Acquistion of a business is a strategic business decision. Business decisions with strategic intent need to be evaluated on the basis of opportunities they create. For example, acquisition of a controlling stake in startups provides an acquirer a bundle of options to expand or integrate on a platform provided by the startups. Acquiring a business having complementary strength provides an option to an acquirer to integrate those strengths and expand on the integrated base whenever it is favourable to him with additional capex. Acquisition decisions offers an acquirer options to improve with additional capex and realise the untapped potential or to keep the acquired business as it is or further sell it off to other eager acquirers.

DCF difficulties
The conventional discounted cash flow (DCF) method of valuation often fails to capture the flexibility or opportunity provided by strategic decisions such as M&A. Valuation under DCF provides an easy procedure to value a company and arrive at a decision to acquire or not. First, estimate the present value of expected cash inflows a target would generate. Second, calculate the present value of cash outflows it requires. Difference between them is the net present value (NPV). If the NPV is positive, acquire. Otherwise do not acquire. Though there are some difficulties in arriving at the discount rate and adjusting for tax and interest, overall the methodology is simple.

One major difficulty with this approach lies in one of its underlying assumptions that investment is based on a now-or-never proposition. In reality, most of the strategic decisions are capable of being delayed. Recent research on investments highlights that companies have opportunities to invest and that they must decide how to exploit them most effectively rather than making capital investments by capital rationing.

It is based on an important analogy with financial options. A company with an opportunity to invest is holding something similar to a financial call option: it has the right but not the obligation that entitles it to a stream of cashflows at any time in future (when circumstances are more favourable) of its choice. Hence, the problem in valuing an acquisition candidate offers a bundle of options. How to value such options and when to exercise those options?

Opportunity cost
Normally, when an acquirer values an acquisition candidate by incorporating in its discounted cashflow, an investment required to realise expected savings and synergies (similar to exercising an option) and its expected cash inflows, it effectively kills an option. It loses flexibility to change its action, should market conditions move favourably in future. This has an opportunity cost (loss of value in the option) that must be included as a part of the cost of the investment. In other words, value of the option a company generates on acquiring another company should be adjusted in the present value of cash inflows within the valuation framework.

Consider this example. An acquirer is faced with a decision to acquire a startup company X at Rs 25 crore for expansion. Following are the possible scenarios in arriving at the cost of production of X under the acquirer's management:

For simplicity, ignore the time value of money and the discounting rate. Assume further that the revenues are fixed at Rs 90 crore (though they can also be subject to similar uncertainty).

The NPV for an acquisition decision by the conventional method would be: (1/3*30) + (1/3*99)+ (1/3*120) = Rs 83 crore; operating profit would be Rs 7 crore; and, NPV would be (90-83-15)= Rs 2 crore. Thus, the conventional approach would not justify the project.

Option values
From option pricing framework, an acquirer after acquiring a company would try and minimise the probability of realising a pessimistic level of cost of production. Thus, an acquisition gives an option to the acquirer whether to go in for profit or loss (nobody would like to continue if there is a loss).

If the scenario turns out to be pessimistic, an acquirer will not go for production because the operating profit would be zero (it would be negative if he continued with production). In alternate scenarios, however, he may choose to proceed with production. The operating profit then would be: (1/3*0)+(1/3*60)+(1/3*9) = Rs 23. This will give an NPV of Rs 8 crore. This justifies the acquisition decision at Rs 15 crore.

This calculation shows that any capital investment, an acquisition for example, that creates an option should be normally valued at a higher level than what a conventional NPV calculation could offer. This difference arises because option itself is valuable as it enables the acquirer to delay his commitment. Acquirer can exercise it when it’s advantageous to him and allow it to lapse when unfavourable to him. The incremental value over and above Rs 7 crore in the above example (the operating profit under conventional method) is the value of the option and it depends on the sizes and probabilities of the losses that an acquirer can avoid.

Greater insights
Recent literature on corporate finance and derivatives has been extensively studying the valuation of financial options. Finance professionals have been extensively using the Black and Scholes model of option pricing in trading in derivatives’ markets across the world. This model can be successfully applied in the valuation and negotiation exercises in M&A as well.

Practitioners have been showing discomfort in applying the discounted cashflow method for evaluating strategic decisions that provide some kind of options to the business. But, due to the unavailability of any alternative richer framework, they have to adjust the discount rate or estimation of cashflows or both, to justify undertaking strategic investment. Examples: research and development expenditure and cross-border acquisitions. Application of the option pricing approach in evaluating strategic decisions such as acquisitions would provide them with greater insights into the valuation and make them better equipped for negotiation. Valuing a strategic option on the basis of the valuation of a financial option would make the existing valuation framework (discounted cashflow method) richer in capturing the uncertainty involved in capital investment decisions.

Consider the following analogy of variables in the option pricing approach with variables in the conventional valuation framework. This may facilitate incorporating an option valuation in the conventional valuation framework.

The following example would make this analogy and incorporation of option pricing approach more clear. Company I, an aluminium manufacturing company set up in collaboration with Company A from Canada. A wants to get out of India and hence wants to sell off its stake. Company H is also in the aluminium sector and is negotiating with A for acquiring its controlling stake and proposes to merge I with H later. A is asking a price which would ultimately cost H Rs 1,458 crore (Rs 1,008 crore for acquiring I and Rs 450 crore additional expenses to realise the untapped potential of I). But at this price, H feels there is hardly any gain to its shareholders, since it gives an NPV of only Rs 0.31. But for H, I represents an attractive opportunity for capturing a strategic position in the Indian and international aluminum sector.

In a bid to simplify the calculation, this valuation has been based on the following assumptions: discount rate is 16 per cent per annum, the perpetual growth rate in cashflows after the terminal year is 3 per cent, annual growth rate in cashflows in phase 1 and 2 are 3 and 15 per cent, respectively.

Black and Scholes
Under the option pricing approach, phase 2 may be considered an optional investment and may be compared with a financial call option H has on acquisition of I at Rs 1,458 crore. This option can be more appropriately valued by the option pricing method rather than the conventional discounted cashflow method. Under the option pricing approach, by the Black and Scholes model, phase 2 would be valued Rs 262 crore rather than Rs 189 crore. Following are the variables assumed for phase 2 for valuation under the Black and Scholes model. Valuation for acquisition of I by H after incorporating option valuation in the conventional valuation framework would be: The phase 2 has higher valuation under option pricing approach than under the conventional discounted cashflow method because there is a time to maturity and option is in the money. One may tempt to say that at time zero, the acquisition has a strategic value of Rs 73 crore.

Does this framework really work? Yes. Though examples shown above are quite simple with restrictive assumptions, still the concept of valuing optional commitments by option pricing approach is more realistic and quite appealing.

Some refinements may be required in the above approach but it seems far more appropriate than valuing options by the conventional discounted cashflow method with fundamentally flawed assumptions, especially when it comes to valuing optional investments.

Dr Jinesh N Panchali is an associate professor with the New Mumbai-based UTI Institute of Capital Markets.