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Exploring Real Option Techniques in Capital Budgeting: Insights from Behavioral Finance

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This chapter discusses the application of real option techniques in capital budgeting and capital structure, highlighting the mixed adoption by managers across various firms such as Merck & Co. and Intel. It illustrates the challenges, including abandonment of techniques and the influence of behavioral biases like overconfidence on decision-making. Examples showcase the implications of project selection on firm value, exploring scenarios of asset substitution and debt overhang. The analysis underscores the importance of understanding behavioral finance in optimizing managerial decisions.

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Exploring Real Option Techniques in Capital Budgeting: Insights from Behavioral Finance

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  1. Chapter 11 APPLICATION OF REAL OPTION TECHNIQUES TO CAPITAL BUDGETING AND CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin

  2. Do Managers Use Real Option Techniques? • Some do. • Merck & Co. • Hoffman-La Roche • Texaco • BP Amoco • Anadarko Petroleum • New England Electric • Intel • Toshiba • Most don't. • 2000 and 2002 surveys of management techniques. • real options ranked 24/25. • 32% of real-options users abandoned the technique.

  3. Roundtable on Real OptionsExample: Sun Microsystems • 2000 Roundtable included CFO of Sun Microsystems. • Sun did not use real option techniques, but CFO indicated the firm was ready to learn. • A year later, CFO indicated that real options might have rationalized bubble prices, but offered no value to the firm.

  4. Example:A Levered Firm • Trees show value of cash flows to debt and equity. • Sum is value of firm. • Bottom node at Year 4 shows impact of default, when value of firm less than value of interest and principal. • Traced back to Year 0.

  5. Implied Put Option Risk neutral probability of up move = Risk free rate – Down Return .05 – (-.04) --------------------------------------- = ----------------- = .1667 Up return – Down return .5 – (-.04)

  6. Small New Project • Value of firm = 95. • New project • increases cash flow in Year 4 by 20 if up • decreases cash flow in Year 4 by 1.8 if down • requires a Year 3 investment of 1.75 • discount rate of 352% • NPV < 0, but close to 0. • Is probability of default affected? • No, it's still 0.

  7. Large New Project • Value of firm = 95. • New project • increases cash flow in Year 4 by 200 if up • decreases cash flow in Year 4 by 18 if down • requires a Year 3 investment of 17.5 • discount rate of 352% • NPV < 0, but close to 0. • Is probability of default affected? • Yes.

  8. Asset Substitution • If larger new project adopted, and down move occurs at Year 4, firm's value declines $9.45 million below debt obligation. • Implied put option increases by $9.45 at Year 4. • Value of put option at Year 3 is 7.5 = 0.833 x 9.45 / 1.05 where 0.833 = 1 – 0.1667. • Managers increase shareholder value, decrease value of debt, by adopting new larger project.

  9. Debt Overhang • Value of firm = 61 < debt obligation 68.25. • New project • increases cash flow in Year 4 by 20 if up • decreases cash flow in Year 4 by 1.8 if down • requires a Year 3 investment of 1.75 • discount rate of 352% • NPV < 0, but close to 0. • Value of put option increases. • Project adopted.

  10. Capital Structure • Debtholders anticipate possibility of asset substitution and debt overhang. • They respond by increasing the cost of debt. • Firms' managers choose to hold less debt than is optimal. • Value of firms' equity less as a result, due to foregone tax shields.

  11. Overconfidence andAsset Substitution • Value of firm = 96. • New project: overconfident beliefs vs. actual • increases up cash flow in Year 4 by 20 vs. 63 • decreases down cash flow in Year 4 by 1.8 vs. 12.6 • requires a Year 3 investment of 1.75 • NPV < 0 not affected by overconfidence. • Overconfident managers reject project, rational managers adopt project.

  12. Unbiased Decision Task • Investment policy obtained by exercising when value of exercising exceeds value of holding. • Optimal investment policy is to wait for an up-move before exercising.

  13. Excessive Optimism • Excessively optimistic managers underweight the value of waiting, and exercise in circumstances less favorable than is optimal. • In this example, managers exercise (invest) immediately.

  14. Biased Backdrop • Excessive optimism and overconfidence induce managers to • overestimate project NPV • overestimate tax shield benefits from debt • underestimate the costs associated with financial distress • These biases increase the tendency to be overleveraged. • Agency conflicts operate in the other direction.

  15. Behavioral Biases Counter Agency Conflicts • Once a debt contract is in place, investment policy can impact the value of the implicit put. • Shareholders and debtholders share the value of a positive NPV project, but the shares need not be positive amounts. • Agency conflicts increase the cost of debt. • Mild excessive optimism and overconfidence induce managers to behave more favorably towards debtholders, thereby leading to increased leverage.

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