Financial valuation Applications and Models phần 10 pot

The option prices at each step are calculated using the option expira-Exhibit 23.13 Dividend Adjusted Black-Scholes Option Pricing Model The original formula for calculating the theoreti

I: Valuation Issues Related to Stock Options 919

more in tune with the real world These models are not only applicable to the ation of stock options but are used to value capital investments, intangible assets,and entire divisions or companies

valu-Before these valuation techniques are introduced, it is important to understandthe characteristics of stock options and the terminology used in describing them.The following paragraphs review those key issues and create the foundation for thework that follows

Definitions

1 American option An option that can be exercised at any time during its life.

2 Binomial option pricing model An option pricing model based on the

assump-tion that stock prices can move only to two values over a short period of time

3 Black-Scholes model A model used to calculate the value of a European call

option Developed in 1973 by Fisher Black and Myron Scholes, it uses the stockprice, strike price, expiration date, risk-free return, and the standard deviation(volatility) of the stock’s return to estimate the value of the option

4 Call option A provision that gives the holder the right, but not the obligation,

to buy a stock, bond, commodity or other instrument at a specified price within

a specific time period

5 Carrying value Also know as “book value,” it is a company’s total assets minus

liabilities, such as debt

6 Employee stock option (ESO) Stock options granted to specified employees of

a company These options carry the right but not the obligation to buy a tain amount of shares in the company at a predetermined price

cer-7 European option An option that can be exercised only at the end of its life.

8 Incentive stock option (ISO) A type of employee stock option with various tax

benefits granted under Section 422 of the Internal Revenue Code of 1986.These options may be granted only to individuals who are employees of thegranting company or a parent or subsidiary of the granting company A num-ber of restrictions under Section 422 may disqualify an ISO, in which case itbecomes a nonqualified stock option

9 Long-term equity anticipation securities (LEAPS) An options contract that

expires more than nine months in advance and can last as long as two years

10 Nonqualified stock option (NSO) A type of employee stock option which is

less advantageous for the employer from a tax standpoint than an ISO, butwhich is less restrictive and generally easier to set up and administer Any stock

Employee stock options (ESOs) are particularly attractive given theability to defer the recognition of these grants as compensation and thefact that cash is not normally involved Vesting rights often are embed-ded in these ESOs to promote employee retention by rewardinglongevity

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option granted to an employee that is not an incentive stock option is, bydefault, an NSO

11 Put option A provision giving the holder the right, but not the obligation, to

sell a stock, bond, commodity or other instrument at a specified price within aspecific time period

12 Strike price The stated price per share for which underlying stock may be

pur-chased (for a call) or sold (for a put) by the option holder upon exercise of theoption contract

Option Basics

Stock options generally grant the holder the right, but not the obligation, toacquire stock in a corporation The lack of an obligatory purchase requirement dis-tinguishes stock options from forward or future contracts where final purchase ismandatory When granted, stock options usually carry an exercise price and astated option term

Stock option plans usually are set up to promote the long-term success of thecompany granting the options by attracting and retaining employees, outsidedirectors, and consultants Options encourage these individuals to focus on thecompany’s long-range goals by granting them an ownership interest in thecompany

Most stock options can be characterized as call options where the holder sesses the right to buy the underlying stock at a specified price and date In contrast,

pos-a put option pos-allows the holder to sell the underlying stock pos-at pos-a specified price pos-anddate Many employee stock ownership plans (ESOPs) contain put provisions (notoptions) for stock owned by employees of the company

The strike price, also known as the exercise price, is a fixed price at which theholder may purchase the underlying stock The exercise price is set upon the grant-ing of the specific option and, under most circumstances, cannot be changed with-out triggering somewhat onerous reporting requirements

Employee stock options are classified as either incentive stock options

or nonqualified stock options

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Options that can be exercised during and up to the expiration date areknown as American options Options that can be exercised only uponthe expiration date are known as European options

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I: Valuation Issues Related to Stock Options 921

Most stock options lapse after a certain time period Incentive stock optionscannot have an expiration date more than 10 years after the granting date.However, publicly traded options generally have expiration dates that are measured

in months rather than years

Contract

The purchaser of an option typically is referred to as the option holder Sellers ofoptions typically are referred to as option writers, since they “write” the option con-tract In exchange for the contract, the option holder pays a premium to the optionwriter There are seven items specified in the option contract:

1 Underlying instrument The instrument that may be bought or sold.

2 Contract size The number of shares of underlying stock that the contract involves.

3 Exercise price (or strike price) The price at which the underlying stock will

transact if the option is exercised

4 Settlement date The date on which money is received for the contract.

5 Expiration date (expiry) The date that the option expires.

6 Style The ability to exercise prior to expiry (i.e., American or European).

7 Premium Price paid for the contract.

While options on stock indices, foreign exchange, agricultural commodities,precious metals, futures, and interest rates exist, the discussion in this chapter is lim-ited to stock options granted to employees of the issuing corporation

Option parameters specify how the option can be exercised The most commonstyles are American and European options American options can be exercised at anytime on or before the expiration date European options can be exercised only on theexpiration date There is a third type of option that is exercisable only on predetermineddates, such as every month, or every quarter They are referred to as Bermuda options

Most publicly traded options have expiration dates of less than a year, but theChicago Board Options Exchange (CBOE) now lists longer-term options on severalblue-chip stocks Known as long-term equity anticipation securities, or LEAPS forshort, these options have longer-term expiration dates In contrast, ISOs normallyhave a 10-year life

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At the money The term used when the exercise price and the underlying price

are equal

In the money The term used when an option’s strike price is less than the

cur-rent price of the underlying stock

Out of the money The term used when an option’s strike price is greater than

the underlying stock price

Warrants

A warrant is a particular type of call option issued by the company itself When thewarrant is settled, the company issues additional shares, increasing the number ofshares outstanding; in contrast, a call option is settled with the delivery of previ-ously issued shares In addition, the cash flows of the company increase with theexercise of a warrant since the exercise price is paid to the company Therefore, thedilution created by the issuance of stock is partially offset by the cash received

Options Trading

Standardized options contracts were first traded on a national exchange in 1973,when the Chicago Board Options Exchange began listing call options Option con-tracts now are traded on a number of exchanges, including the CBOE, PhiladelphiaStock Exchange, American Stock Exchange, New York Stock Exchange, and PacificExchange Some options trade in the over-the-counter (OTC) markets as well Over-the-counter stocks do not have standardized terms but are customized for eachtransaction Due to the customization, the market is limited, thus increasing the cost

of establishing an OTC option contract Most public option trading occurs onorganized exchanges

Components of Value

Two basic components make up the price paid for an option: intrinsic value andtime value The most obvious component of an option’s value is its intrinsic value.This intrinsic value is the amount of money available from the immediate exercise

of the option, or the amount the option is in the money For a call option, thisamount reflects the value of the stock less the exercise price

Volatility is the expected standard deviation of the underlying stock As ity increases, so does the probability that the stock will increase (calls) or decrease(puts) by a large enough magnitude to allow the option to be “in the money” before

stock price declines is limited to the price paid for the call option, no matter whatthe likelihood that the stock price will decline However, the more a stock’s price canincrease over a given period, the higher the option holder’s potential profit Thismakes the option holder prefer high volatility since it increases the chance that thestock’s price will increase above the exercise price.

The final determinant of an options price is the risk-free rate The risk-free raterepresents the interest rate that could be earned by investing the exercise price overthe time period from option purchase to exercise Assuming the option holder hadperfect knowledge that the stock price would increase, the holder would, in effect,

be getting a risk-free loan for the length of the option For a put option, it is just theopposite, since the option holder gives up the potential to invest

The length of time before an option expires is a fairly straightforward concept.The longer the period until expiration, the greater the chance the option will end upabove or below the exercise price of the underlying stock

Exhibit 23.11 summarizes the effects that a change in one variable has on thevalue of an underlying call or put option, all else being equal

Exhibit 23.11 Effect of an Increase in Variable on Option Value

Variable Call Option Put Option

*For European options on dividend paying stocks, value may not increase with time due to the dividend effect.

The Divided Effect

Dividends represent a cash return to the investors A company has the choice ofeither paying dividends or reinvesting that money in the business The reinvestment

of that cash could allow the business to earn more in the future, thus increasing its

Even without being in the money, an option may have value This value

is created by the possibility that the option could be exercised itably in the future Three factors determine time value:

prof-1 Volatility of the stock underlying the option

2 Risk-free rate of interest over the option period

3 Length of time before the option expires

ValTip

stock price Paying out the dividend effectively reduces the stock price by the dend amount on the ex-dividend date (the date that the shareholders of record aredetermined for dividend payment) By reducing the stock price on the ex-dividenddate, the value of a call option decreases and the value of a put option increases.Valuation Tools

divi-With the introduction of stock options and the components that drive their value,tools have been developed to calculate their value The following models weredesigned to value publicly traded options Each has its own virtues and limitations.Understanding those limitations and adjusting for them is the key to valuing a widevariety of options

A discussion of the complex mathematical assumptions used to derive these mulas is beyond the scope of this chapter Software programs of option models areavailable from numerous sources or can be modeled using the provided equation.The focus here is on the benefits of each model and the selection of appropriateinputs for the option valuation models

for-Black-Scholes Model

The most widely recognized option-pricing model is known as the Black-Scholesmodel Developed by Fisher Black and Myron Scholes in 1973, the Black-Scholesmodel was the first model used to calculate a theoretical call price (ignoring divi-dends paid during the life of the option) The model (shown in Exhibit 23.12) usesthe five key determinants of an option’s price:

1 Underlying stock price

2 Exercise price

3 Volatility

4 Time to expiration

5 Short-term (risk free) interest rate

While advanced mathematical techniques were used to develop the Scholes model, it is not necessary to understand the formula’s derivation in order touse it

Black-Normally, each component of the formula is readily available The stock price

is based on the closing price of the stock as of the day of valuation or, when thestock is restricted or in a private company, on the estimated price of the stock

The exercise price is given in the contract.

The time remaining until expiration can be expressed as a percentage of a year

for options with expirations of less than a year or in years for those options withexpiries greater than a year

The risk-free rate is approximated by using rates paid for U.S Treasury bills,

matching the length of the option maturity to the U.S Treasury bill period

Volatility is the expected volatility of the underlying stock Volatility is

measured using the annualized standard deviation of the underlying stock pricemovements Generally, the expected volatility can be calculated from the histori-cal volatility in the stock or the implied volatility from publicly traded stockoptions

When using historical volatility, it is generally best to review the latest month period although longer or shorter periods are sometimes used When long-term options exist or nonrecurring events have occurred, adjustments may be made

12-to reflect expectations of future performance

When the stock is lightly traded or not publicly traded, it may be necessary touse an average of the historical volatilities of similar stocks in the marketplace as aproxy for anticipated volatility It is important to average the volatilities and not cal-culate volatility based on the standard deviation of a portfolio of these guidelinestocks, since diversification among the stocks will lower volatility and not be reflec-tive of the anticipated volatility of an individual stock Industry volatilities also can

be used

Implied volatility is calculated for publicly traded options by adjusting theBlack-Scholes formula to solve for volatility Assuming identical options, thisimplied volatility should represent the market’s indication of expected volatility

As with historical volatility, when the stock is lightly traded, it may be sary to use an average of the implied volatilities of similar stocks in the marketplace

Exhibit 23.12 Black-Scholes Option Pricing Model

The original formula for calculating the theoretical call option price is as follows:

C = S  N(d1)Xe–rt N(d2)Where:

T = Time remaining until expiration

r = Current risk-free interest rate

 = Expected annual volatility of stock price

The natural logarithm, the standard normal cumulative distribution function and the exponential function are all mathematical constants.

The Black-Scholes model also gives a reasonable price for an American call.Earlier, we introduced the two components to option value, intrinsic value and timevalue The early exercise of an American option would forfeit the time value com-ponent

Adjusting Black-Scholes for European Puts. The Black-Scholes formula can

be adjusted to calculate the value of a European put option by applying the put-callparity theorem The concept of put-call parity is that the payoff for a put could bereplicated using a combination of call options, shorting stock, and borrowing Ageneral formulation of put-call parity is:

P = C – S + Xe–rtApplying this to the Black-Scholes option pricing formula and simplifying theequation, the formula for valuing a put option is:

P = S  N(-d1) + Xe–rt N(-d2)While this formula adjusts the basic Black-Scholes formula for a European put,

it does not address the value of an American put Refer back to Exhibit 23.11 One

of the components of time value is the risk-free rate The risk-free rate has a tive value effect on a put option So there is the possibility that an American putoption will have negative time value, thus making early exercise valuable

nega-Adjusting Black-Scholes for Dividends. As previously discussed, the Scholes model assumes that dividends are not paid Since some stocks do pay divi-dends, the model needs adjustment to properly value the options on these stocks Tounderstand this adjustment, one needs to review the effect of dividends on stock price.Basic valuation theory states that a stock is worth the present value of its futurecash flows Cash flows retained in the business are reinvested, creating higher poten-tial future cash flows When dividends are paid, the stockholder receives the cashand can determine whether to reinvest it in the company or in other ventures Thestockholder is equally well off in either case, but cash has come out of the company,reducing its value directly in line with the amount of dividend paid

Black-There are two methods for adjusting the Black-Scholes model for dividends.For short-lived options, the option’s underlying share price could be lowered by thepresent value of the dividends When valuing a longer-lived option, the Black-Scholes model can be adjusted for the expected long-term dividend yield of thestock The formulas in Exhibit 23.13 show the Black-Scholes model adjusted fordividends

While the formulas adjust the Black-Scholes model to estimate the value ofEuropean options in the presence of dividends, American options are not specificallyaddressed The ability to exercise early and avoid the lost value of the stock due todividends (calls) or take advantage of the decline (puts) has additional value overand above the European option

Adjusting Black-Scholes to Price Warrants. The difference between a warrantand a call option is the dilution created by the warrant, which gives the warrant alower value than an option with the same terms The effect of dilution can be cal-culated to derive the value of the warrant The formula is:

I: Valuation Issues Related to Stock Options 927

1Warrant Value   Value of Option Equivalent

Number of Warrants

1
Number of Shares The option equivalent is the value of an option with the same terms as thewarrant

The Binomial Model

The Black-Scholes model allows for the rapid calculation of option value In mostinstances, with the proper adjustments, it yields a fairly accurate estimate of value

to standardized stock options However, its accuracy is more limited in certain ations, the most notable of which is an American put option A more robust optionvaluation model was created in 1979 by John Cox, Stephen Ross, and MarkRubinstein, when they developed a binomial model for pricing stock options Thebinomial model breaks down the time to expiration into time intervals, or steps Ateach step, the stock price will either move up or down How much the stock willmove up or down is related to the stock’s volatility and the option’s time to expira-tion Charting these possible movements at each step produces a binomial tree rep-resenting all of the possible paths the stock price could take during the life of theoption This makes the binomial model more rigorous to apply than the Black-Scholes model

situ-The option prices are calculated at each step of the tree, working from tion to the present The option prices at each step are calculated using the option

expira-Exhibit 23.13 Dividend Adjusted Black-Scholes Option Pricing Model

The original formula for calculating the theoretical call option price is as follows:

C = Sae–bT N(d1) – Xe–bT N(d2)

P = –Sae–bT N(-d1) + Xe–bT N(–d2)Where:

T = Time remaining until expiration

b = Cost of carry (the risk-free rate minus the dividend yield)

 = Expected annual volatility of stock price

ln = Natural logarithm

N(x) = Standard normal cumulative distribution function

e = Exponential function




prices from the previous step of the tree using the probabilities of the stock pricesmoving up or down, the risk-free rate and the time interval of each step Any adjust-ments are put into the model as needed to reflect ex-dividend dates or the optimalexercise for American options Exhibit 23.14 is a pictorial representation of thebinomial tree with the stock price from time 0 through time 3.

Exhibit 23.14 Binomial Tree

Exhibit 23.15 Binomial Model Formulas

Cox-Ross-Rubinstein approach Equal Probability approach

The variables are:

t = Total time in years

t = Length of time period in years = t/n

 = Estimated annual volatility

rf = Current risk-free interest rate

I: Valuation Issues Related to Stock Options 929

At each time period, there is either an upside or downside movement to thestock At time 1, there are two possibilities: The stock price either went up or down

At each time, the number of possibilities increases

The inputs into the binomial model are the same as for the Black-Scholesmodel The volatility input is used to calculate both the upside and downside move-ment and the transitional probability in the Cox-Ross-Rubinstein approach Thisapproach does not work when volatility is low and interest rates are high since thecalculation can lead to transitional probabilities greater than 100 percent The bino-mial model overcomes this problem by assuming the transitional probability is 50percent Exhibit 23.15 shows the general formulas for determining the upside anddownside movement and transitional probability with each approach

Privately Held Stock Options

Privately held stock options typically take the form of warrants that are issued orsold to third parties or employee stock options

Warrants

Warrants can be given to debtors as incentive for the restructuring of debt, sold withother equity in units, or sold individually to raise capital In some cases, the com-pany will structure the warrants so they can be publicly traded More often, war-rants are structured to the specific desires of the purchaser, or their transfer isrestricted

Employee Stock Options

Employee stock options have become a common part of employee and executivecompensation, especially in high-technology firms that are usually short on cash butlong on promise Unlike publicly traded options, ESOs typically have a much longerlife Additionally, ESOs typically have a number of provisions that restrict theirtransfer, exercise, and ownership rights

Benefits of Employee Stock Options

Employee stock options have a number of benefits for the corporation They helpthe company recruit and retain employees by providing financial incentive while notrequiring an initial outlay of cash For start-up firms, this is a highly attractive fea-ture Also, ESOs can be used as part of the compensation strategy for senior execu-tives The Revenue Reconciliation Act of 1993 limited the deductibility of cash

Warrants often are sold in connection with other financial instruments

as a “sweetener” to enhance the attractiveness of the placement of thefinancial instrument they are bundled with or to get favorable terms onanother financial instrument

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salaries above $1 million Stock options, however, qualify as “objectively mined performance-based compensation.” Properly structured, the company candeduct the intrinsic value of the option in the year it is exercised, thus avoiding thelimitation on cash compensation Finally, ESOs are intuitively appealing in that theyreward employees based on the performance that stockholders are most interested

deter-in, the appreciation in the stock itself

Incentive Stock Options versus Nonqualified Stock Options

An incentive stock option (ISO) is an option granted to an employee of a pany to purchase company stock at a specified price for a specified period of timethat qualifies for favorable tax treatment under § 422 of the Internal Revenue Code

com-A nonqualified stock option (NSO) is any option that does not qualify for favorabletax treatment under IRC § 422

With an ISO, there are restrictions on how the option is structured and how itcan be transferred Generally, with an ISO, there are no tax consequences upon thereceipt or exercise of the option, although the difference between the fair marketvalue of the stock and the exercise price are alternative minimum tax adjustments.Upon the sale of the underlying stock, the employee will generally record tax based

on the capital gain The company cannot take a tax deduction for any related pensation expense so long as the ISO is disposed of in a qualifying disposition.Requirements for ISOs include:

com-• The stock option may be granted only to an employee who must exercise theoption while employed or no later than three months after termination ofemployment ( one year if the employee is disabled)

• The stock option must be an option to purchase stock of the employer tion or the stock of a parent or subsidiary corporation

corpora-• The stock may be capital stock of any class of the corporation, including votingand nonvoting common or preferred stock Special classes of stock exclusivelyissued to and held by employees is permissible

• The option must be granted under a written plan , the ISO agreement, specifyingthe total number of shares that may be issued and which employees are eligible

to receive the options

• The plan must be approved in a manner that complies with the charter, bylaws,and state laws that regulate stockholders’ approval within 12 months before orafter plan adoption

• Each stock option issued under the ISO agreement must be written and must listthe restrictions placed on its exercise It must set forth an offer to sell the stock

at the option price and the period of time that the option will remain open

ESOs are characterized as incentive stock options or non-qualifiedstock options

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• The option must be granted within 10 years of the date of adoption or holder approval, whichever date is earlier

share-• The option must be exercisable only within the 10-year period after grant

• The stock option exercise price must equal or exceed the fair market value of theunderlying stock at the date of the grant

• The employee may not own more than 10 percent of the voting power of allstock outstanding at the time of the grant unless the exercise price is at least 110percent of the fair market value of the stock and the option is not exercisablemore than five years from the time of the grant

• The ISO agreement must specify in writing that the ISO cannot be transferred bythe option holder other than by will or by the laws of decedent and cannot beexercised by anyone other than the option holder

• The aggregate fair market value of the stock bought by exercising the ISOs thatare exercisable for the first time cannot exceed $100,000 in a calendar year

To qualify for favorable tax status, the stock must be disposed of after thestatutory holding period The ISO statutory holding period is the later of two yearsfrom the date of granting of the ISO or one year from the date the options wereexercised If the disposition qualifies, an employee receiving an ISO recognizes noincome upon its receipt or exercise In the case of a disqualifying disposition of anISO, the employee recognizes ordinary income in the amount the fair market value

of the stock exceeds the option price The employee also realizes a capital gainwhich is the difference between the fair market value of the stock on the date ofexercise and the disposition proceeds

In contrast, the employer does not receive a deduction with respect to the ing of the ISO; if a disqualifying disposition occurs, the employer will be able todeduct the amount realized by the employee as ordinary income The employer isnot subject to any withholding requirement for the amount of ordinary income rec-ognized from the disqualifying disposition In addition, that ordinary income is notconsidered taxable income for FICA or FUTA purposes

grant-An NSO has no restrictions on its structure or transfer grant-An NSO is taxable tothe employee on grant if:

• The option is publicly traded or is transferable by the optionee

• The option is exercisable immediately in full by the optionee

• Neither the option nor the underlying property is subject to any restrictions thathave a significant effect on the option’s value

• The purchase fair market value of the option privilege is readily ascertainable Generally, options on stock that is not actively traded will be deemed not to have

a readily ascertainable value If the NSO meets these requirements, ordinary income

is recognized based on the value of the option less any amount paid for the option.Since the ordinary income has been recognized previously, any further tax comes inthe form of capital gains based on the selling price of the stock (less any amount paidfor the exercise of the stock) and any amount included in income upon the option’sgrant If the fair market value of the option is not readily ascertainable upon grant,

no tax consequences are recognized until the exercise of the option At that point, thedifference between the amount paid for the stock and the fair market value of thestock received is reported as compensation income The company takes a deductionfor ordinary income equal to the ordinary income realized by the employee

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Vesting

Employee stock options typically have vesting rules associated with them Undervesting, employees gain an increasing right to the stock option awards granted tothem based on their seniority or, occasionally, a performance factor The four mostcommon types of vesting include:

1 Equal annual vesting

2 Cliff vesting

3 Variable annual vesting

4 Hybrid annual/other vesting

In equal annual vesting, the most common type of vesting, an employee’soptions become exercisable at a fixed percentage each year Under cliff vesting, all

of an employee’s options from a grant become exercisable at one specific date Invariable annual vesting, an employee’s options become exercisable each year based

on some individual formula Finally, if an employee’s options first vest after one yearand then vest on a more frequent schedule, this is characterized as hybridannual/other vesting

Valuation Considerations

Valuing nonpublicly traded stock options is not a defined science Significant ences in the terms and rights underlying nonpublic stock options versus their pub-licly traded counterparts can materially affect the value In many cases, determiningvalue puts the analyst in a theoretical world, since many of these options cannot besold based on the terms of the options contract itself In other cases, a sale may havesignificant disincentives that would make a willing seller unwilling to sell the option.Despite the inability to sell the instrument itself, there are benefits to holdingthe option Many times it is necessary to value the benefits under the assumptionthat the benefits could be exchanged

differ-Before discussing valuation issues related to ESOs, as with any valuation, theanalyst must appropriately define the assignment:

• Follow valuation procedures to define the assignment appropriately so that theright level/standard of value, valuation date, and procedures are used

• Gather appropriate support

• Analyze the data in a meaningful and appropriate manner before arriving at aconclusion and writing the report

Reasons for Valuing

For publicly traded options, like publicly traded stock, a valuation is not necessarywhen the publicly traded price accurately reflects value However, in some situationsthere are sufficient differences between the publicly traded instrument and theinstrument being valued to necessitate a valuation For instance, when a corporateinsider, a person in a position to control the business affairs of the corporation orwho has access to inside information, holds an option, the stock that is associated

I: Valuation Issues Related to Stock Options 933

with the option may be restricted, thus affecting the stock’s value as well as theoption’s In other cases, there may be no public market for the options and/or thestock, such as ESOs in private firms

One reason ESOs are valued is to estimate the value of the common stock in abusiness The ESO reflects a right of ownership against the company since the com-pany must issue shares to meet the ESO obligation By taking the enterprise valuederived and subtracting debt, one arrives at an indication of value of the equity Thecurrent stockholders and the option holders share the rights to the equity By sub-tracting the value of the options, the value to the current stockholders can be esti-mated It may also be necessary to consider tax benefits related to the types of ESOsoutstanding in this calculation

Volatility

As noted earlier, volatility is based on the anticipated return of an underlying stock.This volatility can be estimated from the historical or anticipated volatility of a pub-lic stock For an option that is not publicly traded but where the company has pub-licly traded options with different terms, the implied volatility of those other optionscan be used to estimate the volatility of the private option For instance, in valuing

an option with five months remaining to expiration, the average of the impliedvolatility of a four-month option and six-month option may be appropriate

A key exception to the determination of volatility occurs when a valuation is

done under Statement of Financial Accounting Standards No 123, Accounting for Stock-Based Compensations, where a volatility of zero is applied in calculating the

fair value of an ESO Since most option models require an input for volatility, anextremely low volatility, 0.0001, can be used for the calculation

As discussed earlier, it is important to average the volatility calculations of theseguideline companies as opposed to creating an index of the companies and calcu-lating the volatility of that index The diversification of the index will smooth the

The causes driving the need for a valuation are fairly universal: tion/divorce, management planning, tax oriented (gift or estate), trans-action oriented, or financial reporting

litiga-ValTip

If the underlying stock is lightly traded or not publicly traded,volatility can be estimated using a representative sampling of guidelinecompanies or an industry benchmark

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934 OTHER VALUATION SERVICES AREAS

standard deviation and result in a volatility measure that may not represent theanticipated volatility of an individual stock

When using guideline companies to calculate volatility, begin by selecting agroup of companies using the same factors used in selecting guideline companies forpricing multiples If the stock is not publicly traded but has been valued using themarket approach, the guideline companies used in that analysis would be a goodstarting point for volatility analysis

When selecting guideline companies in a market approach valuation analysis,

it is important to be familiar with the operations and markets of the subject pany, its size, growth prospects, liquidity, profitability, turnover, and leverage Whenselecting guideline companies for volatility estimation, it is also important to knowthe history of the price movements and any intervening events that may haveaffected those movements

com-When the event is historical, exclude it by calculating volatility for the timeinterval before the event and after the event If the event is anticipated, use impliedvolatilities from options expiring before the event or exclude the company’s volatil-ity from the average

It also can be useful to compare how volatility has changed from one time period

to the next, especially when industries or companies are in flux or evolving rapidly.Trends in volatility, including growth, decline, seasonality, and cyclicality, can materi-ally affect the expectations of future volatility This also can be useful when the sub-ject company is at an earlier stage of development than the publicly traded companies.Finally, it may be necessary to adjust the analysis for the anticipation of events,such as a public offering of the stock As of the end of 2002, there was no consen-sus on how to adjust for this Clearly, a consideration of the chance of going publicand the potential option payoffs for going public versus remaining private must bekey among the factors considered

In arriving at a conclusion of the volatility to apply, as when arriving at a clusion of value, it is necessary to weigh all the evidence and the strengths and weak-nesses of each part of the analysis to reach a reasonable conclusion Since volatilityhas the greatest potential effect on the price of an option, it is important to give sig-nificant attention to the development of this variable

con-Marketability

Marketability has two potential effects on the value of stock options

1 There are marketability issues if the underlying stock that the option is based on

is either not marketable or if its marketability is restricted

If an intervening event is identified in the analysis, it may be ate to exclude it from the volatility

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I: Valuation Issues Related to Stock Options 935

2 There may be a reduction in value due to the lack of marketability if the optionitself is not marketable

In the first situation, there is the lack of marketability of the underlying stock.The current value of the stock is an input in both the Black-Scholes and binomialoption pricing models Being a derivative, the option is tied to that stock’s value on

an as-if-publicly-traded basis or a discounted value reflecting the lack of ketability If there is a way to structure the transaction to avoid the lack of mar-ketability and allow the option holder to receive unrestricted, publicly traded shares,then the as-if-publicly-traded value of the stock is the appropriate input If there isnot a way for the holder to receive unrestricted shares, then the discounted stockprice may be the appropriate input

In the end, the consideration of an appropriate discount for the lack of ketability is a matter of the analyst’s informed judgment In arriving at an estimate,

mar-it is important to take into account the value components of an option, mar-its terms,and the characteristics of the markets for publicly traded options The value of anoption is made up of both an intrinsic value and time value, and since the optioncan be exercised to receive the underlying stock, the intrinsic value may not be asaffected by the lack of marketability of the option itself, (assuming the options arevested) Therefore, the marketability analysis may focus more on the time valuecomponent

Vesting

One of the last components to consider in valuing ESOs can be one of the mostimportant Vesting determines the ability to gain the rights to the stock optionawards If the terms of the vesting agreement are not met, then the employee willnever receive ESOs subject to vesting

There are two general schools of thought on vesting:

1 The option does not exist until the vesting requirements have been met

2 An unvested option is an asset just as future pension proceeds are deemed anasset

By reviewing the facts and circumstances of each case, the likelihood that theoption will vest can be established and adjustments made to reflect the currentvalue of the option For valuing individual grants, this leads to a probability-weighted approach to valuation When valuing the pool of options that a company

The final consideration is the marketability of the option itself Thereare no studies available regarding the lack of marketability of closelyheld stock options

ValTip

has given, it is also possible to look at the historical ratio of options granted tooptions vested to estimate the number of stock options that will vest for the entirepool of options.

J: REAL OPTION VALUATIONS

Introduction

Managerial decisions often have the same characteristics as an option An optiongives the holder the right, but not the obligation, to perform some action Havingthis right provides management with flexibility in decision making that can createvalue not captured by traditional valuation methods The process of identifying thevalue associated with management decisions is real option analysis The very sim-plified example below illustrates this concept This is a highly complex area.Example (Illustration Only)

Digicell, a manufacturer of telecommunications equipment, has the opportunity toacquire the rights to the patented technology of a competitor who is currently infinancial difficulty The patented technology is a “hands-free” device that allows anindividual to operate a cellular phone through voice commands Digicell believesthat the technology has important practical applications and is currently five yearsahead of any competing technology

To proceed with the manufacturing of the patented technology, Digicell wouldhave to invest $50 million to ready the technology for market Digicell’s manage-ment has prepared a set of projections indicating that the technology will generate

$10 million in free cash flow each year for at least the next five years They assume

an 18 percent rate of return, based on the risk of the project The estimated presentvalue (PV) of the expected cash flows is:

NPV of the technology = –$50 million + $10 million (PV of an annuity for 5

of these questions represents decisions that are made on a daily basis by corporatemanagers involving millions, and sometimes billions, of dollars The fundamentalquestion that these managers need answered is: Are these projects creating value?Managers sometimes go forward with a project based on a “gut feeling” evenwhen traditional discounted cash flow analysis shows a negative net present value

J: Real Option Valuations 937

The reason for this is that traditional discounted cash flow methods do not capturethe value that is associated with managerial flexibility

While DCFs may not capture all of the value associated with managerial bility in decision making, a financial model does capture this value Real optionanalysis is based on the use of option pricing models applied to managerialdecisions

flexi-Many managerial decisions follow the structure of options In the example,Digicell has the right to acquire and further develop and manufacture the voice-acti-vated “hands-free” device but not the obligation to do so In many respects this issimilar to a call option scenario where the investor pays for the rights to investshould market conditions prove optimal or to decline to invest if market conditionsare poor The patented technology could serve as a call option for Digicell, whereDigicell could purchase it now as a “right” to further investment, should it appearappropriate to do so later

In this example using traditional valuation methods , the DCF analysis cates a net present value of the project of less than $0 But this analysis fails to con-sider the value of the flexibility of waiting to invest further Real options analysiscaptures this value, allowing better decision making

indi-Management often encounters the need to apply real options in strategic sions:

deci-• Timing Delay the decision until more information is available.

• Flexibility Present value of the ability to switch to a different course of action as

future circumstances dictate (e.g., a cogeneration power plant that can switchbetween oil and coal, depending on market prices)

• Operating The value of the ability to expand on contract operations.

• Growth The current value of future payoffs An example is the value of

Amazon.com generated by its potential to sell other products in addition tobooks

Traditional discounted cash flow models may not determine the value

of flexible managerial decision making

Option Basics

An option provides the investor with the right, but not the obligation, to buy or sell

a specific amount of an underlying asset during a specified period of time (seeChapter 23, “I: Valuation Issues Related to Stock Options”) The right to buy anasset is called a call option The right to sell an asset is called a put option

The value of an option is determined by a number of variables:

• Current value of the underlying asset

• Volatility in the value of the underlying asset

• Strike exercise price

an asset at a fixed price within a fixed time period Therefore, an increase in thevalue of the underlying asset decreases the value of the put option

Volatility of the Value of the Underlying Asset

The greater the volatility in the value of the underlying assets, the greater the value

of the option on that asset Options were designed to provide a hedge against assetvolatility Therefore, the more chance an asset will exhibit wide variations in price,the more valuable protection against those changes (i.e., options) will be

Strike Price

The strike or exercise price is the fixed price at which the option holder has the right

to trade in the underlying asset (buy in the case of a call option or sell in the case of

a put option) The higher the strike price, the less valuable the call option becomes.The higher the strike price, the more valuable the put option becomes

Time to Expiration

The longer the time to expiration of the option, the more valuable both call and putoptions become The rationale being that the longer the time to expiration, thegreater chance the value of the underlying security will be at an advantageous posi-tion for the holder of the option prior to the time of expiration

Risk-Free Rate

Since an option carries an up-front cost, the holder of an option has an opportunitycost in purchasing the option The level of interest rates also affects the present value

of the exercise price of option An increase in the risk-free rate increases the value

of a call option and decreases the value of a put option

Black-Scholes Model

The Black-Scholes model is currently the most recognized and widely used ical model for the valuation of options Black and Scholes assumed that it is possi-ble to set up a hedged, or riskless, position consisting of owning a share of stock andselling the option on the stock Provided that the options are priced correctly, anyprice movements in the stock would be offset by opposite movements in the optionvalue Therefore, the investor is at no risk and the investment should yield a risk-free rate of return

theoret-The value of a European call option (one exercisable only on the call date) bythe utilization of the Black-Scholes formula is:

e = Base of natural logarithms

N(d) = Cumulative density function (area under normal curve)

ln = Natural Logarithm

r = Current risk-free investment/maturity same as expiration of option

T = Time to option’s expiration, in years

The call option pricing formula produces prices that vary directly with time andvolatility, and inversely with interest rates The Black-Scholes model is the basicmathematical model that is often used to estimate the value of real options (seeChapter 23, “I: Valuation Issues Related to Stock Options”)

Moving from Financial Options to Real Options

Exhibit 23.16 is a comparison of terms of a financial option versus a real option:

Exhibit 23.16 Options Comparison

Financial Option Real Option

Underlying asset Stock price PV of project returns Volatility Variance of stock returns Variance of project returns

Time to maturity Contractual Period to make decision Ownership rights Dividends forgone Cash flow forgone

Time to exercise American or European American or European

Real Option Steps

Four steps are involved in performing a real options analysis:

1 Identify the proper question

2 Select the analytical technique

3 Identify the inputs

4 Make conclusion

Identify the Proper Question

The first step in performing a real option analysis is to frame the questions to beanswered Which decision or series of decisions will create the most value for theproject and the company? Is there value in delaying a decision until better informa-tion is available? Is there value in the flexibility of changing the technology at a laterdate? Does the company have flexibility to expand or contract capacity as marketconditions change?

Select the Analytical Technique

Once the analyst is comfortable that a real option may add value, the next step is toselect an analytical technique to estimate the value added by a real option Again,the most common analytical technique is the application of the Black-Scholesoption-pricing model

Identify the Inputs

The next step in applying real option analysis is to identify the inputs to the model.Digicell needs the following inputs to the Black-Scholes pricing model:

• Exercise price = PV of cash flows from the technology if developed now or $31.3million

• Stock price = initial investment = $50 million

• Time to expiration = time period to make decision = 5 years

• Volatility = standard deviation of returns for typical telecommunications ment manufacturer = 0.40

equip-• Risk-free rate = U.S Treasury yield for next five years, assumed to be 5 percent

The value of the real option to acquire the technology in our example can beestimated as:

Several other analytical techniques may better suit an individual lem These models include financial models, dynamic programming,and Monte Carlo simulation

prob-ValTip

d1= ln (31.3/50) + (5% + 0.402/2) (5)

The rights to the technology are worth $8.64 million

These inputs indicate that value of the real option to delay the decision to buildthe manufacturing plant until better information about the marketplace becomesavailable is $8.64 million

The net present value in the example indicates that if the project were taken today through an investment in both refining the technology and building theplant, the project is worth -$18.7 million This analysis takes into account the riskreflected by the uncertainty of the marketplace and competing technologies What ifsome of the uncertainty can be eliminated? What would the value of the project betoday under these conditions?

under-Conclusion

Management has the ability to delay the investment in the new plant so Digicells’smanagement can ascertain more realistic information about the market beforeinvesting the $50 million in the new plant The value created by having the flexibil-ity to delay the project until more information is available can be estimated throughreal option analysis

K: MAXIMIZING SHAREHOLDER VALUE

Introduction

One of the paramount goals of corporate management is to create shareholdervalue The development and application of a value creation strategy is complex,involving the three basic concepts:

1 What is value?

2 How is value determined?

3 What can be done to create additional value?

These abstract concepts can be explored through financial analysis and ing, which can be used as a basis for managerial decisions to plan for future valuecreation

model-Valuation analysts are uniquely qualified to assist corporations with value ation strategies because they understand what value is, how value is determined, andthey know the value drivers of a particular company However, the focus here is onwhat can be done to create additional value and how analysts can assist corporatemanagers to answer this question

Many public and private corporations have specific programs in place to ure and maximize their shareholder value Some of the more prominent names, such

meas-as Coca-Cola, Georgia Pacific, Sprint, and other such “shareholder value creation”companies, have developed specific programs to assist management in making thebest decisions to maximize shareholder value

For a value creation program to succeed, it must be designed to provide bettermanagerial decision making as well as maximize shareholder wealth In a properlydesigned program, strategic decisions such as capital investment and acquisitionsare tied to value creation Management at all levels should be accountable for valuecreation, which solidifies corporate goals and creates management cohesion Sincevalue per unit of capital is measured, capital is used more efficiently A well plannedshareholder value creation program provides a framework to create a cohesive welldisciplined management team Analysts can be indispensable in developing theseshareholder value creation programs

Economic Value Added

The EVA concept was developed into a specific product and popularized by the sulting firm Stern Stewart as a trademarked program in the 1980’s It expanded aconcept that was developed in the early 1920s at General Motors and later refined

con-by Alfred Rappaport at Northwestern University.28, 29

The proponents of EVA believe that economic profits are a more appropriatereturn of shareholder investment rather than accounting profits EVA practitionersbelieve that if the returns are positive after taking a charge for invested capital, then

One well-known value creation program used by many companies iseconomic value added or “EVA.”

ValTip

The concept behind EVA is that shareholder value is created by mizing “economic profit” or the returns to the shareholders after tak-ing a “charge” for the capital investment of the company

the company is creating shareholder value If the returns are negative after taking acharge for invested capital, then the company is destroying value Stern Stewartexpanded the concept of measuring economic profits into a specific program ofmanagerial decision making designed to maximize economic profit.

While EVA is one of the most widely known shareholder value creation grams, a variety of other such programs are based on the concept of identifying andmaximizing the economic profit of a company Some of them are:

pro-• Value-Based Management

• Cash Value Added

• Shareholder Value Management

These programs are similarly based on the idea that value is created if thereturn on investment is greater than the cost of capital

Economic Profit

Each of these shareholder value creation programs is based on a particular concept

of economic profit and its measurement Many financial analysts believe that nomic profit is a more appropriate measurement of returns on shareholder invest-ment and thus can be used as a basis for value creation

eco-Most financial analysts understand that conventional accounting-based ures of company performance, such as net profit, return on equity, and earnings pershare, usually do not tell the complete story The limitations of accounting-basedmeasurement are recognized in valuation analysis, which measures performancebased on cash flow The concept of economic profits extends cash flow-based per-formance measurement by taking into consideration the cost of capital

meas-Example (Illustration Only)

Company A and Company B are identical except that Company A uses equipmentthat is fully functional but is also older and fully depreciated, while Company B usesequipment that was acquired last year for $1 million and is being depreciated over

a five-year period The operating performance of both companies is the same exceptfor depreciation and interest expense (Exhibit 23.17) Using traditional accounting-based performance measures, Company A’s net profit margin and return on equitywould be higher than Company B’s measures (Exhibit 23.18) Does this mean that

Economic profit in its most simple form is free cash flow generated by

a company less its return on investment by the shareholders in the pany Economic profits take into consideration the opportunity cost ofthe investment

com-ValTip

944 OTHER VALUATION SERVICES AREAS

Company A is creating more value for its shareholders than Company B is creatingfor its shareholders? Probably not If financial performance is measured in terms ofgross cash flow (it is usually debt free net cash flow but this quickly illustrates theconcept), Company B actually may have more cash flow when the tax effects ofdepreciation are considered (Exhibit 23.19)

Now assume that Company A has invested capital of $1 million capitalized at

a market weighting of 20 percent debt and 80 percent equity Also assume thatCompany B has invested capital of $1 million and is weighted at market rates of 50percent debt and 50 percent equity Each company has a pretax cost of debt of 8percent and a cost of equity of 20 percent to its shareholders (see Exhibits 23.20 and23.21) (For illustrative purposes, we have assumed equal costs of equity eventhough Company B probably has higher equity costs due to its higher debt.However, Company B’s overall cost of capital would still be lower.) What is the eco-nomic profit of each company?

In this example, the economic profit of each company is derived by subtractingthe cost of invested capital from its cash flow As shown in Exhibit 23.22, Company

B generates $112,000 in economic profit compared to $1,000 generated byCompany A

Exhibit 23.17 Operating Performance

As a further demonstration of how conventional accounting measures may tort measures of return, Company A’s net income is $170,400 compared toCompany B’s net income of $36,000 Yet Company B generates much greater eco-nomic profit than Company A Company B is creating more value for its share-holders, even though its operating performance is identical to Company A.Traditional accounting measures are limited in measuring shareholder value cre-ation Economic profit may be a much better measure of value creation.

Exhibit 23.20 Invested Capital and Returns

Returns on Invested Returns on Invested Invested Capital Invested Capital Capital Capital

Total Cost of Capital _ _$ 169,600 $124,000 (1) ($200,000 x 08) x (1 – 40) = $9,600 after tax

Less: Cost of Capital 169,600 124,000

Economic Profit $ 800 $ 112,000

Rounded $ 1,000 $ 112,000

How to Maximize Shareholder Value

Based on the previous EVA analysis, there are four general ways to increase holder value:

share-1 Earn more profit without using more capital Value is created or increased when

a company implements efficiencies and reduces its operating costs withoutincreasing its investment in new assets For example, a company could add a sec-ond or third shift without a significant capital expenditure, as opposed to build-ing another plant

2 Use less capital Many companies use this method to create value For example,

a company can create a production schedule that requires less inventory andlower costs associated with fixed assets and working capital

3 Invest capital in higher return projects A company can focus on business lines

that generate the highest return after the total capital costs are deducted Forexample, a company contemplating an additional product line should compareits capital costs with its anticipated return on that capital when deciding whether

to invest in the project

4 Lower the cost of capital A company can use an optimal capital structure that

lowers the required return on capital For many private companies, this meansincreasing the level of lower-cost debt in the capital structure

Steps in Creating Shareholder Value

Four steps are involved in creating shareholder value:

1 Identify the value drivers

2 Estimate the cost of invested capital

3 Estimate the economic profits

4 Tie management decisions to value creation

Value Drivers

One of the first steps in creating shareholder value is to understand what drives thecurrent value Identifying the value drivers of a company includes both financialanalysis and analysis of management strategy

Exhibit 23.23 Common Value Drivers

management can analyze the margins of different product lines or certain types ofcustomers to ascertain the value drivers that allow for competitive advantages.Exhibit 23.23 lists some common value drivers.

Unique Technology. Having a proprietary technology that is protected frompotential competitors allows a company to increase revenue both through customergrowth and higher pricing The increased revenue from this value driver results ingreater cash flow to the shareholders than the shareholders would otherwise receive,thus increasing value The proprietary technology is the value driver for these com-panies

Customer Relationships. Many companies have close relationships with theircustomers These relationships drive the company’s value For example, automobilemanufacturers subcontract the production of certain parts to companies that spe-cialize in the design and manufacture of that particular part The part manufacturerrequires close collaboration with the automobile manufacturer, its customer Thiscustomer relationship drives the parts manufacturer’s value

Cost Advantages. Some companies use cost advantages as a value driver.Southwest Airlines is a pioneer in no-frills, low-cost air travel and has been quitesuccessful financially Southwest normally flies routes that are not dominated by alarger carrier so the routes have lower gate costs Southwest also focuses on a quickturnaround at the gates, which reduces the time its airplanes are on the ground Theless time the planes are on the ground and the more time they are in the air, the morerevenue the planes are generating These policies spread Southwest’s fixed costs over

a larger revenue base Lower costs means more cash flow to the shareholders,increasing shareholder value Southwest Airlines’ value driver is lower fixed coststhan larger carriers

Trade Names or Trademarks. A trade name can be a tremendous value driver.The Coca-Cola Company has a proprietary formula to make soft drinks that hasremained virtually unchanged for nearly a century Coke’s strategy has been to letothers manufacture (bottle) its products and to focus primarily on its brand At themost basic level, Coke’s most valuable assets are a formula and a trade name, whichare Coke’s competitive advantages With these competitive advantages, Coke hasbecome one of the largest companies in the world and owns one of the most, if notthe most, recognized trade name in the world Clearly, one of Coke’s value drivers

is its trade name

Access to Capital. Access to capital is also a value driver for many companies,particularly those that are planning for strong growth Many high-growth compa-nies partner with venture capital firms and other types of investment funds tofinance their growth The access to capital allows growth to proceed at a greaterpace However, it is high-priced capital

The other side of access to capital is that the lower the cost of that capital, thehigher the value of the company, all else being equal Those companies that haveaccess to immediate, lower-cost capital have an advantage over competitors that paymore for capital access

Cost of Capital and Amount of Capital Employed30

Measuring both a company’s true cost of capital and its total capital employed ischallenging Most analysts understand the cost of debt capital, which is the interestthat is paid on borrowings on an after-tax basis A key consideration is the meas-urement of the cost of equity capital employed by the company For a publiclytraded company, the cost can be measured with widely accepted financial modelsand publicly available information However, the cost of equity capital is more sub-jectively measured in a privately held company As discussed elsewhere in this book,public guideline companies and other market proxies can provide a reasonable esti-mate of a privately held company’s cost of capital

A second analysis concerns the amount of capital tied up in the company, whichmay differ from what appears on the balance sheet For example, a company maybenefit for years from expenditures for research and development and for employeetraining, but accounting principles usually require these items to be expensed at thetime they were incurred Existing balance sheets and income statements may have

to be adjusted to reflect these and other similar items to provide a more accuratemeasure of the total capital employed in a company

Estimating Economic Profits—Example Continued (Illustration Only)

We previously discussed how conventional accounting measures might distort themeasure of adding value for the shareholders Proponents of programs that createshareholder value argue that a better measure of corporate performance is economicprofits rather than traditional accounting-based measures Economic profits are themeasure of cash flow returns to the shareholders after deducting the opportunity cost

of capital The idea behind using economic profits as a measure of shareholder return

is that value is created only if the returns to the shareholder are greater than the cost

of capital If returns are less than the cost of capital, then value actually is destroyed

As shown in Exhibits 23.24 and 23.25, Companies A and B have the sameoperating performance Let’s assume both companies have revenue of $1 million.Both companies’ revenues are expected to grow at 10 percent per year with a long-term growth rate of 6 percent The operating performance before depreciation andinterest expense is expected to be exactly the same for both companies

For EVA purposes, developing a measure of a company’s total cost ofcapital will involve using the actual capital structure of the companyrather than an optimal capital structure, since the goal of measuringshareholder value is analyzing the actual cash flow returns to the share-holders less the actual opportunity cost of equity capital

ValTip

30 James R Hitchner and Mark L Zyla, “Valuers Can Do More for Clients Than Determine

Value” CPA Expert (Winter Issue, 1996), p 14

K: Maximizing Shareholder Value 949There are only two differences between the two companies:

1 Company A’s equipment is fully depreciated while Company B recently chased new equipment for $1 million and is depreciating the equipment over afive-year period

pur-2 The capital structure of Company A is financed with 80 percent equity and 20percent debt, while Company B is financed at 50 percent equity and 50 percentdebt

Exhibits 23.24 and 23.25 show the expected operating performance of eachcompany Which company is creating more value for its shareholders?

Exhibit 23.24 is a projection of cash flows to the shareholders of Company

A Exhibit 23.25 is projection of cash flows to the shareholders of Company B.Notice in Exhibit 23.24 that net income for Company A is projected to be

$170,400 for the year 20XX In Exhibit 23.25 net income for Company B for theyear 20XX is projected to be only $36,000 However, the projected economicprofit for each company tells a completely different story The projected economicprofit for Company A for the year ending 20XX is expected to only be $10,400.The projected economic profit for Company B is projected to be $136,000 (Inthis example we are using net cash flow versus gross cash flow to capture futureworking capital and capital expenditure needs.) Even though Company B hasmuch less net income than Company A, it is creating much greater value for itsshareholders Why is that?

Two differences between the companies have a tremendous impact on the ference in the value creation between them

dif-1 The depreciation expense of Company B impacts its net income but not its cashflow generation The greater the cash flow generation, the greater the value

2 Company B has a much lower cost of capital than Company A due to its higherlevel of debt in the invested capital A lower cost of capital means that the oppor-tunity cost of capital in the calculation of economic profits is lower, resulting in

a higher level of economic profits

Exhibits 23.24 and 23.25 are modified versions of the familiar discounted cashflow analysis The analysis is modified to estimate economic profits or returns aftertaking into consideration the opportunity cost of capital Rather than discountingfree cash flows to present value, the analysis discounts the economic profits to pres-ent value The sum of the present values of the economic profits is the additionalvalue created for the shareholders under the assumptions in the analysis

How can this information be useful for management when planning strategies

to create value for shareholders? This type of analysis can be useful in modelingwhether strategies or additional investments either create or destroy shareholdervalue This analysis also can be useful in determining how a company can createadditional value and how much additional value is created or destroyed All one has

to remember are the four basic tenets to value creation:

1 Earn more cash flow without using more capital Both Company A and

Company B have the same level of invested capital of $1 million Yet Company

B has a higher level of generation of free cash flow than Company A does.Company B’s ability to generate more free cash flow per unit of invested capitalcreates a higher level of additional value for its shareholders

2 Use less capital Both Company A and Company B use the same level of capital.

However analysts can use the economic profits model to analyze returns to theshareholders under scenarios utilizing less capital

3 Invest in higher-return projects The economic profit model is useful to compare

the returns on various projects to allow management to invest in the projectsthat have higher returns per unit of capital employed

4 Lower the cost of capital Company B has a weighted average cost of capital of

12.4 percent compared to the weighted average cost of capital of Company A of17.0 percent, thus creating a greater level of value for its shareholders The eco-nomic profit model shows how the cost of capital influences the value creationability of each company

Analysts can assist management of corporations with their value creationstrategies by keeping in mind these four basic tenets for value creation and usingthem to model managerial strategic or investment decisions

Management Decisions to Value Creation

While analysts can use the economic profits model to analyze managerial decisions

as to their level of value creation, value is not actually created until implemented bymanagement The corporations that are most successful in utilizing value creationprograms have one key step in common: They tie managerial decisions to the cre-ation of value

In these organizations the fundamental question that is asked in each strategicdecision is: How does this add value? Line managers understand the need to createvalue in these organizations and also have the authority to make value-creatingdecisions

One way to incentivize management is to tie their compensation to increases inshareholder value Many of the best-performing companies that utilize shareholdervalue creation tie value creation to management compensation either through man-agement bonuses or stock options Aligning compensation to value creation causesmanagement to “think like owners” to create shareholder value A well designedmanagement compensation system allows management to share in the wealth thatthey create

The organizations that are best at creating shareholder value tivize their management to think like the owners of the business

incen-ValTip

To successfully tie management compensation systems to value that managerscreate, management must have the authority to affect the implementations of avalue-creating strategy Think about the four general tenets that can be used to cre-ate value These decisions can be made not only on a companywide basis but also

on a reporting unit level Value creation therefore can be measured not only on acompanywide level but also at each reporting unit level Management compensationcan be tied to value creation at the reporting unit as well

Conclusions

One of the primary goals of management in most companies is to create shareholdervalue The idea of creating shareholder value seems simple enough; however, inpractice, it may be difficult to implement One difficulty is that standard accountingmeasures may not adequately measure the returns to shareholders Many propo-nents of shareholder value creation programs use a concept of economic profits tomeasure returns to shareholders Economic profits are cash flow returns to share-holders after the consideration of the opportunity cost of capital

A well-designed value creation program incorporates each of these basic tenetsinto its everyday management decision-making process Management is incentivized

to make decisions based on the impact of increasing shareholder value

One key to a successful value creation program is to tie management sation to value creation Management must, however, have the authority to makethe appropriate decision to create value The results of their decisions can be meas-

Management must have the authority to make decisions that createvalue In other words, management must have the authority to makecapital budgeting discussions, capital investment decisions, andcost–of-capital decisions, and to increase returns on capital

ValTip

There are four general ways to increase shareholder value:

1 Create more cash flow without using more capital

2 Use less capital

3 Invest in higher-return projects

4 Lower the cost of capital

ValTip

954 OTHER VALUATION SERVICES AREAS

ured using the concept of economic profits, and their compensation can be tied tothe value creation results of their decisions

For more information on maximizing shareholder value see Tom Copeland,

Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed (New York: John Wiley & Son, Inc., 2000).

Valuation analysts are uniquely qualified to assist managementwith the design and implementation of value creation strategies.Analysts can expand traditional valuation methodologies to incorpo-rate the concept of economic profits to analyze, model and measurehow value is created Analysts can be indispensable not only in meas-uring what the value is today, but in assessing how to increase valuetomorrow

ValTip

At various points throughout the modified report we will stop and present ValuationViews (VV) that explain various concepts, as well as controversial issues.

This report format is one of many that analysts can use in presenting businessvaluations All schedules have been omitted as they are not necessary for explainingthe VVs Some of the terms, numbers, sources and other data have been changed forease of presentation Furthermore, the initial view presented may not always be thebest view in a particular valuation

manage-Is There Such a Thing as a Nonmarketable Controlling Interest?

Most analysts believe that there is no such thing as a “nonmarketable” trolling interest Their point is that a 100 percent controlling interest is as mar-ketable as any company of like kind that wants to be sold by the owners

con-(continues)

Others say that it can be nonmarketable depending on the underlying tion methodologies used For example, when using either the capitalized cashflow (“CCF”) or discounted cash flow (“DCF”) method in the incomeapproach, analysts often rely upon Ibbotson data to develop their discountand cap rates These rates are based on public company rates of return thatinclude the almost instant liquidity of the stock Even a 100 percent control-ling interest in a closely-held company lacks this level of liquidity Therefore,some analysts will take a discount to adjust for this difference An entire com-pany cannot be sold in just a few days as public stock can be

valua-In our opinion, the fair market value of 100 percent of the common stock inLEGGO Construction, Inc., on a nonmarketable, control basis, as of December 31,

1999, for management purposes, is (rounded):

Fair Market Value to Whom?

The standard of value here is fair market value The question then is fair ket value to whom? The standard answer is to a “hypothetical buyer.”Furthermore, the seller is not LEGGO’s current owner but a “hypotheticalseller” of the shares However, on a practical basis, it may be hard to ignorewhom the seller is, since it is the client The company may want the value toreflect the results of its management goals and philosophies Assuming a “typ-ical” hypothetical management team would operate the company in a similarmanner, then the value is fair market value However, if the company operateddifferently from others, then investment value may be the more appropriatestandard of value

mar-Valuation is not an exact science subject to precise formula Rather, it is based

on relevant facts, elements of common sense, informed judgment, and ness Our scope was unrestricted and our methodology and analysis complied withthe Uniform Standards of Professional Appraisal Practice In addition, this valuationreport and the values determined herein cannot be used or relied on for any purposeother than for internal management planning

reasonable-956 VALUATION VIEWS AND CONTROVERSIAL ISSUES: AN ILLUSTRATION

1 Treas Reg Sec 25.2512-1 (Gift Tax Regulations).

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Restrictions on the Use of the Valuation PurposeValuation analysts usually put restrictions on the use of the valuation Valuescan differ depending on the purpose of the valuation LEGGO managementwants to know the value of the whole company to do internal planning Thisvalue is on a stand-alone basis reflecting the results of how the current man-agement team runs the company The valuation could have been for anotherpurpose such as sale to a strategic buyer, minority gifts for tax purposes, anESOP, or a dissenting rights case Each of these probably would result in dif-ferent values For instance, there might be a control premium for the strategicbuyer; the gifts of minority interests might have large discounts for lack ofcontrol and for lack of marketability; the ESOP value may have a higher valuethan the gift value but lower than the stand-alone value and much lower thanthe strategic value; and the dissenting rights value would differ depending onhow that particular state treats discounts The same company can have quitedifferent values under differing circumstances.

The enclosed narrative valuation report and exhibits, as well as all documents

in our files, constitute the basis on which our opinion of fair market value was mined Statements of fact contained in this valuation report are, to the best of ourknowledge and belief, true and correct In the event that facts or other representa-tions relied on in the attached valuation report are revised or otherwise changed,our opinion as to the fair market value of the common stock of the Company mayrequire updating However, Valking LLP has no obligation to update our opinion ofthe fair market value of the common stock of the Company for information thatcomes to our attention after the date of this report

deter-No partner or employee of Valking LLP has any current or contemplated futureinterest in the Company or any other interest that might tend to prevent them frommaking a fair and unbiased opinion of fair market value Compensation to ValkingLLP is not contingent on the opinions or conclusions reached in this appraisal report.Very truly yours,

Val Dude, CPA/ABV, ASA, CBA, CVA

VALKING LLP

INTRODUCTION

Description of the Assignment

Valking LLP, was retained by Mr Tom Profit to determine the fair market value of

100 percent of the common stock in LEGGO Construction, Inc., (the Company) on

a nonmarketable, control basis, as of December 31, 1999, for management purposesand internal planning

Summary Description and Brief History of the Company

The Company was incorporated in 1978 in the State of Anystate The Company is

a closely-held subcontractor whose revenues are predominately earned from sewer

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and waterline construction, primarily in southern Anystate The Company is nowstructured as an S corporation

Tax-Effecting S Corporations?

The valuation of S corporations and other pass-through entities could be themost controversial issue in business valuation today The main issue is whether

to tax-effect S corporation income There really are four options:

1 Tax-effect the income at corporate rates

2 Tax-effect the income at the personal rates

3 Do not tax-effect the income at all

4 A combination or hybrid of the other options

The tax court has dealt with the matter of tax-effecting S corporations

in several recent court cases, (Adams v Commissioner, T.C Memo 2002-80; Heck v Commissioner, T.C Memo 2001-34; Wall v Commissioner, T.C Memo 2001-75; and Gross v Commissioner, T.C Memo 1999-254, affd.

276 F.3d 333 (6th Cir 2002)) The most famous is Gross v Commissioner,

where the court opined that taxes should not be assumed in valuing theshares of the company The value of the shares was much higher since pre-tax income was essentially capitalized at what appears to be after-tax dis-count rates

It is important to remember that a court case decision is based on the factsand circumstances of that particular case In addition, court decisions are ulti-mately the result of the legal strategy employed, decisions by the taxpayer and

the quality of the attorneys and experts The Gross case has created much

dis-cussion in the valuation community Let us look at some of the underlyingdetails of the case

• The size of the blocks of stock (a series of gifts) being valued were 0.63percent and 0.95 percent of the total outstanding shares respectively

• The shares were subject to a shareholders’ agreement that restricted theirtransferability to family members and furthermore prevented transfer toanyone who would jeopardize the Company’s S corporation status TheTax Court found that the shareholders agreement was designed to protectthe Company’s S corporation status Also, the shareholders had a separatewritten agreement to be taxed as an S corporation for at least 10 years

• The Tax Court recognized that the probability of losing the S corporationstatus should be a factor in the valuation, but the taxpayer did not pres-ent any evidence about the probability of such a loss in this case

• The taxpayer’s valuation expert admitted at trial that there was “growingcontroversy” in the appraisal community about tax-effecting S corporations

• The Company had a history of strong growth and a policy of distributingmost of its income to its shareholders There was no evidence that theCompany would not be able to make shareholder distributions sufficient

to cover the personal tax obligations of shareholders in the future

The unique facts and circumstances of the Gross case are not generally

applicable to other valuations Some other general observations follow:

958 VALUATION VIEWS AND CONTROVERSIAL ISSUES: AN ILLUSTRATION

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