some companies that, ex post, would have been very profitable. Michelle Roe, the Chief Financial Officer of Smith, explained that the company's long- standing policy on capital budgeting is to evaluate proposed investments using the net present value (NPV) decision model. Generally speaking, projects that have a positive expected NPV are accepted under the presumption that such projects add to shareholder value. In the cases of the acquisition targets to which the BOD was referring the projected NPVs were not large enough to make the investments worthwhile ex ante. After hearing this explanation from Michelle, Jerry Monter, the Chairman of the BOD, responded with the statement that if NPV had led the company to pass up on a number of valuable investment opportunities, were there better approaches for assessing the values of potential acquisition targets? Specifically, he suggested that the problem with the current NPV approach may be that some key information is systematically omitted from consideration. He also stated that he had read recently that for proposed investments characterized by significant risk and uncertainty a conventional NPV analysis may undervalue a project, and that in these situations the application of a real-options valuation approach would make more sense. Michelle agreed that she would have one of her controllers, Carolyn Dow, look in to this and report back to the BOD at next month's meeting 2. Industry background Demand for energy conservation products and services has escalated over the past few years for several reasons. More companies and individuals have become focused on the need to protect the environment. In terms of performance, escalating energy costs have affected the operating income and therefore realized investment returns) of many companies. As a result, more companies are considering the use of alternative energy sources (eg, solar panels, wind energy technology, ethanol) to meet their energy requirements and to control energy-related costs. Further, the demand for these products has influenced the entry of more firms to the market. While the additional demand for products and support is to some extent offset by increased competition in this area, the overall impact on energy firms has been unclear. As a company with a history of products and services in this field, Smith has experienced ebbs and flows in its bottom line due to the changing nature of the energy market, on both the supply and the demand side. One particularly important force that has been generating a lot of concer in the energy industry is the uncertainty associated with technology that will become available in the next few years for improvements in efficiency. One manifestation of this increased uncertainty has been the significant differences in future growth forecasts provided by various industry analysts. It has also been pointed out that the market price of stocks of energy technology companies seem to be deviating significantly from estimated values based on forecasted after-tax cash flows. In the minds of some experts, this situation is very similar to what the markets faced in the 1990s with technology companies like Amazon, Google, and Yahoo, where traditional valuation techniques yielded estimated share values that were significantly below market-based stock prices. In large part, this discrepancy between predicted and actual market price was attributable to the fact that the cash-flow-based valuation models ignored the value of significant growth options available to these companies. Based on these arguments, a number of leaders in the energy technology industry were suggesting that companies such as Smith investigate alternate valuation techniques to properly account for the value of the growth and/or flexibility options that could potentially be exploited by the company in the future. 3. An acquisition proposal Carolyn identified potential revenues and costs related to the purchase of the Jones Company the project currently under consideration. She wanted to present to the board a traditional discounted cash-flow (DCF) analysis that focused on the estimated NPV of this acquisition. But, she also wanted to present an analysis of this investment proposal based on the use of a real-options valuation model that, she thought, would incorporate the estimated value of any growth or flexibility options embedded in this proposed investment The data that were generated to complete the traditional DCF analysis are shown in Table I. The revenues and expenses are expected to increase by 10 percent each year for years 2 and 3 (with the exception of depreciation and amortization, which will not change). From the third year on the growth in ather-tax cash flow for the acquisition target is expected to be 5 percent into perpetuity. The investment bunkers hired by Joncs had citablished an asking price of $2.5 million. Table 1 Year 1 Revenues Cost of goods sold (excluding depreciation) Depreciation of manufacturing equipment and plant Operating expenses (excluding depreciation and amortization) Depreciation and amortization office equipment (straight-line basis) Income tax rate (combined federal and state) $450,000 $200,000 S120,000 $75,000 $15,000 40 percent Based on advice from an expert consultant who had experience with similar acquisitions in the past, Carolyn estimated that the growth in revenues would likely be normally distributed with a volatility (1.9. dispersion) of 25 percent. Similarly, she has estimated that the growth rate for costs would be approximately normally distributed with a volatility of 15 percent. She has also assumed that the growth rate for costs and the growth rate for revenues would be negatively correlated, at 220 percent The risk-adjusted discentrate the weighted average, after-tax cost of capital for one is med to be 13.18 percent for valuation purposes that the risk-free les 5 percent for all mounties Of course, sitivity analyses can be performed to determine the sensitivity of the decision model to these assumed at Carolyn pondered about flexibilities or growth options that might be embedded in this potential acquisition. For example, because there was considerable uncertainty regarding the cash flow projections, Carolyn felt that Smith Company should consider delaying the acquisition by two yeurs. If the acquisition were delayed, she estimated that at that time Smith would have to pay $3 million for Jones, the acquisition target. Alternatively, she thought that if the acquisition were made today, Smith could become more informed about Jones's operations and prospects over the next three ycars and could therefore, at some future point, either expand or contract the operations of the target. If the Jones Company were purchased today, Carolyn thought that three years hence Smith might be able to expand capacity and after-tax cash flow by 50 percent, at an end-of-year three cost of $0.8 million Similarly, three years from now, Smith could cut back 30 percent of capacity, with an estimated after-tax cash flow from disposal of assets of S0.5 million Carolyn is now faced with the decision to value this project for the purpose of presenting it to the BOD. She wonders whether the proposed acquisition would be desirable if analyzed on the basis of a traditional DCF (1.c. NPV) approach. She also wondered about how she could incorporate into the analysis the various options described above. Finally, she wondered about the sensitivity of her recommendation with respect to the assumptions she made in conjunction with her evaluation of the proposed acquisition 4. Case requirements 1. Define the term "real options" and draw a contrast to "financial options." In what sense does the existence of real options add value to a proposed investment project? 2. Provide an overview of the major types of real options that can be embedded in capital investment projects 3. Distinguish between a traditional DCF analysis of a capital expenditure proposal (cg. NPV) and a real-options analysis of that same proposal 4. On the basis of the data provided in the case: What is the estimated NPV of the acquisition that Smith Company is considering? . On the basis of your analysis, is the acquisition desirable? Why or why not? How sensitive is your recommendation to the assumption regarding the volatility of returns? For each investment alternative, calculate the estimated NPV under each of the following assumed project-retum volatilities: 89.75,70,50 and 30 percent. Are the results you obtain expected? What can you conclude based on this analysis? The Smith Company: a case on capital budgeting and real options 1. Introduction The Smith Company, an energy technology company, has grown over the years through its internal operations, as well as through acquisitions. Most of these endeavors have been very successful, but more recently the Board of Directors (BOD) of Smith has begun to question why the senior managers of Smith did not acquire some companies that, ex post, would have been very profitable. Michelle Roe, the Chief Financial Officer of Smith, explained that the company's long- standing policy on capital budgeting is to evaluate proposed investments using the net present value (NPV) decision model. Generally speaking, projects that have a positive expected NPV are accepted under the presumption that such projects add to shareholder value. In the cases of the acquisition targets to which the BOD was referring the projected NPVs were not large enough to make the investments worthwhile ex ante. After hearing this explanation from Michelle, Jerry Monter, the Chairman of the BOD, responded with the statement that if NPV had led the company to pass up on a number of valuable investment opportunities, were there better approaches for assessing the values of potential acquisition targets? Specifically, he suggested that the problem with the current NPV approach may be that some key information is systematically omitted from consideration. He also stated that he had read recently that for proposed investments characterized by significant risk and uncertainty a conventional NPV analysis may undervalue a project, and that in these situations the application of a real-options valuation approach would make more sense. Michelle agreed that she would have one of her controllers, Carolyn Dow, look in to this and report back to the BOD at next month's meeting 2. Industry background Demand for energy conservation products and services has escalated over the past few years for several reasons. More companies and individuals have become focused on the need to protect the environment. In terms of performance, escalating energy costs have affected the operating income and therefore realized investment returns) of many companies. As a result, more companies are considering the use of alternative energy sources (eg, solar panels, wind energy technology, ethanol) to meet their energy requirements and to control energy-related costs. Further, the demand for these products has influenced the entry of more firms to the market. While the additional demand for products and support is to some extent offset by increased competition in this area, the overall impact on energy firms has been unclear. As a company with a history of products and services in this field, Smith has experienced ebbs and flows in its bottom line due to the changing nature of the energy market, on both the supply and the demand side. One particularly important force that has been generating a lot of concer in the energy industry is the uncertainty associated with technology that will become available in the next few years for improvements in efficiency. One manifestation of this increased uncertainty has been the significant differences in future growth forecasts provided by various industry analysts. It has also been pointed out that the market price of stocks of energy technology companies seem to be deviating significantly from estimated values based on forecasted after-tax cash flows. In the minds of some experts, this situation is very similar to what the markets faced in the 1990s with technology companies like Amazon, Google, and Yahoo, where traditional valuation techniques yielded estimated share values that were significantly below market-based stock prices. In large part, this discrepancy between predicted and actual market price was attributable to the fact that the cash-flow-based valuation models ignored the value of significant growth options available to these companies. Based on these arguments, a number of leaders in the energy technology industry were suggesting that companies such as Smith investigate alternate valuation techniques to properly account for the value of the growth and/or flexibility options that could potentially be exploited by the company in the future. 3. An acquisition proposal Carolyn identified potential revenues and costs related to the purchase of the Jones Company the project currently under consideration. She wanted to present to the board a traditional discounted cash-flow (DCF) analysis that focused on the estimated NPV of this acquisition. But, she also wanted to present an analysis of this investment proposal based on the use of a real-options valuation model that, she thought, would incorporate the estimated value of any growth or flexibility options embedded in this proposed investment The data that were generated to complete the traditional DCF analysis are shown in Table I. The revenues and expenses are expected to increase by 10 percent each year for years 2 and 3 (with the exception of depreciation and amortization, which will not change). From the third year on the growth in ather-tax cash flow for the acquisition target is expected to be 5 percent into perpetuity. The investment bunkers hired by Joncs had citablished an asking price of $2.5 million. Table 1 Year 1 Revenues Cost of goods sold (excluding depreciation) Depreciation of manufacturing equipment and plant Operating expenses (excluding depreciation and amortization) Depreciation and amortization office equipment (straight-line basis) Income tax rate (combined federal and state) $450,000 $200,000 S120,000 $75,000 $15,000 40 percent Based on advice from an expert consultant who had experience with similar acquisitions in the past, Carolyn estimated that the growth in revenues would likely be normally distributed with a volatility (1.9. dispersion) of 25 percent. Similarly, she has estimated that the growth rate for costs would be approximately normally distributed with a volatility of 15 percent. She has also assumed that the growth rate for costs and the growth rate for revenues would be negatively correlated, at 220 percent The risk-adjusted discentrate the weighted average, after-tax cost of capital for one is med to be 13.18 percent for valuation purposes that the risk-free les 5 percent for all mounties Of course, sitivity analyses can be performed to determine the sensitivity of the decision model to these assumed at Carolyn pondered about flexibilities or growth options that might be embedded in this potential acquisition. For example, because there was considerable uncertainty regarding the cash flow projections, Carolyn felt that Smith Company should consider delaying the acquisition by two yeurs. If the acquisition were delayed, she estimated that at that time Smith would have to pay $3 million for Jones, the acquisition target. Alternatively, she thought that if the acquisition were made today, Smith could become more informed about Jones's operations and prospects over the next three ycars and could therefore, at some future point, either expand or contract the operations of the target. If the Jones Company were purchased today, Carolyn thought that three years hence Smith might be able to expand capacity and after-tax cash flow by 50 percent, at an end-of-year three cost of $0.8 million Similarly, three years from now, Smith could cut back 30 percent of capacity, with an estimated after-tax cash flow from disposal of assets of S0.5 million Carolyn is now faced with the decision to value this project for the purpose of presenting it to the BOD. She wonders whether the proposed acquisition would be desirable if analyzed on the basis of a traditional DCF (1.c. NPV) approach. She also wondered about how she could incorporate into the analysis the various options described above. Finally, she wondered about the sensitivity of her recommendation with respect to the assumptions she made in conjunction with her evaluation of the proposed acquisition 4. Case requirements 1. Define the term "real options" and draw a contrast to "financial options." In what sense does the existence of real options add value to a proposed investment project? 2. Provide an overview of the major types of real options that can be embedded in capital investment projects 3. Distinguish between a traditional DCF analysis of a capital expenditure proposal (cg. NPV) and a real-options analysis of that same proposal 4. On the basis of the data provided in the case: What is the estimated NPV of the acquisition that Smith Company is considering? . On the basis of your analysis, is the acquisition desirable? Why or why not? How sensitive is your recommendation to the assumption regarding the volatility of returns? For each investment alternative, calculate the estimated NPV under each of the following assumed project-retum volatilities: 89.75,70,50 and 30 percent. Are the results you obtain expected? What can you conclude based on this analysis