Executive Summaries

Executive SummariesSource: Financial Management, Vol. 22, No. 3 (Autumn, 1993), pp. 6-22Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665920 .

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Executive Summaries

Managing Financial Distress and Valuing Distressed Securities: A Survey and a Research Agenda

The role of high leverage in corporate restructuring, popular- ity of junk bonds (original-issue, high-yield bonds) and the savings & loan crisis have been important aspects of the finance scene in the 1980s. A very active academic literature has developed in recent years on dealing with financial distress and the private and court-supervised mechanisms of resolving default. The purpose of this article is to survey the empirical and theoretical research on (i) managing financial distress, and (ii) valuing corporate securities incorporating payouts in troubled reorgani- zations. New research on both topics is contained in the nine

papers presented in this Financial Distress Special Issue of Fi- nancial Management. These papers are also surveyed in the context of related past research.

I also present an agenda for future research in these areas. A

simple conceptual framework for managing financial distress is

presented. First, the theoretical work and recent empirical evidence on asset restructuring is summarized and the theory and evidence on private debt restructuring (debt workouts) is collected. I then review the theoretical and empirical research on the formal bankruptcy (Chapter 11) process. Efficiency aspects of the current U.S. bankruptcy procedure, the design of an optimal bankruptcy procedure, and proposals for bankruptcy reform are also discussed, as well as the valuation of corporate securities and contracts with significant probabilities of default. Finally, some

promising areas and topics for future research are considered. This research can provide the financial manager with many

insights:

(i) Given the liquidity characteristics of the assets under management, what are the optimal strategies for liquidity management? How much leverage is optimal? For a given level of leverage, what innovative features can be used in the debt contract to reduce the costs of financial distress? What is the optimal design for the structure of the debt contract to facilitate easier renegotiation if the firm is in financial distress later? The structure of the contract may involve maturity and seniority structure, cross-default clauses, public versus private debt, single versus multiple creditors, and level of bank debt involved. The past research reviewed in Section II and the special issue articles by John and Opler provide many answers.

(ii) Understanding debt workouts is important for the financial manager. What are the determinants of a successful workout? What kinds of terms are common in the renegotiated

debt contract? What are the important features in a successful distressed exchange offer or consent solicitation for a covenant change? What role do banks play in debt workouts? What are the relative direct costs of a private restructuring versus a formal Chapter 11 process? The answers to many of these questions appear in the research reviewed in Section III.

(iii) A number of studies have examined the shareholder wealth effects of events in financial distress using daily stock price data. The manager could benefit by learning to interpret these studies and anticipate the market reactions of his firm's stock. The wealth effects of the different mechanisms of resolving distress may provide the manager with an objective criteria to choose among the alternatives.

(iv) The features of the current Chapter 11 bankruptcy process in the United States, parallel systems in other countries and proposals for its reform and features of the design of optimal procedures are reviewed. Understanding the features of the bankruptcy process and its effect on managerial incentives and investment efficiency is important. Management compensation structures can be optimally designed to provide managers with appropriate incentives in and out of financial distress. Corporate boards can also finetune their monitoring role to compliment the features of the bankruptcy process. The manager should also be aware of DIP financing and other financing methods in bankruptcy and aspects of strategic bankruptcy filing.

(v) The importance of estimating the probability of bankruptcy and its determinants has been emphasized in exten- sive work by Altman and others. Coats and Fant, in their special issue paper, use an artificial intelligence technique ("neural network") to predict future solvency. The financial manager can incorporate these valuable inputs in asset and liability management as well as in the pricing of distressed securities. Other valuation models are also surveyed which can be used by the financial manager for valuing distressed securities and designing strategies for investing in them.

Kose John

From Financial Management, Vol. 22, No. 3, Autumn 1993, pages 60-78.

6



FM EXECUTIVE SUMMARIES 7

Controlling Financial Distress Costs in Leveraged Buyouts With Financial Innovations

Leveraged buyouts have often been funded in ways which

appear to reduce the risk and cost of financial distress. Leveraged buyout financing methods include the use of specialist sponsors, strip financing, covenants which require that excess cash flows be paid to debtholders, and debt provisions which allow deferral of interest payments in periods of financial distress.

In theory, these methods of structuring deals reduce incentive

problems between stakeholders of the firm and reduce the costs of resolving financial distress. For example, financing with a

leveraged buyout sponsor such as Kohlberg, Kravis and Roberts

brings in a third party with interests which are aligned both with those of debtholders and equityholders. This will limit conflict between parties and can also provide a mechanism for capital infusions in periods of distress. Similarly, the use of strip financ-

ing in which equity and debt are held by the same parties, can minimize conflict between stakeholders. The use of covenants which require payout of excess cash flows may also reduce incentive problems between financial claimants by restricting equityholder flexibility to reinvest resources in projects which debtholders perceive as risky and undesirable.

This study finds that these innovative financing techniques were frequently used in 63 LBOs which occurred in 1987 and 1988 - at the peak of the LBO boom. In addition, this study tests whether these financing methods lower the risk-adjusted weighted cost of debt in LBOs. To the extent that innovative financial techniques lower financing costs, then financial markets ex ante believe that their use lowers the deadweight costs of debt finance. The main results show that sponsorship by an LBO specialist lowers the weighted average cost of LBO debt and the imputed cost of capital by roughly 60 basis points. In contrast, there is no evidence that strip financing lowers the costs of debt finance. This may reflect contracting problems which allow strip financing arrangements to be circumvented when it is in the interest of some claimants to unbundle their claims to the detri- ment of others. Furthermore, asset sale covenants which force payout of cash are frequently used but not associated with lower financing costs. One factor which may explain this result is that asset sales may hinder the productivity of remaining assets with the effect of decreasing the probability of on-time payout of cash flows from remaining assets. In addition, debt provisions which allow deferral of interest payments on junior debt and which maintain a minimum bond value are used in many of the LBOs in the sample. While these provisions do not lower financing costs, their use indicates that LBO capital structures are designed to avoid the need for debt workouts or Chapter 11 proceedings in periods of financial distress.

This research has important implications for public policy- makers worried about the risk that highly leveraged transactions can increase the fragility of the financial system in economic downturns. By pointing to the various sorts of "armor" used to minimize the risk and impact of financial distress in leveraged buyouts, this research suggests that many concerns about the adverse macroeconomic impact of LBOs expressed in the 1980s were unjustified. Debt covenants were used which assured rapid repayments of debt and which gave firms the flexibility to operate even with temporary shortages of cash (e.g., PIK debt). Many LBOs appear to have been financed in a way which specifically allowed firms to ride out temporary downturns in the economy.

This research also has several implications for corporate financial policy. First, the results suggest that it is difficult to

contractually sidestep conflicts between equityholders and debtholders in highly leveraged transactions with strip financing and covenants which force certain equityholder actions. The

possibility that strip financing arrangements can be unbundled at the cost of debtholders appears to be a very real one. Second, the results highlight the value of guaranteeing debt financings with the involvement of an organization which has repeatedly trans- acted in the marketplace. LBO sponsors appear to play this role

effectively as was argued by Michael Jensen in his widely discussed article "The Eclipse of the Public Corporation." There are

already many contexts where similar guarantees take place (e.g., asset-backed securities, bank guarantees of commercial paper), and there may be areas where financial transactions can be structured to create further value.

Finally, the empirical methods used in this research could be

applied more broadly to establish pricing guidelines in the junk bond market. Traditional bond pricing methods rely on relatively simple one- and two-state variable arbitrage pricing models. While widely used, these methods are particularly difficult to

apply when pricing complex bonds of highly leveraged firms with rich covenant structures and many layers of debt. Junk bonds instead could be priced "off the market" using a regression equation similar to that shown in this paper which shows the

average market price of cash flow risk, leverage, covenant provisions, etc. For example, the regression model could be used in a trading context to identify bonds yielding more than expected, given issuer and security characteristics.

Tim C. Opler




8 FINANCIAL MANAGEMENT / AUTUMN 1993

Accounting Measures of Corporate Liquidity, Leverage, and Costs of Financial Distress

Liquid assets such as cash and marketable securities constitute a considerable portion of total assets, say 6.3% to 9.6%, of

manufacturing firms. Financial managers pay a lot of attention to the measurement and management of corporate liquidity. It has also been recognized that a consequence of severe shortage of

liquidity is financial distress. This study analyzes the relationship of the costs of financial distress to the level of corporate liquidity maintained and leverage.

The financing contracts of a firm can be loosely categorized into hard and soft contracts. An example of a hard contract is a

coupon debt contract which specifies periodic payments by the firm to the bondholders. If these payments are not made on time, the firm is considered to be in violation of the contract and the claimholders can seek specified and unspecified legal recourses to enforce the contract. The assets of a firm also have a natural

categorization based on liquidity. Cash or cashlike (marketable) securities are liquid assets. Long-term investments (such as plant and machinery), which may only produce liquid assets in the future, may be called "illiquid" assets. The firm is in financial distress when the currently available liquid assets are severely inadequate to meet the current obligations of its hard financial contracts. Management may try to cope with financial distress by (i) selling assets, either current or fixed, or (ii) renegotiating with its creditors to arrange a deferred payment schedule. Debt restruc-

turing may be done privately in a workout or formally in a Chapter 11 bankruptcy reorganization. The total costs of (i) and/or (ii) constitute costs of financial distress. Two testable implications are: (a) the proportion of total assets invested by a firm in liquid assets (e.g., cash and marketable securities) will be increasing in its costs of financial distress, and (b) the proportion of debt in the

capital structure of a firm will be decreasing in its costs of financial distress.

The most important cost of asset liquidation is the destruction of going-concern value that occurs when assets are sold to pay down debt. This loss of value will be greater for intangible assets and assets that generate firm-specific rents (e.g., growth opportunities, managerial firm-specific human capital, monopoly power, and operating synergies whose value depends on the firm's assets being kept together). Replacement cost approxi- mates what the firm's assets could be sold for piecemeal, and is

positively correlated with the liquidation value of the assets. Firms with a higher market value/replacement cost ratio will have a higher cost of asset liquidation. Therefore, Tobin's q ratio (equal

to market value/replacement cost) will be used as a proxy for the loss of going-concern value in asset sales and premature liquida- tions associated with financial distress. The costs of liquidation are higher for firms that produce unique or specialized products. Their workers and suppliers often have job-specific skills and

capital, and their customers find it difficult to find alternative

servicing for their relatively unique products. For these reasons, a high degree of specificity or uniqueness engenders high distress costs. Expenditures on research and development over sales and

advertising over sales are indicators of uniqueness. As a proxy for asset specificity, a dummy variable SPC is constructed, where SPC equals one for firms with SIC codes between 3400 and 4000 (firms producing machines and equipment) and zero otherwise.

I estimate a linear relationship between corporate liquidity and proxies for the costs of financial distress. The liquidity ratio is positively related to these proxies (such as Tobin's q, R&D and

advertising expenditures, asset specificity, and the probability of

bankruptcy). It is negatively related to proxies for alternate sources of anticipated liquidity such as intermediate cash flows, debt financing, length of cash cycle and the collateral value of assets.

I estimate a linear relationship between debt (two measures: total debt and long-term debt) and proxies for costs of financial distress. Total debt is also negatively related to Tobin's q and asset

specificity as well as measures of intermediate cash flows. Long- term debt is also negatively relatively to Tobin's q and asset

specificity. Overall, the evidence is strongly consistent with the

hypothesized positive relationship between corporate liquidity and financial distress costs, and the negative relationship between

corporate leverage and financial distress costs. The conceptual framework and the empirical results can be

used by financial managers and consultants to determine the

liquidity and leverage policies of their firms. All the variables used in this study can be computed for the specific firm of interest from available data. Models in Equations (1) and (2) can be used

normatively to guide the implementation of my framework for

specific firms. In some cases, the models may be reestimated for a more appropriate subset of firms. The linear models I have used can also form the starting point for developing and estimating a more elaborate nonlinear specification, when appropriate.

Teresa A. John





Absolute Priority Rule Violations and Risk Incentives for Financially Distressed Firms

In a June 12, 1990 Wall Street Journal article entitled "Warn- ing Flag: When a Firm's Stocks and Bonds Diverge," the stocks and bonds of companies such as Pan Am and TWA were cited as

being clearly mispriced. How, the article asked, could Pan Am's stock be trading at $2.50 per share when its senior debt was only worth 30 to 40 cents on the dollar? A managing director of a mutual fund was quoted as stating the prices were "totally ridicu- lous," and he further remarked, "Either the bond is too cheap or the stock is too high." The article noted that, "At least in theory, if a company's creditors' can't be fully paid, its stock, which ranks lower among its financial obligations, is next to worthless." In other words, the absolute priority rule (APR) will be followed. The APR states that creditors should be fully compensated before shareholders receive any portion of the bankrupt firm's value.

In fact, a number of recent papers report that the APR is violated in about 75% of corporate bankruptcies. Estimates of the

proportion of firm value received by shareholders in violation of the rule range from 2.4% to 7.6%. Many critics have argued that APR violations are an example of how Chapter 11 of the Bank-

ruptcy Code is used by shareholders to expropriate wealth from creditors. In an efficient market, however, expropriation does not occur because creditors account for a departure from the APR when they buy the debt. Indeed, studies have found that distressed firms' stocks and bonds appear to be efficiently priced. Thus, the

"divergence" of Pan Am's stock and bond prices cited above was

probably a reflection of the market's anticipation of a departure from the APR.

This paper demonstrates that, in an efficient market, a deviation from absolute priority can actually be beneficial; it can play an important role in ameliorating bondholder concerns about the incentive of shareholders to increase the riskiness of the firm's assets. This problem arises because shareholders are residual claimants on the value of the firm with limited liability. If the bondholders are naive, a rise in the firm's riskiness benefits shareholders at the expense of bondholders. This is because

higher riskiness implies a greater chance that shareholders will receive a big payoff, while limited liability protects them from the concurrent increase in the likelihood of a large loss. An increase in risk reduces bond value, because bondholders do not receive a larger payment than what they were promised if a substantial return is generated; conversely, a precipitous loss

implies a lower value of their claim in the event of bankruptcy.

This risk incentive can involve more than a simple transfer of wealth from bondholders to shareholders; it can reduce the value of the firm, because shareholders will invest in negative net

present value projects if they are risky enough. Bondholders, however, are not naive and recognize the risk

incentive. They price the firm's debt with the expectation that shareholders make investment choices towards high risk (albeit lower value) projects. The reduction in firm value resulting from the choice of high-risk/low-value projects is an agency cost associated with issuing debt that is absorbed by shareholders. Hence, it is in the interest of shareholders to seek contracts -

explicit or implicit - that reduce, or even eliminate, agency conflicts.

Conversion or call provisions included in bond indentures are two well-known examples of the use of explicit financial con-

tracting to mitigate the risk incentive. Convertibles mitigate the incentive because equityholders are forced to share the residual

payoff with converting bondholders in the event of a large payoff. Call provisions reduce the incentive through a decrease in the

underlying bond value (in response to a risk shift) thereby dimin-

ishing the value of the call provision held by shareholders. These traditional methods of controlling risk-shifting lose their effec- tiveness, however, as the firm approaches financial distress because the probability of a conversion or call approaches zero. The shareholders of the financially distressed firm have a strong incentive to "go-for-broke" by shifting the firm's assets into very high-risk projects because they have little to lose (i.e., limited

liability means they can only lose the value of their stock and when the firm is financially distressed the stock value is low).

We argue that a departure from the APR may be viewed as an

implicit feature of the bond contract (implicit because this feature is not explicitly mentioned in the bond covenant at the time of debt issuance). The attractiveness of the APR violation feature is that it is most effective when the more traditional methods (call or convertible provisions) are least effective. Intuitively, when shareholders expect to receive a payoff in the event of bankruptcy, they have more to lose and consequently the "go-for-broke" strategy is less alluring.

Allan C. Eberhart and Lemma W. Senbet





Does Default Risk in Coupons Affect the Valuation of Corporate Bonds?: A Contingent Claims Model

The early work of Black and Scholes, and Merton, made the connection between conventional options and corporate liabilities. The standard textbooks now employ option-pricing argu- ments in discussing the valuation of stocks, bonds, convertible bonds and warrants; this discussion extends to the various features (such as call and sinking-fund features) that now are ap- pended to these issues. The technique is to recognize that the value of a particular security derives from, or is contingent on, the value of the firm and other economic variables (such as the yield curve for government securities), and then apply the same valuation procedure that one would use to value a call option on some underlying common stock.

Despite the theoretical linkage to option pricing, there have been few attempts to make this "contingent claims" approach operational. A typical corporation's capital structure tends to involve many debt and preferred issues with various indenture provisions, and this tends to increase the complexity of the model. The model's application requires a clear delineation of the values of various senior securities upon the incidence of bankruptcy. Previous studies used various simplifying assumptions in order to apply the contingent claims valuation model. One of their findings is that the default spread between a corporate bond's yield and the government bond yield predicted by the model is much smaller than the observed spread, using conventional levels for the other input parameters in the model.

In this paper, we develop contingent claims valuation models for corporate bonds and show that they are capable of generating yield spreads consistent with the levels observed in practice. We

incorporate important features in the valuation related to the occurrence of and payoff upon insolvency and focus on the

default risk of coupons in the presence of dividends and interest rate risk. In order to employ contingent claims methods, it is

necessary to write down a set of "boundary" conditions that summarize the incidence of insolvency and the subsequent financial payoffs to the various securities. Readers should be alerted to the fact that we have a long way to go before we can adequately represent the complex interactions between various claims within this quantitative approach. Our model differs from previous attempts at contingent claims valuation by building a cash-flow- related condition for the onset of insolvency.

Numerical solutions are employed to show that the resulting yield spreads are sensitive to interest rate expectations, but not to the volatility of the interest rates. Interaction between call provisions and default risk in determining yield spreads is explicitly analyzed to show that the call provision has a differential effect on Treasury issues relative to corporate issues.

Our model provides a realistic framework to characterize credit and interest rate risks. It is possible to extend our analysis to calibrate the term structure model to the Treasury curve. This will allow practitioners to use our framework to analyze the

pricing of corporate issues. In addition, the model will provide a

quantitative guideline to hedging decisions. More realistic financial distress scenarios are also readily incorporated in the framework that we have proposed. The direct extensions are left as

topics for future research.

In Joon Kim, Krishna Ramaswamy, and Suresh Sundaresan





Marketability and Default Influences on the Yield Premia of Speculative-Grade Debt

Following several years of severe price volatility, market uncertainty and a number of well-publicized controversies, the issuance of high-yield bonds virtually ceased by 1990, suggesting that interest in these instruments might disappear as well. During 1991 and 1992, however, total annual returns on high-yield bonds approached 40%, and with it record new issuances. Analysts and investors alike have since revisited the unresolved questions regarding risk of high-yield bonds and their associated yield spreads.

Prior academic interest in the high-yield bond market focused on determining whether these bonds collectively provided adequate compensation for their inherently higher default risk. Such studies were ordinarily conducted using portfolios of bonds rather than individual bonds and typically centered on new issues, not seasoned issues.

In this paper, we explore determinants of yield spreads between high-yield bonds and U.S. Treasuries for a sample of individual, seasoned high-yield bonds. We examine the influence of default risk, marketability risk, convertibility and underwriter prestige on yield spreads and offer hypotheses on the importance of these components.

Our modeling procedure explores both the impact of default risk and the impact of marketability on yield spreads. We model default risk using a combination of traditional firm-based liquidity and leverage variables computed from publicly available financial statements and stock price information. Variables include: net liquid balance, standard deviation of stock returns, cash from operations and market-to-book ratios. We also use bond information such as issue size and convertibility in assessing default risk, and use frequency of bond trades and volatility of bond prices to assess marketability risk.

We compiled our sample using the set of all 838 industrial firms identified in Standard & Poor's COMPUSTAT PC Plus which had bonds rated below BBB- in any quarter during the study period 1980 through 1992. We then collected all available

bond price, stock price and financial statement data on these firms from a variety of sources. We eliminated any firm and bond from the final dataset which had incomplete data since our factor

analytic modeling procedure (LISREL) requires complete data on every bond we use in the study. As a consequence of using this

methodology (which mitigates several econometric difficulties inherent in other econometric techniques), we reduced our final dataset to 107 bonds representing 78 firms.

Our results support prior academic findings which associate greater default risk with larger yield spreads. In addition, after

controlling for the impact of default, we find that our marketabil-

ity measures contribute to the explanation of yield spreads. For

example, yield spreads narrow when bond trading frequency increases, and yield spreads tend to increase when bond price volatility increases. We interpret these results as evidence that investors demand compensation for reductions in marketability.

Since speculative-grade debt probably exhibits more pronounced differences in default and marketability risk than other debt, relationships uncovered in this paper may contribute to a

greater understanding of yield spreads for all debt. In particular, we anticipate that marketability risk, which has received little attention in prior empirical research, will become more important in future work regarding yield spreads. Moreover, we believe additional refinements of our model criteria might potentially benefit practitioners and academics attempting to price risky debt. For example, aspects of this paper could assist bond analysts in deciding which variables to collect, monitor and model. More

importantly, we believe that extensions of our model might lead to a better understanding of relative bond price efficiency and

mispricing.

Joel Shulman, Mark Bayless, and Kelly Price





Recognizing Financial Distress Patterns Using a Neural Network Tool This study builds neural networks (NNs) which estimate the

future financial health of firms. A neural network is a relatively new mathematical approach for recognizing discriminating patterns in data. We use NNs here to identify financial data patterns which consistently distinguish generally healthy firms from distressed ones. The purpose is to detect early warning signals of distressful conditions in currently viable firms. Being able to form highly reliable early forecasts of the future health of firms is critical to bank lending officers, investors, market analysts, portfolio managers, insurers, and many others in the field of finance.

The traditional approach and present standard for predicting financial distress uses multiple discriminant analyses (MDA). MDA is a statistical means of weighting the relative value of information provided by a combination of financial ratios. But MDA has been sharply criticized because the validity of its results hinges on restrictive assumptions. These restrictions are, in many cases, incompatible with the complex nature, boundaries and

interrelationships of financial ratios. In such cases, the power of MDA is compromised and the results may be erroneous. Other studies have suggested alternatives to MDA, including logit, probit, recursive partitioning, expert systems, and nonparametric models. However, none of these approaches has replaced MDA as the standard for comparison.

We show that NNs are a promising alternative to MDA. The

paper presents Cascade-Correlation, the particular NN used in our comparison study of NN and MDA models for predicting financial distress. We discuss how the NN computer-implemented training process works, how it autonomously gleans relationships from the data, and how it builds a unique neural network structure. The completely flexible NN method for cap- turing and communicating knowledge about the data allows a neural network to uncover complex, imbedded patterns that other

techniques cannot detect or describe. Our study examines 282 firms which were in operation during

the period 1970-1989. Ninety-four of the firms were formally identified and reported by their auditors as (at some point over the period) being financially distressed. The remainder (188

firms) were reported by their auditors to be healthy and viable. Specifically, we looked at five ratios widely considered to be prime determinants of financial health: working capital/total assets, retained earnings/total assets, earnings before interest and taxes/total assets, market value of equity/book value of total debt, and sales/total assets. Half of the firms of each type were used to develop NN and MDA models and the rest served as a test sample.

Our decision to use auditors' reports rather than the traditional bankruptcy filing as our indicator of financial distress was based on a desire to focus on the "practical" relevance of a correct prediction. Bankruptcy of a firm may occur after a prolonged period of financial distress. If so, there is little practical use for a predictive model since the distressed nature of the firm is obvious to virtually all of the firm's stakeholders, i.e., shareholders, employees, vendors, etc. On the other hand, the published auditors' reports we used are expected to precede bankruptcy, perhaps quite substantially. In addition, bankruptcy is only one outcome of financial distress. Others include reorganization, liquidation, and acquisition by a viable firm. Regardless of the outcome, losses and risks preceding the final resolution are likely to be incurred by stakeholders. Bad audit reports can cause bond ratings to be lowered, lines of credit to dry up, and other business relationships to be disrupted. Thus, the use of auditors' reports as the prediction criterion covers a broader range of events than does the bankruptcy filing and should have more relevance to decision- makers.

The test results suggest that the NN approach is more effective than MDA for the early detection of financial distress developing in firms. The NN models consistently correctly predicted auditors' findings of distress at least 80% of the time over an effective lead time of up to four years. A statistical comparison of results showed that the NNs were always better than the MDA models for identifying firms which eventually received bad audit reports. Thus, NNs appear to be reliable forecasting tools, whose use may be particularly warranted when the costs associated with misclassifying a distressed firm as healthy are high.

Pamela K. Coats and L. Franklin Fant





Market Reaction to Bond Downgradings Followed by Chapter 11 Filings

Over time, the bond ratings of companies mired in financial difficulties are usually downgraded by rating agencies such as Standard & Poor's or Moody's. After the ratings are lowered, some companies slide down into the abyss of bankruptcy, while others survive by reorganization. Our study examines the impact of bond downgradings on the market, focusing on the sensitivity of the market, i.e., the change of stock prices, in detecting the likelihood of bankruptcy of companies which receive the same

degree of bond downgradings. Our systematic and empirical approach, in which we introduce the concept of first consistent downgrading, is unique from previous studies on bond rating changes.

In this study, we focus on situations of financial distress and the ability of rating agencies to capture all relevant information known to the market. To best illuminate this avenue of research, we have introduced the concept of first consistent downgrading, which is defined as the earliest downgrading after which there are no upgrades (although there can be additional downgrades) until the company either files for Chapter 11 bankruptcy or the study period ends, and prior to which there has never been any downgrade for the company in question.

As in earlier work, we employ the event-study methodology. The event is defined as the first consistent downgrading of the bond. We select a two-year period (510 business days) ending 11 days before the event as our comparison period. The actual event, the change in the bond's rating, is taken as the 21-day period beginning ten days before and ending ten days after the downgrade announcement, plus the downgrade date itself. The selected bonds must have been publicly traded and listed with a rating from S&P or Moody's, and whose companies filed for Chapter 11 between September 1977 and October 1988.

Two samples are analyzed. The first sample contains companies listed on the New York or American Stock Exchange that experienced a bond downgrade and subsequently filed for Chap- ter 11. The other group constitutes a matching sample of firms that underwent an identical downgrading of their bonds but did not file for bankruptcy protection. For example, if a firm's bond was downgraded from AA to B, then followed by a Chapter 11 filing, we looked at the monthly S&P Bond Guide for another firm (matching sample) which was also downgraded from AA to B but did not file for bankruptcy.

The results of the statistical analysis show that the bond downgradings negatively affect shareholder wealth, and that the daily excess return of companies in the Chapter 11 sample is

significantly lower than that of the corresponding non-Chapter 11 group with the same bond downgrading. For instance, the mean residual return of the Chapter 11 sample is -3.199, in contrast to -0.204 in the matching sample. This implies that the new information the rating agencies provide to the equity market is not complete. The market, on average, is capable of distinguish- ing between these two groups of firms. It seems to "know" in advance that those downgraded companies which later file for bankruptcy are in worse financial shape than those which do not, and behaves as if it assigns an even lower grade to the bonds of the financially distressed company, which the rating agencies should have done by including the bankruptcy risk that the market itself predicts. It is our empirical finding that the Chapter 11 filings happen two years after the first consistent downgrading, which points to a high degree of market insight into the future prospects of companies.

These provocative results put forth the question that, if the market is able to assess the higher bankruptcy potential, why isn't it already incorporated into the stock price? That is, why does the bond downgrading itself stimulate a strong negative reaction if the superior knowledge already exists in the market? The cue redundancy theory might provide a plausible answer. When decisions have to be made in the absence of all necessary information, managers or investors usually base their decisions on available data that are known to be associated with or indicative of the unknown, yet vital information. A series of consistent confirming data points - redundant cues - will finally reach that certain threshold where the decision-maker is willing to act as if the missing information were known. In the case of the

present study, the market may have information pointing to a concern about the continuing viability of a company, but not quite enough information to move it to action. The bond downgrading, then, may be the independent confirming data point needed to cross the threshold or to reinforce the conclusion of looming financial distress, and the market reacts accordingly.

Our conclusions may provide investors with a more precise knowledge of the workings of the market and a more sensible way to interpret the signals the market sends out, and suggest that insightful investors should actually take action before the bond downgrading announcement to obtain abnormal excess returns.

Keqian Bi and Haim Levy





Troubled Savings and Loan Institutions: Turnaround Strategies Under Insolvency

Unexpected increases in interest rates during the early 1980s and decreases in asset quality in the late 1980s caused massive losses throughout the savings and loan industry. Insolvency was common, if not the rule. But because of bureaucratic forbearance, funding constraints, and federal deposit insurance, hundreds of insolvent thrifts continued to operate. This is because regulatory agencies were unwilling or unable to close thrift institutions immediately upon insolvency. Instead, they progressively reduced the thrift capital requirement and later refrained from enforcing that requirement in the hope that the industry would recover. Coupled with deposit insurance and the expanded investment and lending powers granted to the industry in the early 1980s, this regulatory forbearance gave thrift managers the opportunity to pursue strategies to turn around their firms, to regain profitability and to restore adequate capital levels.

Most previous studies have examined differences between insolvent and well-capitalized firms. In contrast, we begin with a sample of poorly capitalized thrifts. We investigate the turnaround strategies adopted by recovered institutions and compare them to those of thrifts that failed. For example, regulators gave troubled thrifts the opportunity to restructure their assets towards shorter-term commercial or consumer loans, which in turn would allow these firms to reduce their risk and to raise their asset

quality. Alternatively, thrifts might have concentrated on traditional mortgage lending or utilized their expanded powers to

grow rapidly in the hope that long-shot gambles would pay off. Did the thrift industry seize this opportunity? Did managers

of successful thrifts adopt different strategies to turn around their firms than managers of their unsuccessful counterparts? Or did

they select the same strategy and simply enjoy good fortune? We explore these questions by examining the business strat-

egies of the 300 largest thrifts that failed to meet the federally mandated five percent capital requirement at the end of the 1970s. We compare the asset and liability portfolios of thrifts that recovered by the end of the 1980s with those of thrifts that did not. To examine portfolio changes through time, we compare portfolios at the end of December 1979, June 1985 (to correspond to new Federal Home Loan Bank Board regulations) and Decem- ber 1989.

Our results show that when the crisis surfaced in the early 1980s, recovering thrifts operated in a fashion similar to failing thrifts. However, in the mid-1980s, recovering firms pursued risk-minimizing strategies while nonrecovering firms pursued riskier and, on average, higher-growth strategies. This growth pattern runs counter to that of most industries, which typically

shrink during times of financial stress. Unsuccessful thrifts used far more brokered deposits, while recovered thrifts pursued a

core-deposit growth strategy of expanding their assets at a rate

they could fund primarily with inexpensive retail deposits. The asset growth of unsuccessful thrifts is consistent with a speculative growth strategy, while that of recovered thrifts is more consistent with the natural market growth associated with successful firms. Perhaps surprisingly, the unsuccessful thrifts' riskier portfolios earned less total income than their successful

counterparts' safer portfolios; over time, losses on the unsuccessful thrifts' lower quality portfolios eroded earnings. Perhaps equally surprising, given media attention to fraud and managerial misconduct, we find no evidence of excessive perquisite con-

sumption in unsuccessful thrifts. We find that only 24% of the 300 thrifts in our sample

eventually did recover between the end of 1979 and the end of 1989, while 55% fail or merge. The others survive as independent institutions, but with less than the three percent capital requirement of the Financial Institutions Reform, Recovery, and En- forcement Act of 1989; that is, they not only failed to rebuild their

capital to the previous five percent requirement, they did not even meet the much less stringent hurdle in place by the end of the decade. Even with continued regulatory forbearance, we find no evidence that their condition improved.

These results have important implications for both thrift man-

agers and supervisory agencies. Our results suggest that success-

fully turning around poorly capitalized thrifts during the 1980s was neither easy nor likely. Those managers that were successful tended to concentrate on more traditional thrift activities involv-

ing lower-risk assets and liabilities. Regulatory agencies and thrift supervisors charged with monitoring the industry cannot

ignore the recovery rate for our sample thrifts of a mere 24% and further, our evidence suggests that identifying firms which would

eventually recover would, at best, have been very difficult. Al-

though other studies have shown that it is relatively easy to

distinguish risky thrifts from safe ones, pinpointing which of the insolvent institutions will ultimately recover may not be possible using only financial data. Although not the focus of this study, this result suggests that regulatory forbearance could have been

costly to taxpayers.

Ramon P. DeGennaro, Larry H.P. Lang, and James B. Thomson





Response of Distressed Firms to Incentives: Thrift Institution Performance Under the FSLIC Management Consignment Program

The Management Consignment Program (MCP) was adopted in 1985 by the Federal Savings and Loan Insurance Corporation (FSLIC) in an attempt to minimize the acute adverse incentive

problems present when insolvent thrift institutions are allowed to continue in operation. The management of problem thrifts were

replaced by new management teams, selected by federal regulators and compensated on a contract basis. They were expected to maintain service to depositors and improve the condition of the thrift's books and records while more permanent solutions were

explored. Without close monitoring by the FSLIC, problem institutions with low or negative net worth would have an incentive to take on risky strategies which could further erode net worth. Under the MCP, given the new incentive structure, agency theory predicts that there would be no incentive to exert effort in other than a risk-averse way. However, in an attempt to preserve asset values, the new managers may lock in negative or inadequate profit margins, thereby precluding the possibility of a return to

solvency by a successful (lucky) gamble for large profits. There- fore, although the MCP may have reduced total costs to the FSLIC, as a result of the absence of a profit motive and the conservative strategies followed, the chances of the MCP institutions recovering to solvency may have been significantly lowered when compared to similarly insolvent institutions that were allowed to operate outside of direct government control.

Previous research on insolvency and failure within the thrift

industry has focused on techniques to develop early warning signals or to evaluate the costs to the federal insurance funds when institutions fail. The contribution of this paper is twofold. First, a limitation of previous failure studies is that their primary goal is to examine the determinants of closure when solvency may be the more meaningful event to explain. This paper uses generally accepted accounting principles (GAAP) to determine insolvency in establishing a prediction model. Second, using the bankruptcy prediction model, this paper examines the extent to which inclu- sion in the MCP and the resulting alternative management structures affected the behavior of financially distressed thrifts. The

methodology is as follows:

(i) A two-step logit bankruptcy prediction model is developed. The logit model provides an estimate of an observation's

probability of falling into prespecified categories. In this case, the categories were GAAP solvent and GAAP insolvent. The model coefficients were generated by using proxies for the factors that are expected to explain solvency. The variables included were proxies for credit risk,

liquidity risk, interest rate risk, operational risk, and variables necessary to control for external factors. The model was validated by using a holdout sample to test predictive ability.

(ii) The chances of recovering to solvency for the MCP institutions were then compared over time by using the logit model developed in step one. The results were tested by comparing the change in the mean scores over time and by comparing the average change for each institution between two time periods.

(iii) The MCP institutions were then compared with similarly insolvent institutions that were not placed in the MCP but allowed to continue to operate.

The model's accuracy rate of 91.5% compares favorably with the results of similar studies. It also correctly classifies 90.1% of the observations in the holdout sample. In determining the impact of the MCP on the probability of solvency over time, the results show that the probability of insolvency increased at an increasing rate, with the rate of increase peaking in the third quarter after an institution was placed in the program. The changes are consistent with our expectations that placing an institution in the MCP will reduce its chances of recovering to solvency. Part of the change, however, may be attributed to better reporting by the new managers rather than reflecting a decrease in operational efficiency.

A second test compared the rate of deterioration of the MCP institutions with similar problem institutions that were not placed in the program. The results show that although the chances of recovery had decreased for both groups, the chances were less for MCP institutions than for the control group.

The implication is that the program does not reduce the probability of a need for FSLIC financial assistance in the final resolution. The reduced chances of recovery by the MCP institutions are presumably compensated for by a reduction in the size of the insurance losses. There are savings from resolving problem institutions as early as possible, but if resources are inadequate to do so in a timely manner, then an interim program is necessary. This paper contributes empirical evidence on the relative merits of alternative approaches for dealing with distressed depository institutions during the interval between the time a bank becomes critically undercapitalized and the time a permanent solution is in place.

Janice M. Barrow and Paul M. Horvitz





Stakeholder Losses in Corporate Restructuring: Evidence From Four Cases in the North American Steel Industry

This paper presents an empirical investigation of costs associated with four major restructurings in the North American steel

industry over the past decade. In contrast to many previous studies which concentrated mainly on the impact of restructuring on shareholders and bondholders, this study considers the losses suffered by all stakeholders of the four sample firms. The stakeholders examined include labor, suppliers, unsecured creditors, and government agencies in addition to the debtholders and

preferred and common shareholders. The study also examines the administrative and legal costs associated with restructurings. The aim of the paper is to evaluate the wealth losses suffered by all stakeholders and to conduct a longitudinal analysis of these

restructurings in order to evaluate the relative magnitude of these wealth losses. The combined losses suffered by all stakeholders in the four restructurings analyzed in this paper are estimated at

approximately $7 billion. These four restructuring cases exemplify the restructuring

issues in an industry which, at its peak, employed close to 550,000 and was considered to be one of the most important industries in North America. These restructurings reflect the

impact of five major threats to the steel industry in the 1980s, including the introduction of labor-saving technology, overseas

imports, competition from substitute materials such as plastics, overall slow economic growth, and the emergence of super- efficient mini-mills.

The four restructurings studied are: Wheeling-Pittsburgh Steel Corporation (WPSC), LTV Steel, Weirton Steel, and Al-

goma Steel. WPSC (1985) and LTV (1986) represent cases where the firms filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code; Weirton (1984) represents an employee buyout using the employee stock ownership plan (ESOP) ar-

rangement allowed under the United States Tax Code; and Al-

goma Steel (1991) represents a recent Canadian case where the

company applied for protection under the Companies Creditors'

Arrangement Act (Canada). In the latter two cases, the major players were the parent firms whose shareholders and debtholders indirectly suffered the losses incurred by these parent companies (the actual amount of these indirect losses could not be determined). WPSC emerged from Chapter 11 in 1991; Weirton and Algoma are operating under the ownership of their

employees; at the time of completion of this paper, LTV was still under Chapter 11. This paper is based on data from various sources, including year-end reports, plans of restructuring, inter- views with company officials, and newspaper and magazine articles.

Our analysis and results indicate that previous studies may have significantly underestimated the total wealth losses associated with restructuring. As the nonshareholder losses are found to be significant, it can be argued that these stakeholders may wish to be more vigilant about the impact of labor and capital structure decisions on the company's well-being.

Although individual cases provide different situations, circumstances, and degrees of complexity, certain generalizable conclusions emerge. First, the estimates of shareholders' losses depend on assumptions about the time period for the estimation. If shareholders' losses are computed based on the period immediately surrounding the announcement of restructuring, these losses are not very large in relation to those suffered by other stakeholders. Not surprisingly, extending the period prior to the announcement by one year indicates a higher degree of losses. Second, notwithstanding the wealth losses suffered by shareholders, losses suffered by other stakeholders are also significant and, at times, considerably higher than those incurred by shareholders. Third, shareholders' contribution to the overall restructuring process is not very significant if compared to contributions by the other stakeholders. Fourth, concessions made by labor and other nonshareholders have a significant positive impact on the health of the company in the period following the initiation of the restructuring procedure. Fifth, in the case of the three U.S. companies, government concessions and assistance were significant and imply an indirect and negative wealth impact on the average U.S. taxpayer.

An analysis of the post-bankruptcy period indicates that the operating and financial performance of the sample firms im-

proved in the post-restructuring period. The major reasons for this

improvement in the performance were the wage concessions made by labor and the suspension of interest payments to both secured and unsecured debtholders. There are also some indica- tions that the overall productivity of these firms also improved in the post-bankruptcy period. It is, of course, impossible to com-

pare this performance to the performance that would have been achieved had these firms not undergone the restructuring process. In any event, this improvement in the overall performance and the resulting increase in company profits allowed labor to recoup some of the wage concessions through the participation in profit- sharing arrangements negotiated during the restructuring process.

Vijay M. Jog, Igor Kotlyar, and Donald G. Tate





Real Options and Interactions With Financial Flexibility This article serves two main purposes. First, it aims to provide

a comprehensive overview of the existing real options literature and applications, as well as to present practically useful principles for quantifying the value of various real options. Second, it takes a first step towards extending the real options literature to recognize various interactions with financial flexibility. Overall, the

paper illustrates how to practically analyze managerial flexibility in the case of various types of both real as well as financial

options, recognizing that these option values may interact. The comprehensive literature review traces the evolution of

the real options revolution, organized around thematic develop- ments covering the early criticisms, conceptual approaches, foundations and building blocks, risk neutral valuation and risk ad-

justment, analytic contributions in valuing different options sep- arately, option interactions, numerical techniques, competition and strategic options, various applications, and future research directions.

An oil refinery and operation example is then used to concep- tually discuss the basic nature of the various real options that may be embedded in capital investments. Under the common assumption of all-equity financing, the paper presents, through simple numerical examples, practically useful principles for valuing upside-potential operating options, such as to defer an investment or expand production, as well as various downside-protection options, such as to abandon for salvage value or switch use

(inputs/outputs), and abandon project construction by defaulting on planned staged investment outlays.

Building on the above principles, the paper subsequently takes a first step toward analyzing potential interactions with financial flexibility. Departing from the standard assumption of

all-equity financing, the paper extends the analysis in the presence of financial leverage within a venture capital context and examines the potential improvement in equityholders' value as a result of additional financial flexibility resulting from equityholders' option to default on debt payments, noting potential interactions with operating flexibility. These interactions may be more pronounced if lenders would accept a lower interest rate than the equilibrium return. The beneficial impact of staging venture capital financing in installments (thereby creating an

option to abandon by the lender, as well as an option to revalue later at potentially better terms by each party), and when using a mix of debt and equity venture capital financing is also explored.

In particular, structuring capital financing in sequential stages may be beneficial to both parties: the lenders (venture capitalists) maintain an option to abandon the venture in midstream by refusing to contribute second-stage financing in case of interim project failure; in turn, this allows potentially better financing terms for the equityholders (entrepreneurs). In the case of all-debt financing, for example, savings can be achieved in the form of lower interest costs. In the case that later-stage financing is to be provided by lenders in exchange for an equity ownership share based on the project's market value as it will be revealed at some future interim stage, equityholders can gain by suffering less equity dilution when a higher project value is assessed in the reallocation of claims following a good interim state.

More generally, the flexibility to actively revalue the terms of a financing deal to better match the evolution of operating project risks as the project moves into successive stages is particularly valuable, compared to a passive alternative where the financing terms are irrevocably committed to from the very outset under less complete information. Thus, the future operating outcomes of a project can be altered by future decisions, of either equityholders or lenders, depending on the inherent or built-in operating and financial options and the way the financing deal is structured (e.g., the staging of financing or the mix of debt and equity claims). Understanding potential interactions between the firm's operating and financial options/decisions, and designing a flexible financing deal that better reflects the evolution of a project's operating risks as it moves through different stages, can mean the difference between success or failure. Options-based valuation can thus be a particularly useful tool to corporate managers and strategists by providing a consistent and unified approach toward incorporating the value of both the real and financial options associated with the combined investment and financial decision of the firm.

Lenos Trigeorgis





Reversion, Timing Options, and Long-Term Decision-Making Discounted cash flow analysis is the most common method

for evaluation of investment projects, yet practitioners worry about its shortcomings. In particular, there is concern that standard DCF comparisons may introduce bias against long-term investments. Here, we explore a possible source of such bias in the structure of the uncertainty underlying project cash flows, and the way it is incorporated into project discounting.

Project risks usually are driven by key uncertainties that underlie the larger cash flows. The case we analyze is a common one, where the dominant risk originates in project revenues which are a function of an uncertain output price. This uncertainty can be thought of as resulting from unpredictable shocks, big and small. (If a specific example helps, think of the world oil market.) If this price tends to revert to a long-term equilibrium in the face of short-term shocks, and this fact is ignored in the analysis, then the uncertainty in the cash flows will be mis-estimated and the associated discounting will be incorrect.

To identify when to be concerned about this "reversion"

phenomenon, consider how a price shock today (say, a sudden run-up in price) influences expectations of prices in the near and

long-term future. If near and long-term expectations change by the same proportion, then there is no reversion. This is the random-walk view of uncertain prices that, if applied to project cash flow, implicitly underlies most DCF applications. If, however, the influence of the information gained from the shock tends to decay as one looks farther into the future, then reversion is at work. One would expect this effect in circumstances where an event now is less and less relevant to the state of the economy the farther out in the future one looks. This will happen, for example, where long-term supply and demand limit how long an excep- tionally "low" or "high" price can be sustained: after a shock, the

price tends to revert to some "normal" long-term equilibrium. Such output price reversion has a straightforward effect on

now-or-never decisions, with no operating options. The stronger the reversion, the less is the uncertainty in long-term revenues when compared to short-term. With less uncertainty, the risk

discounting for long-term revenues should be reduced in relation to that for short-term revenues. This is the first of several influences of reversion on project value, called the "risk-discounting" effect. Because of it, the use of a single discount rate to value

project alternatives with different operating lives will introduce a bias against the longer-term opportunities.

The presence of options complicates matters. Besides the

risk-discounting effect, two other influences can be identified. One is the familiar "variance effect" in option valuation: a long- term reduction in uncertainty due to reversion tends to decrease

long-term option values. The other is a "future reversion" effect, which occurs where the future reversion in the price means or medians can directly influence asset values. This happens, for

example, with American options through an influence on the timing of exercise. In any particular case, the overall effect of reversion can be a complicated mix of these three effects.

Two sets of examples have been investigated using this three-

part classification. The first are American call options on the

output price, and we examine options that are currently at-the-

money. We find that counteracting risk-discounting and variance effects give conflicting results for the influence of reversion on

European options. However, the early exercise premium for an American option is also influenced by a future-reversion effect which increases with the degree of reversion. The net result is that

neglecting reversion creates a bias against longer-term American

timing options. The second set of examples involves now-or-never decisions

and investment timing options for projects that produce over a series of years and which differ in their operating lives. We show how a bias against long-term alternatives can occur, in a now-or- never analysis of the projects, through the use in the valuation of the longer project of a corporate discount rate based on the valuation of the shorter one. It is a clear example of the bias

against the long-term inherent in single-rate discounting. If reversion is neglected in the presence of an initial timing option, then, in our examples, bias remains against the project with a

longer operating duration, even if mitigated somewhat. When

considering the same operating project, however, longer timing options tend to be relatively overvalued if reversion is neglected.

These results suggest that it may be useful to revisit earlier "real options" work based on random-walk models. Also, they indicate that, where market conditions are likely to yield reverting behavior, managers need to consider adjustments in discount rates for long-lived as opposed to short-lived investments.

David G. Laughton and Henry D. Jacoby





A Real Options and Game-Theoretic Approach to Corporate Investment Strategy Under Competition

An investment strategy encompasses a sequence of tactical investment projects, of which several may yield a low return when considered in isolation. Some low-return investment projects can

actually be seen as the first links in a chain of subsequent investment decisions. The value of these projects does not derive so much from their expected cash inflows but rather from the

option to invest in a follow-up project for future commercial

exploitation. For example, an R&D project, the development of a new technology, or entry into a new geographical market may create future investment opportunities. In strategy, these projects are often compared with options for future company growth.

Standard forecasting of the expected cash inflows implicitly assumes investing in the follow-up project, or does not take

properly into account the value of flexibility to reject the follow-

up project if events turn out to be unfavorable. Application of

option theory can be used as an analytical tool to evaluate such flexible projects and to support the overall investment strategy.

We here consider the timing of the follow-up project analo-

gous to the timing of the exercise of a call option on a dividend-

paying stock. In this investment strategy, decisions involving the creation of capacity may be postponed so that management can decide not to invest if market demand turns out to be unfavorable. On the other hand, deferral also has disadvantages since during the postponement period the firm misses the net operating cash inflows. However, the call option analogy must be seen in the context of market structure. Emerging competition or rivalry may create an incentive to invest early, as postponement of the follow-

up project may result in project value erosion. This is particularly so if early investment would preempt competitive entry.

This paper casts the real options approach for project timing in a microeconomic framework to analyze aspects of competition. Using game-theoretic principles, we propose various investment tactics in an oligopolistic market. Simple numerical exam-

ples illustrate solving the timing problem under competition. Given the complexity of real-world problems, we provide a

prototype approach for investment timing that practitioners can

adjust to their particular application.

We use the expected economic rents or excess profits for

forecasting the operating cash inflows. Barriers to entry or a distinct competitive advantage over existing competitors (e.g., economies of scale and scope, absolute cost advantages, or

product differentiation) are the real source of economic rents. The firm therefore needs to identify those markets in which it has a

temporary or permanent competitive advantage, and concentrate investment in these areas. Understanding potential barriers to

entry helps identify these markets and potential value-creating investment opportunities. One strategy, for example, will be directed towards increasing capacity because of economies of scale, or broadening when economies of scope are important in the market.

An investment opportunity under perfect competition is like a "public good" of the whole industry. Expected economic rents attract new entrants to the market, so new entrants will diminish returns until expected and required returns are equal. Absence of a structural competitive advantage may thus result in a tendency to invest early to preclude this erosion of value. An investment

opportunity in a monopoly is exclusive, so during the postponement period there is no expected loss in value due to competition. Compared to perfect competition, there is a stronger tendency under monopoly to postpone follow-up projects with relatively low net present values. On the other hand, an exclusive project with large present value creates a tendency to invest early. Oli-

gopoly is between these extremes in that the timing of a project will be influenced by the behavior of individual competitors. Where firms in the industry have asymmetric market power, early investment could preempt entry. The investment tactic in the

follow-up project will be influenced by the value of the project in relation to market uncertainty and the threat of preemption. We use game-theoretic principles combined with option theory for

setting an investment strategy and, based on the reaction of

competitors, we propose various investment tactics.

Han T.J. Smit and L.A. Ankum





Creating Value by Spawning Investment Opportunities A central managerial concern is how to generate a "proper

mix" of investment projects. Funds are needed for the strategic search for new investment opportunities as well as for the main- tenance of operational business lines. Any investment, especially in strategic projects such as new technology, brand name or company image, may generate future investment opportunities (hence the use of the word "spawning"). Investment opportunities can be seen as call options on certain capabilities or assets. This

paper presents new tools for analyzing the spawning structure and for managing investment opportunities over time.

In this paper, I introduce the concept of "spawning" and illustrate how value can be created by a proper spawning structure. Spawning structure is intimately tied to the "constant im-

provement" and "learning curve" effects. As we will see, it is not

enough to look at individual projects or at the aggregate investment outlay. Rather, the proper mix of strategic and operating projects is a key to profitable growth.

My recommendation is to use the concept of the expanded net present value, which is the sum of passive NPV plus the combined value of option and synergy effects. This concept incorporates determination of the standard NPV of quantifiable cash flows and (even a crude) modelling of the value of the option and synergy elements, backed by managerial intuition. The spawning matrix model in this paper provides one approach for checking managerial intuition.

The spawning matrix model has some interesting "qualitative" analytical features that can help us better understand the value and optimal management of investment opportunities: (i) The steady-state mix of projects provides a reference point for the allocation of funds among the various project categories. (ii) The value of the business unit is the "expanded NPV" of the business unit's cash flows under the optimal investment strategy. This value provides a reference point for the market value of the business unit, taking into account all the synergy and cross-time effects among the projects. (iii) The only true source of synergis- tic growth comes from the feedback mechanism, where projects spawn each other both ways. In traditional analysis, a collection of separate projects is worth the sum of the values of the individual projects. A collection of projects linked together through cross-spawning is worth more than the sum of the individual projects.

In the applications of the spawning idea, the quantitative estimation of a full-blown spawning matrix is quite difficult, so in real-life cases, it is necessary to concentrate only on a couple of investment categories and focus on the crucial spawning effects. For example, the spawning model in the Finnish pharma- ceuticals company, Farmos, after some experimentation, was

finally cast as a nonlinear simulation model, where the projects did not spawn each other directly but generated sales opportunities for other projects. A practical starting point is to look at the synergy effects between cost-cutting and marketing efforts.

The real option value in the model can be analyzed using risk-neutral probabilities and risk-free discounting. The uncertainty in project value that is revealed during the active implementation stage further strengthens the importance of the spawning and synergy effects among projects.

Based on our analysis and applications, there are two generic project types that should typically have a high strategic value:

(i) Growth Projects: If they are successful, growth projects create a lot of investment opportunities in other profitable future projects. Typical projects of this type include strategic positioning investments, visionary development of new products, or acquisition of new technologies and marketing channels. Essentially these are projects with growth options attached to them.

(ii) Feedback Projects: If implemented properly, these projects may create nontraditional interproject feedback and generate investment opportunities including strategic projects. Typical examples include factory floor rationaliza- tion and cost efficiency projects that can lead to innovations in production and product design. The key here is to harness and build upon the experiences obtained at the operating level. "Learning curve" and "constant improvement" effects are practical examples of such cross-spawning at work.

In the analysis of the value of spawning, several qualitative implications have emerged. These insights can be used in shaping the company's investment strategy, even without trying to put precise estimates on the spawning coefficients. The spawning model (even with stylized numbers) brings home the importance of synergy and growth option effects in the valuation of projects. Focusing on the question of the "optimal mix" of project categories could lead to a fruitful strategic analysis of what type of projects the company currently has or should attempt to develop. Trying to understand the structure of the spawning matrix, in particular, would raise several crucial questions for management in charge of the investment program: Do we have enough cross- spawning to spark a real boost for profitable growth? How can we develop feedback mechanisms from operating projects into strategic projects? These types of issues are at the core of successful strategic planning.

Eero Kasanen





Case Studies on Real Options This paper presents major insights gained from actual, prac-

tical cases of real option applications in cooperation with Shell

group planning. The main interest of Shell was to conduct a number of exploratory studies on the use of option pricing theory in capital budgeting decisions. The studies were part of a group planning program to adapt existing and to develop new tech-

niques for strategic decision-making. The theory of option pricing has been well-received by prac-

titioners, who have struggled with discounted cash flow analysis for many years. The ability of option pricing theory to quantify flexibility in strategic investment projects makes it a very appeal- ing choice. This is especially so when one considers the fact that

flexibility is often not explicitly taken into account by standard discounted cash flow analysis. Incorporating the value of flexi-

bility could increase the total value of the project and may increase the probability of acceptance, an incentive for practitioners to apply option pricing theory in capital budgeting. The value of flexibility of an investment project is basically a collection of real options, which can be priced with the techniques known from financial options.

Despite this incentive, the process of adapting option pricing theory to the practice of strategic decision-making is far from smooth. In most cases, the introduction of option pricing theory requires practitioners to fundamentally reconsider their standard

capital budgeting techniques. In this paper, the process of adapting option pricing theory in practice is illustrated by three cases. These selected investment projects with embedded options are described in detail: a timing option in the offshore industry, a

growth option in the manufacturing industry, and an abandon- ment option in the refinery industry.

Restating the problem in a suitable framework for analysis is the most important part of the process. Often management is not familiar with how to formulate the investment project with the embedded options as potential choices. Furthermore, there is a

tendency to include too many options, of which only a few are valuable. Thus, most time is spent to find out whether or not the

project is indeed flexible, i.e., has valuable embedded options, and how to restate the problem. In these cases, I present some of the difficulties encountered in this process. Usually the result at this stage is the formulation of the problem guided by the follow-

ing basic question: Can the costs of the (additional) flexibility be justified by the benefits when the flexible alternative is compared to the alternative without flexibility?

With respect to the required inputs, it is important to define the uncertainties that management faces, because volatility is an important variable that is needed for option pricing theory. Other numbers, like the present value of net cash inflows and the

investment outlay are also necessary for discounted cash flow

analysis. In practice, it turns out that it is not always possible to find agreement about the volatility number and therefore, sensitivity analysis is always necessary. One other aspect is the influence of competition. Often competition determines the time to

maturity of the option. In all cases, we present, in more or less detail, the considerations with respect to the data and the inter-

pretations of the results. The theoretical foundations for the actual cases studies are

limited to the simpler version of option pricing models. In spite of their simplicity, the analyses can provide management with considerable intuition. As mentioned before, the cases were developed with the Shell staff members, who were unfamiliar with the theory. The basic results and the sensitivities of these results to changes in the underlying input variables, however, seem consistent with their intuition. In the cases that we examined, the problems had to be simplified, although this too was also common practice when a standard DCF analysis was used.

Based on these experiences, I suggest that the main contribution of option pricing theory in capital budgeting is twofold. First, it helps management to structure the investment opportunity by calling attention to the different investment alternatives with their

underlying uncertainties and their embedded options. A side- benefit is that it usually leads to a reexamination concerning the use of the standard capital budgeting techniques. Second, it can handle flexibilities within the project more easily than the traditional discounted cash flow analysis. Although other models such as decision-tree analysis or Monte Carlo simulation can also be used, they tend to become complicated and are frequently mis- applied.

This paper shows that it is worthwhile to consider option pricing theory in addition to discounted cash flow. The best way to proceed is to find cases similar to the ones presented in this

paper. It is always easier to convince people within the firm when using a familiar project. It is then important to carefully formulate flexibilities within the project as embedded options. Usually it is best to start with a single example that includes only one important option. This has the added advantage that standard option pricing software can be used to determine the value of that option. The ability to produce some results could cause people to become more enthusiastic and to be more inclined to analyze their projects using option pricing theory. However, the experience with Shell showed that adapting option pricing theory in capital budgeting is a long-term process.

Angelien G.Z. Kemna





The Value of Flexibility: The Case of a Dual-Fuel Industrial Steam Boiler

This paper employs a general model of flexibility to value a dual-fuel industrial steam boiler.

First, we illustrate the shortcomings of conventional capital budgeting techniques to value flexible projects (such as the dual-fuel boiler) and motivate the need for new analytical techniques. Briefly, discounted cash flow methods ignore the "operating flexibilities" that give project managers options to make and revise decisions in response to changing external conditions. For example, when facing uncertain prices, operating flexibilities can protect the firm against some of the adverse price movements by reconfiguring into an alternative "mode of operation" that is less affected by the adverse prices.

Next, we present the general model of flexibility where a project can be switched between several operating modes. The model captures the decision-tree nature of the problem and incorporates risk in a manner that is consistent with modem finance theory.

The main contribution of this paper is the case study application. Industrial steam boilers provide an ideal context to apply our model of flexibility. They embody a simple technology with a single variable input (fuel) and a single output (steam). Specif- ically, we consider a 350 hp. Package Firetube Boiler manufac- tured by Cleaver-Brooks, which is configured to produce steam at a pressure of 125 psig per hour (an annual output rate of approximately 1190 MBtu). This quality and rate of output can be achieved by firing either natural gas or No. 2 fuel oil. However, due primarily to their different combustion temperatures, the two fuel types vary in their burning efficiencies. The flexible boiler adapts to changing prices by utilizing the efficiency differences and the resulting cost differences under the alternative input fuels. This provides a significant source of value that is otherwise ignored in a DCF valuation.

In order to estimate the profit functions, we rely on an engi- neering model which captures heat losses in producing steam as a function of the ambient temperature, flue gases, and the operating pressure. We estimate the stack gas losses and radiation/con- vection losses under the two alternative fuel burning configura- tions. Our estimates show that firms would be indifferent between operating the boiler with gas or oil at a relative (Btu-adjusted) oil/gas price ratio of 1.04. Market prices of $0.60 per gallon of No. 2 fuel oil and $1.90/MBtu for natural gas translate into a

comparable relative price of approximately 1.2. This suggests

that a natural gas boiler would be preferred to one that is fired by oil. However, due to the volatility of the relative price of gas to fuel oil, a decision rule that takes into account the relative price dynamics may make a flexible boiler even more preferable.

We then model the evolutionary process of the relative oil/gas price. The high degree of substitution between these two fuel sources suggests a mean-reverting process of relative prices of oil to gas. We set the long-run mean price such that the two boilers could be operated at equal cost. Using prices during the period January 1984 through December 1987. We estimated an annual volatility of 18.1% and a mean-reversion adjustment factor of 36.8%.

When switching is costless, the value of flexibility (estimated at $26,000) exceeded the incremental purchase cost ($5200). However, even flexible boilers incur costs to switch between fuel

types due to potential work interruptions, re-contracting costs, and costs of physically switching fuel types, and would depend on the specific application. We approximated the switching cost to equal one month's fuel cost. Although the advantage is somewhat attenuated, the flexible boilers still dominate. Perhaps, this

explains why over 80% of the boilers sold by major manufactur- ers are of the dual-fuel type.

Finally, we computed the critical relative price at which firms would switch between oil and gas. For our base-case parameter values, the firm would switch from gas to oil if the relative oil

price falls below 0.92, and it will switch from oil to gas if the relative price rises above 1.5.

Our results have not only the obvious implications for investment in flexible technologies, but may also influence the equilibrium market prices of substitute fuels. For instance, if oil boilers were cheaper to operate under current energy prices, the threat of

potential future gas price increases will tend to maintain the status quo and dissuade oil-using firms from switching into gas-operated technologies. However, the introduction of flexible technologies reduces the switching costs and enables firms to choose the lower cost alternative fuel source. Ironically, the very presence of flexible technologies may reduce the volatility of relative price changes and reduce the value of flexibility.

Nalin Kulatilaka




Date post:	15-Jan-2017
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