Lecture 12
Allocating Capital and Corporate Strategy
The LG Group
Started a cosmetic
cream factory in the
late 1940s
Start a plastic business to produce
•plastic caps
•combs,
•toothbrushes,
•and soap boxes
A tanker-shipping
company
LuckyGoldstar
group
Largest
insurance
company in
Korea
Financial Markets and Corporate Strategy, David Hillier
Manufacture electrical and
electronic products and
telecommunication
equipment
Advanced valuation techniques
Real options • Refers to the application of the derivatives
valuation methodology introduced in Chapters 7
approach
and 8 to value real assets.
Ratio
• Values an investment at approximately the same
ratio of value to a salient economic variable as an
comparison
existing comparable investment for which the
approach
same ratio is observable.
Competitive • Attributes positive net present value to any
project of a firm that can identify its competitive
analysis
advantages and a negative NPV to any project
approach
where competitors have the advantages.
Financial Markets and Corporate Strategy, David Hillier
Sources of positive net present value
•Competitive advantage
Barriers to entry
Economies of scale
Economies of scope
•Economies of Scope, Discounted Cash Flow, and Options
•Option Pricing Theory as a Tool for Quantifying Economies of
Scope
Result 12.1
New opportunities for a firm often arise as a result of information and
relationships developed in its past investment projects. Therefore, firms
should evaluate investment projects on the basis of their potential to generate
valuable information and to develop important relationships, as well as on the
basis of the direct cash flows they generate.
Financial Markets and Corporate Strategy, David Hillier
Valuing Strategic Options with the Real
Options Methodology
Exhibit 12.1 Cash Flows of Forward Contracts to Exchange Qt Units of Copper for Cash at
Future Date t
Financial Markets and Corporate Strategy, David Hillier
Example 12.1: Valuing a Gold Mine
AngloGold Ashanti, a South African mining firm, own the Geita Gold Mine in the North of Tanzania. The mine,
which was commissioned in 2000, has a total 8.474 million ounces of gold (source: AngloGold Ashanti
Tanzania report). Although in a normal year between 300,000 and 600,000 ounces are extracted, for the
purposes of this example assume that all the gold will be extracted in year 1 (2.474 million ounces) and year
2 (6 million ounces). The most recent year’s extraction costs were $497/oz, however this is exceptionally
high because of an unusual combination of drought followed by extremely heavy rains in the Mwanza region
of Tanzania where the Geita Gold Mine is situated. A more appropriate estimate of extraction costs is
$275/oz which is roughly equal to the average costs in 2004 and 2005. The current forward prices are $851
per ounce for a one-year contract and $900 per ounce for a two-year contract. The annually compounded
risk-free rates are 3.75 percent for one-year zero-coupon bonds and 4 percent for two-year zero-coupon
bonds.
What is the present value of the cash flows from the mine, assuming that payments for the mined gold are
received at the end of each year?
Answer:
$851(2.474million)  $275(2.474million) $900(4million)  $275(6million)

1  .0375
(1  .04) 2
 $4.841billion
Mine value 
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.2 Future Cash Flows and Current Costs
of Geita Gold Mine versus Portfolio of Forward
Contracts and Zero-Coupon Bonds
F1 = Year 1 forward price $851 per ounce
F2 = Year 2 forward price $900 per ounce
Cost
Investment
Cash Flow
Beginning of First
End of First Year
Year
Geita Gold Mine
PV Unknown
2.474 (p1  $275)
a. Forward contract to buy 2.474
million ounces of gold at
$0
2.474 (p1  $851)
beginning of year 1
b. Forward contract to buy 6
million ounces of gold at
beginning of year 2
c. Buy zero-coupon bonds;
Maturity  year 1 Face amount
= $2.474 (851  275)
d. Buy zero-coupon bonds;
Maturity = year 2
Face amount = $6(900  275)
Total: a + b + c + d
Cash Flow
End of Second Year
6 (p2  $275)
$0
$0
$0
6(p2  $900)
$2.474(851  )
1.0375
$2.474(851  275)
$0
$0
$6 (900  275)
$2.474 (p1  $275)
$6 (p2  $275)
$6(900  
1.042
$4.841 billion
Financial Markets and Corporate Strategy, David Hillier
Valuing a Mine with an Abandonment Option- A
Binomial Illustration of the Brennan-Schwartz Method
Exhibit 12.3 Payoffs of a Gold Mine with a Shutdown
Option
The equation that the same tracking portfolio also yields $5.296 billion if gold prices are high is
x($900  $851) + y (1.0375) = $5.296 billion
Simultaneously solving the equations for scenarios 1 and 2 gives the tracking portfolio
x = 15,175,501 ounces of gold received from a one-year forward contract
y = $4.388 billion invested in zero-coupon bonds
The value of this tracking portfolio is $4.388 billion. Therefore, the gold mine must also have a value of $4.388 billion.
Financial Markets and Corporate Strategy, David Hillier
Valuing a Mine with an Abandonment
Option - continue
•Practical Considerations
•Risk-Neutral Valuation
•Exchange Options and Volatility
•Generalizing the Real Options Approach to Other Industries
Result 12.2
A mine can be viewed as an option to extract (or purchase)
minerals at a strike price equal to the cost of extraction. Like a
stock option, the option to extract the minerals has a value that
increases with both the volatility of the mineral price and the
volatility of the extraction cost.
Financial Markets and Corporate Strategy, David Hillier
Valuing Vacant Land - Exhibit 12.4
Binomial Trees for Land Valuation
Financial Markets and Corporate Strategy, David Hillier
Valuing Vacant Land - Exhibit 12.4
Binomial Trees for Land Valuation
Financial Markets and Corporate Strategy, David Hillier
Valuing Vacant Land - Exhibit 12.4
Binomial Trees for Land Valuation
Financial Markets and Corporate Strategy, David Hillier
Result 12.3
Vacant land can be viewed as an option to
purchase developed land where the
exercise price is the cost of developing a
building on the land. Like stock options, this
more complicated type of option has a
value that is increasing in the degree of
uncertainty about the value (and type) of
development.
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.5 Cash Flows for Clacher’s
Brewery Timing Decision in Example 12.5
Financial Markets and Corporate Strategy, David Hillier
Result 12.4
Most projects can be viewed as a set of mutually
exclusive projects. For example, taking the
project today is one project, waiting to take the
project next year is another project, and waiting
three years is yet another project. Firms may
pass up the first project, that is, forego the
capital investment immediately, even if doing so
has a positive net present value. They will do so
if the mutually exclusive alternative, waiting to
invest, has a higher NPV.
Financial Markets and Corporate Strategy, David Hillier
Valuing the Option to Expand Capacity
Example 12.6: Valuing the Option to Increase a Brewery’s
Capacity
Clacher Industries is considering building another cider brewery. The
brewery will generate cash flows two years from now, as described in
Exhibit 12.6. The cash flows from the brewery will be £200 million
following two good years (point D), £150 million following one good
and one bad year (point E), and £100 million (point F) following two
bad years. The initial cost of the plant is £40 million (point A). After
one year, however, if the state of the economy looks good, the firm
has the option to double the plant’s capacity by investing another £140
million.
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.6 Cash Flows If There Is No
Capacity Change at Year 1
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.7 Cash Flows If Plant Capacity Is
Doubled at Good Node in Year 1
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.8 Market Portfolio Payoffs for Determining
Risk-Neutral Probabilities in Example 12.6
Financial Markets and Corporate Strategy, David Hillier
Valuing Flexibility in Production Technology:
The Advantage of Being Different
Example 12.7: The Effect of Capacity Expansion on the Choice to Be Different
The tree diagram in panel A of Exhibit 12.9 illustrates some of our assumptions,
namely:
1. In a good economy, the cost of producing refined sugar with sugarcane is €0.60 per
pound and the cost of using sugar beets is €0.54 per pound.
2. In a bad economy, the cost of producing refined sugar with sugarcane falls to €0.40
per pound. However, the demand for sugar beets is somewhat less cyclical than
sugarcane because it is not generally used to produce refined sugar. Thus, the cost
of producing refined sugar with sugar beets falls somewhat less to €0.50 per pound.
3. The risk-neutral probabilities associated with each of these two states of the
economy (seen next to the branches of the tree diagram in panel A of Exhibit 12.9)
are assumed to be .5.
4. The price of refined sugar is always €0.03 per pound greater than the cost of
production using sugarcane, which is reasonable because virtually all producers
use sugarcane as their input.
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.9 Production of Refined Sugar
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.9 Production of Refined Sugar
Financial Markets and Corporate Strategy, David Hillier
Exhibit 12.9 Production of Refined Sugar
Financial Markets and Corporate Strategy, David Hillier
The Ratio Comparison Approach
Result 12.5 (The Price/Earnings Ratio Method.)
The present value of the future cash flows of a project can be found
by (1) obtaining the appropriate price/earnings ratio for the project
from a comparison investment for which this ratio is known and (2)
multiplying the price/earnings ratio from the comparison investment
by the first year’s net income of the project. In a similar vein, a
company should adopt a project when the ratio of its initial cost to
earnings is lower than the price to earnings ratio of the comparison
investment. (Alternative ratio comparison methods simply substitute a
different economic variable for earnings.)
Financial Markets and Corporate Strategy, David Hillier
The Ratio Comparison Approach
Result 12.6
The price/earnings ratio of a portfolio of stocks 1 and 2 is a weighted
average of the price/earnings ratios of stocks 1 and 2, where the
weights are the fraction of earnings generated, respectively, by stocks
1 and 2. Algebraically
P  w P1  w P2
1
2
NI
NI 1
NI 2
where
P/NI = price/earnings ratio of the portfolio
Pi /NIi = price/earnings ratio of stock i (i = 1 or 2)
wi = fraction of portfolio earnings from stock i
Financial Markets and Corporate Strategy, David Hillier
Example 12.8: Price/Earnings Ratio
Comparisons with Multiple Lines of Business
Ford is considering the opportunity to enter the European passenger bus market.
Assume that General Motors (GM) currently produces similar buses from which it
realizes 10 percent of its earnings. The rest of GM’s cash flows come from
automobile lines that are essentially the same as Ford’s.
If GM’s price/earnings ratio is 11.07, and if the price/earnings ratio of its automobile
division is (as seems reasonable) assumed to be the same as the price/earnings ratio
of Ford, which is 11.2, what is the implied price/earnings ratio for the bus division?
Answer: Ninety percent of GM’s earnings have a price/earnings ratio of 11.2, 10
percent of the earnings have a price/earnings ratio of x, and the total GM value is
11.07 times the company’s total earnings. Viewing GM as a portfolio of a pure
automobile business and a pure bus business, and applying Result 12.6, implies that
x must solve
.9(11.2) + .1x = 11.07
Thus, x = 9.9.
Financial Markets and Corporate Strategy, David Hillier
The Effect of Earnings Growth and Accounting
Methodology on Price/Earnings Ratios
•The Effect of Leverage on Price/Earnings Ratios
Result 12.7
Assume the market value of the firm’s assets is unaffected by its leverage
ratio. Also assume that all debt is risk free. Then, if the ratio of price to
earnings of an all-equity firm is larger than 1/rD, where rD is the interest rate on
the firm’s (assumed) risk-free perpetual debt, then an increase in leverage
increases the price/earnings ratio. If the price/earnings ratio of an all-equity
firm is less than 1/rD, then the increase in leverage lowers the price/earnings
ratio of the firm
•Adjusting for Leverage Differences
Financial Markets and Corporate Strategy, David Hillier
The Competitive Analysis Approach
Result 12.8
(The Competitive Analysis Approach.) Firms in a competitive market should
realize that they can only achieve a positive NPV from a project if they have
some advantage over their competitors. When other firms have competitive
advantages, the project has a negative NPV.
•Determining a Division’s Contribution to Firm Value
•Disadvantages of the Competitive Analysis Approach
Financial Markets and Corporate Strategy, David Hillier
When to Use the Different Approaches
•Valuing Asset Classes versus Specific Assets
•Tracking Error Considerations
•Other Considerations
Financial Markets and Corporate Strategy, David Hillier
Thank You