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We document that firms decrease their leverage when they convert growth options into tangible assets. We argue that the act of growth option exercise decreases information asymmetry about the firm, which in turn reduces the relative cost of issuing information-sensitive securities such as equity. We show that leverage is negatively correlated with unexpected capital expenditure, our proxy for growth option conversion. The negative relationship becomes stronger when the information environment of a firm deteriorates following a reduction in analyst coverage after a brokerage house merger. Overall, our findings are contrary to standard trade-off and pecking order theories, but are consistent with recent work on signaling and growth options.
In this paper, we develop a structural model that captures the interaction between the cash balance and investment opportunities for a rm that already has some debt outstanding. We consider a rm whose assets produce a stochastic cash flow stream. The fi rm has an opportunity to expand its operations, which we call a growth option. The exercise cost of the growth option can be financed either by cash or costly equity issuance. In absence of cash, we derive implicit solutions for equity and debt prices when the option is exercised optimally, under both rm value and equity value maximization objectives. We characterize the optimal exercise boundary of the option, and its impact on the optimal capital structure and the debt capacity of the rm. Next, we develop a binomial method to investigate the interaction between cash accumulation and the growth option. In this framework, the fi rm optimally balances the payout of dividends with the buildup of a cash balance to finance the growth option in the "good states" (i.e., high asset value states), and to provide liquidity in the "bad states" (i.e., low asset value states). We provide a complete characterization of the firm's strategy in terms of its investment and dividend policy. We find that while the ability to maintain a cash balance does not add significant value to the rm in absence of a growth option, it can be extremely valuable when a growth option is present. Finally, we demonstrate how our method can be extended to firms with multiple growth options.
This dissertation, "Real Options, Portfolio Effects and Financial Structure: Theory and Evidence From Hong Kong Real Estate Companies" by Jianfu, Shen, 沈建富, was obtained from The University of Hong Kong (Pokfulam, Hong Kong) and is being sold pursuant to Creative Commons: Attribution 3.0 Hong Kong License. The content of this dissertation has not been altered in any way. We have altered the formatting in order to facilitate the ease of printing and reading of the dissertation. All rights not granted by the above license are retained by the author. Abstract: The aim of this research is to investigate corporate behavior, including investment and financing decisions, when corporations face uncertainty and flexibility/inflexibility, and to explore the effects of this behavior on real option valuation. It expands the real options analysis framework into two paths: the first is to add institutional details, portfolio aspects and financial structure into the classical real option model; the other is to extend the real option model into a firm valuation model with corporate investment and financing decisions. Two types of theoretical models are developed. The first set of theoretical models follows the framework of binomial option pricing. Three binomial option pricing models are constructed to represent real estate development in Hong Kong, in which developable land has different flexibility in accordance with covenants in typical land lease contracts. First, the firm may have contractually limited time to complete the development following conversion of urban fringe/agricultural land into commercial/residential land after paying a negotiable "land premium"; second, it may buy land from the market without development time constraints; or thirdly it may buy land at public auction also with contractual development time constraints. The three binomial models deal with the flexibility/inflexibility in these land development circumstances imposed by institutional arrangements. Interaction effects from cost-saving through co-development and potential price increases through agglomeration effects from co-location of multiple options are included in the binomial models. The financial structure of the firm is also seen to influence real option values, because capital structure could imply different capital costs in the exercise of the real options, which is ignored in traditional real option theory. In addition to the traditional factors in financial option pricing models, numerical examples show that interaction effects and capital structure influence real option values and their investment thresholds. The second set of theoretical models aims to value both real flexibility and financial flexibility dynamically and simultaneously. Financial flexibility in the firm, which is seen as an important factor in the capital structure decision, is itself seen as analogous to a real option in project valuation, as the firm can use some debt capacity to invest in the opportunity but still preserve unused capacity for future opportunities. The thesis argues that the firm owns the financial flexibility to adjust its debt through sale of its existing assets or to use these as loan collateral. The firm with more collateralizable assets would have larger debt capacity, use more debt and invest more through the flexible utilization of debt capacity. Two empirical tests are conducted to confirm the findings of the theoretical models, structured into three principal hypotheses: firstly, real option value is not only determined by embedded flexibility, but also by the existing corporate asset structure through interactions and the firm's ability to trade or collateralize its existing assets (properties); second, real option value and real option execution/investment is directly influenced by external financing decisions due to financial frictions and constraints; and thirdly, financial flexibility is expected to increase corpor
Renowned valuation expert Aswath Damodaran reviews the core tools of valuation, examines today’s most difficult estimation questions and issues, and then systematically addresses the valuation challenges that arise throughout a firm’s lifecycle in The Dark Side of Valuation: Valuing Young, Distressed and Complex Businesses. In this thoroughly revised edition, he broadens his perspective to consider all companies that resist easy valuation, highlighting specific types of hard-to-value firms, including commodity firms, cyclical companies, financial services firms, organizations dependent on intangible assets, and global firms operating diverse businesses. He covers the entire corporate lifecycle, from “idea” and “nascent growth” companies to those in decline and distress, and offers specific guidance for valuing technology, human capital, commodity, and cyclical firms. ·
We examine whether values of equity options traded on individual firms are sensitive to the firm's capital structure. Specifically, we estimate the compound option (CO) model, which views equity as an option on the firm. Compared to the Black-Scholes (BS) model, the CO model reduces pricing errors by 20% on average, and pricing improvements monotonically increase up to 70% with both leverage and expiration. We show that the CO model implies a market value of firm leverage and allows imputation of the firm's implied volatility, both of which have potential applications in corporate finance.
Corporate Payout Policy synthesizes the academic research on payout policy and explains "how much, when, and how". That is (i) the overall value of payouts over the life of the enterprise, (ii) the time profile of a firm's payouts across periods, and (iii) the form of those payouts. The authors conclude that today's theory does a good job of explaining the general features of corporate payout policies, but some important gaps remain. So while our emphasis is to clarify "what we know" about payout policy, the authors also identify a number of interesting unresolved questions for future research. Corporate Payout Policy discusses potential influences on corporate payout policy including managerial use of payouts to signal future earnings to outside investors, individuals' behavioral biases that lead to sentiment-based demands for distributions, the desire of large block stockholders to maintain corporate control, and personal tax incentives to defer payouts. The authors highlight four important "carry-away" points: the literature's focus on whether repurchases will (or should) drive out dividends is misplaced because it implicitly assumes that a single payout vehicle is optimal; extant empirical evidence is strongly incompatible with the notion that the primary purpose of dividends is to signal managers' views of future earnings to outside investors; over-confidence on the part of managers is potentially a first-order determinant of payout policy because it induces them to over-retain resources to invest in dubious projects and so behavioral biases may, in fact, turn out to be more important than agency costs in explaining why investors pressure firms to accelerate payouts; the influence of controlling stockholders on payout policy --- particularly in non-U.S. firms, where controlling stockholders are common --- is a promising area for future research. Corporate Payout Policy is required reading for both researchers and practitioners interested in understanding this central topic in corporate finance and governance.
Examines the ways in which real options theory can contribute to strategic management. This volume offers conceptual pieces that trace out pathways for the theory to move forward and presents research on the implications of real options for strategic investment, organization, and firm performance.
The first essay, "Why do firms issue convertible securities? New evidence on sequential financing" investigates the sequential-financing hypothesis on the use of convertible securities (Schultz, 1993a; Mayers, 1998). Examination of conversion-forcing calls of warrants reveals significant increases in investment and financing activity for the calling firms around the time of the call. While evidence of investment and financing increases subsequent to the call is consistent with the hypothesis, there is also evidence of increases prior to the call. Furthermore, the call signals a subsequent decline in firm performance. Calling firms experience significantly higher sales growth than industry medians prior to year of the call but become indistinguishable from them subsequent to the call. Similar findings have been reported for calls of convertible debt. Multivariate analysis does not provide evidence that investment growth in the year of the call is related to existing investment opportunities, controlling for call proceeds. Overall, our findings raise questions on the validity of the sequential-financing hypothesis. The second essay, "Corporate investment, market value, and book-to-market: An empirical investigation," examines the association between market value, book-to-market (B/M), and corporate investment. Firms assigned to big and low-B/M (B/L) portfolios significantly increase investment prior to the portfolio formation year. Their market values rise and their leverage levels diminish. Small and high-B/M (S/H) firms reduce investment and increase their market leverage. When we form portfolios based on investment growth (i.e., exercise of investment opportunities), average returns are significantly lower for high investment stocks. Within investment growth groups, there is weak evidence of a value premium. Furthermore, corporate investment growth is highly significant in cross-sectional and time-series regressions and contains information similar to that of B/M. This evidence is consistent with the model of Berk, Green, and Naik (1999), who relate exercise of growth options to firm-specific fundamentals and observed returns.
Presents in-depth, comparative analyses of German, UK and US company laws illustrated by leading cases, with German cases in English translation.