l 06 adding value by post loss financing

7/29/2019 L 06 Adding Value by Post Loss Financing

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Adding Value By Post-Loss

Financing

Lecture 6

Dr. Tahir Khan DurraniCEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD

“I’m just glad we got

out before interest rateswent up again.”



We will address:

the impact of risky events on the firm

determinants of corporate value and how thesources of value can be affected by riskyevents

the classification of risky events

the effects of loss and post-loss investmentdecisions.

Dr. Tahir Khan Durrani

2



Direct loss:

liability settlement or rebuilding the plant

Indirect loss:

Reputation, future demand or increased cost of production.

Risky events:

Asset loss, transfer of wealth, and shocks to costs and

demand.

Values at Risk:

Current operation value and franchise value.


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Alternative risk Alternative contract structure

Alternative counterparty

Also alternative thinking

Not just cost of insurance (i.e. premium)

But value of insurance (i.e. capitalreleased)


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DL)r :(KVDL

k1

r KV(E) 000

n

1tt

000


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Existing Assets: Call these assets K0 - plant, distribution channels, etc. The expected rate of return on assets is r 0, Return in year t, from current assets is net of the cost of

renewing and repairing and replacing these assets in year

t. L is the liquid assets at time t. E(Et)t = K0r 0,t

Where V0(K0;r 0) is the PV, at time 0, of the cash flowsgenerated



Future Investments:

The firm also makes future investments, at time t,Kt, in new assets and each of the new

investments makes subsequent expected annualrate of return of r t,i.

The net c/f generated in some future year t, frominvestments made from assets not currently inplace, is:

-Kt + Vt(Kt;r t)


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Total Firm Value (Internal funding/retained earnings): Assume that future investments are made from internal

earnings.

Equation rewritten as:

V(F) = V(A) + V(R) +L

Where: V(A) = value of existing operations,V(R) = the franchise value

L = liquid asset


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Lk1

)r ;(KVK-)r :(KVV(F)

0n

1tt tttt000



Destruction of existing productive asset,

Transfer of value to third party,

Shock to the cost function,

Shock to demand.


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Risk Event Effect

K0 r0 Kt r i,t L T

Loss of Asset × × × ×

Transfer of value × × ×

Cost shock × × × ×

Demand shock × × × ×

Key: is direct effect

× is secondary effect Dr. Tahir Khan Durrani

15



What is the effect: Value of existing assets depleted, K0 falls.

Reduction in output and change in demand,

affecting r 0. K0r 0 are reduced, leaving the firm with

inadequate funds to fund new investments,either K

tfall or firm resort to external financing,

incurring dead-weight costs T.

As Kt falls, r t increases.


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Plastique makes plastic beads that are sold in to several firms.The firm makes two different formulas, and these aremanufactured separately at two plants, A and B. The projectedpre-loss outputs of these two plants are 100 and 140 units for 10years respectively. The values (replacement cost) of these plantsare £5m and £7m respectively. The firm also has liquid assets,cash, of £5m. One of the plant B is totally destroyed in a fire.Plant A is operating at 90% capacity and thus can increaseoutput to 111 units. The customer list is shown below:

The cost of capital is 10% and transaction (issue) costs are£0.3m(T(0.3)

What are the choices faced by the firm?

Customer 1 2 3 4 5 Total

Units sold 76 35 50 29 50 240

Profit 1.2 0.5 0.6 0.3 0.4 3.0


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Before the loss, K0 = £12m and the annual profit of £3mrepresented a 25% rate of return for 10 years (r0 = 0.25).

Before the loss, Plastique planned to build a new plant

with different product line at the end of the current yearat a cost of £8m, with 10 years earnings of 16.875% (k 1= £8m, r1 = 0.16875).

After the loss K0’ = £5m (primes are used to denote

values after the loss). Internal funds are £6.7m (5m of liquid assets and 1.7m

from remaining two customers).


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The after loss return is calculated as follows. From the table, customer 1 and 2 offers a higher

profit rate per unit sold than customers 3, 4 and 5.

Thus, the entire capacity of the surviving plant A, 111units can be sold to the first two customers.

The profit of £1.7m represents a 34% rate of return on

K0’ = £5m, i.e., r 0’ = 0.34.

The higher profit in the remaining customers 1 and 2party offsets the fall in K0, this limiting the fall in

earnings.


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Rebuild plant B (raising at least $0.3m externally) and forgo newinvestments:

K0’ = 12m; r

0= 0.25 k1’ = 0; T (£0.3m); L’ = 0

Forgo plant B, undertaking new investment, and raise at least

$1.3m externally: K

0’ = 5m; r

0= 0.34 k1’ = 8m; T (1.3m); L’ = 0

Rebuild plant B, undertake new investment, and raise at least

$8.3m externally:

K0’ = 12m; r

0= 0.25 k

1’ = 8m; T (8.3m); L’ = 0

Forgo plant B, undertaking new investment, and raise nothing

externally:

K0’ = 5m; r

0= 0.34 k1’ = 0; T (0); L’ = 5m


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Event: Liability Suit or creditor default. Three direct effects - absorption of current

earnings (r 0,t), deplete liquid assets (L), or require raising new funds incurring T.

Firm might sell off current productive assets, K0.Plausible where: liability claim is very large and can only be paid by asset

disposal.

The claim itself lowers the rate of return on those assets,such that the assets have higher disposal value than valuein use.

Firm forgo new investments or finance the from externalsources.


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Instead of the fire that destroyed Plant B, Plastique’s has just had a£6m liability award made against it for defects in design that makesits product fail crucial applications.

The post loss evaluation reveals the following: The adversepublicity will dampen demand for its current product such that theexpected profit will fall from £3m per year to £2m. While thereplacement cost of current asset is £12m (5m+7m) and the assetshave a disposable value of only £8m.

The intended new investment, Kl, is for a product that is unrelated

to the existing product line and is not likely to suffer any demandcontamination from the law suit.

After paying law suit, Plastique has internal funds of L+K0r0 – 6m =5m+2m-6m = 1m, which are insufficient to fund the project.

What reinvestment options are available to Plastique?Dr. Tahir Khan Durrani

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Retain current plant and forgo new investment: K

0’ = 12m; r

0’ = 0.167 k1’ = 0; T (0); L’ = 1m

Retain current plant, undertaking new investment, raise new

money for balance of settlement:

K0’ = 12m; r0’

= 0.167 k1’ = 8m; T (7); L’ = 0 Selling current plant, undertaking new investment, raise new

money for balance of settlement:

K0’ = 0; r

0’ = 0 k1’ = 8m; T (1); L’ = 0

Sell current plant, forgo new investment, and default (at $1m onthe settlement):

K0’ = 0; r

0’ = 0 k1’ = 0; T (0); L’ = 7m


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Notice that the last option is liquidating upthe firm. If the firm is liquidated before thecurrent year’s profit is earned, its liquidation

value is only £7m, Which is being the cash reserve £5m plus

the proceeds of the sale of assets of £8m

minus the settlement of £6m. Bankruptcy is an ex-post risk management

option.


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Change in currency rates, change in interestrates, unionisation or new regulations, etc.

Earnings (r 0), will be randomly shocked,

Smaller resources to finance new projects, Use of external finance, with transaction costs

(T),

Real option (Closing down existing plant), if the rate of return on salvage value of existing

assets is reduced below a competitive level,shareholders benefit by liquidating current

activities.Dr. Tahir Khan Durrani

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The misfortune of Plastique this time is that newregulations on the handling, transportation, and disposal of chemicals used in production cause a significant increasein costs, reducing profit from £3m to £1m, and thereforer0,1 is reduced to 8.333%. (This is a return on replacement

value of 12m, the equivalent return on salvage value of 8mis 12.5%). Should new investment be undertaken, r1, will be reduced to 8%.

Plastique has internal funds of L+r 0,1= 5m+1m = 6m,

which are insufficient to fund the new project. Firm can sell off existing assets for £8m and fund new project.

What post-loss investment options are available to thefirm?


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Retain current plant and forgo new investment: K

0’ = 12m; r

0’ = 0.083 K1’ = 0; T (0); L’ = 5

Retain current plant and undertake new investment

(borrowing $2m): K

0’ = 12m; r

0’ = 0.083 K1’ = 8m; T (2); L’ = 0

Sell current plant and undertake new investment:

K0’ = 0; r

0’ = 0 k1’ = 8m; T (0); L’ = 5

Sell current plant and forgo new investment:

K0’ = 0; r

0’ = 0 k1’ = 0; T (0); L’ = 13


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Shifts in tastes (M&S) or a down turn inthe economy, shift in taste (either for brandor product.

Increase in interest rates, currency ratesand regulation resulting in reduceddemand for consumer durables.

Directly Affects profits from existingoperations.

Similar indirect effects to those of cost

changes.Dr. Tahir Khan Durrani

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Three important issues arise from thisexample: The loss event poses a set of investment

decisions. The first concern replacement of thelost asset. In the previous example, replacementof the asset added value, but under differentcircumstances a value-maximizing strategy can

be to abandon this asset. This can be so if thereplacement requires external financing thatincurs large transaction costs.


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The event can lead to reevaluation of decision on new projects and a changein the franchise value. A change in

investment cash flows for new projectsor if the depletion of internal funds andthe costs of external financing crowd

out marginal projects.


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The loss of value depends on the post-event investment decision but will not,in general, be equal to the cost of

replacing the asset. Under idealconditions the measure of lost value willbe made under the assumption that

value-maximizing post-lost decision aremade.


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Crisis management is the formulation of a response planfollowing some corporate trauma.

The effect of an event can be mitigated by careful

handling.

Exhaust all value adding post-loss investmentopportunities for increasing its value.

Value-maximising configuration should be chosen toreflect all available and estimated information on capitalcosts and future cash flows.


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K0 and r 0: Value of current assets and the return on these assets,

assuming no loss.

K0´(N) and r 0´(N): Value of current assets and return with a loss but no

replacement.

K0´ and r 0´:

Value of current assets and return with a loss and optimalreplacement.

The reinvestment cost, C=K0´-K0´(N)


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Follows normal capital budgeting procedures.

We captioned pre-loss firm value by thisequation:

Taking into account various direct and indirect

effect of a risky event, we rewrite this equationas


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T-L

k1

)r ;(KVK-)r :(KVV(F)

0n

1t t

tttt

000

T-L

k1

)r ;K(VK-)r :K(VCV(F)

0n

1t

tttt000

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Post-loss investment decisions include bothreinvestment in destroyed or damaged assets anddecisions on new investments.

Apply capital budgeting rule for all newinvestments, using after-loss information

For optimal reinvestment decision, lets expand thenotation to three potential values for K0 and r 0.


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N

1t

ttttT

k1

)r ;K(VK-NPV

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''

0

'

0

'

0

'

0

'

0

'

0 T-(N)]r(N);[KV-]r;[KVC-NPV


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Post-loss investment decision is madeaccording to this equation:

Where:

T´ = transaction costs for financing the

reinvestment

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It is important to be able to measure the costof risky events.

For example, an analyst wishing to value a

firm that is subject to liability exposure needsto measure the impact of that exposure onthe stock value.

A risk manager knowing his firm is exposed toprospective property loss might seek toreduce the possibility of such loss byimproving safety, such as by installing


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There are a number of indirecteffects, and the final impact on

shareholders is the change in value of their shares, before and after theevent.

This change in value rests as muchon the post-event decision as on thedirect cost.


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Consider the after-loss value of the firm, with direct cost denotedDC, and the primes denoting after-event values of capital assetsand returns give as

If all other parameters are the same, the post-loss value differ fromthe pre-loss value by only DC.

Value lost as a result of a risky event is is also a result of thechanges between the pr-loss and post-loss values of K and r

V = - DC + V0(.) + Vt(.) - T This measure of loss assumes that value-maximising investment

decisions are made after the loss.


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T-L

k1

)r ;K(VK-)r :K(VDC(F)V

0n

1t

tttt

000

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Why abandon a project?

When to abandon a project? This is a real option (the decision to

discontinue some activity) An option to “put” equity to creditors at a zero

strike price (default put option).

Going concern value is less than salvagevalue

Based on New NPV information


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“Abandonment” refers to the decision todiscontinue some activity, be it the firm itself or some project.

Abandonment of the firm can mean either thatthe firm is abandonment by shareholders andpassed on to the creditors or that the

operations are liquidated. Passing the firm to creditors is an option that

is implied by limited liability.


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On a smaller scale, a firm can choose todiscontinue a product line and will add value fromdoing so if the ongoing value is less than thesalvage value.

These choices are illustrations of real option.

As financial options are instruments that allowinvestors the choice of trading in some security at

prearranged conditions, real options are other choices that have similar structure.

The decision by a firm to avail itself of bankruptcylaw is such a choice.


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The conditions of the law are fixed inadvance, and if the firm finds itself in asituation in which equity would assume anegative value, it can exercise the option topass the firm to creditors.

Shareholders have the right to sell their equityto creditors at a zero price even though the

residual value of the equity is negative.

In short, this right is an option to put theequity to creditors at a zero striking (or

exercise) price.Dr. Tahir Khan Durrani

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In any project the option to walk away haspotential value, which value arises because of new information.

Having a fire, a liability suit, or a currency lossis new information. Theses events canchange the remaining value of the firm or of a

project. The option to abandon means that the firm

can decide whether to continue an operationor wind it up.


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New investment opportunities with a positiveNPV before the loss may not have a positiveNPV after the loss. The loss can change

everything. When a loss occurs, the reinvestment

decision rest on a comparison of quite

different numbers: the (revised) post-losscash flows and the replacement cost of theasset.


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Normal capital budgeting criterion for newinvestment is presented in the followingform:

Is it worth it to continue operations?

Where: S is the resale value, L- means just before theloss, K0 is the initial capital cost, E is the expectationfunction, and C future cash flows.


n

1t

0Kt)

tk(1t

C0E)InvestmentlNPV(Initia

n

1t tkt)(1t

CLS,KLEt)abandonmenlossNPV(pre

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The decision is made at time 0 usingexpectations of future cash flows, Ct, at thetime denoted E0.

The term k0

refers to the initial (time 0)capital cost.

At some later date the assets were in place,

but a loss such as a fire has occurred. Did it make sense for the firm to have those

assets in productive use just before the loss

(which we will denote time L-)?Dr. Tahir Khan Durrani

48



Implicitly (may be even explicitly), the firmmust have made a decision not to sell off those assets for their resale value at that

time. KS,L- (the first superior, S, refers to the resale

value and the second, L-, means just beforeloss).

This implicit decision can be summarized inthe following adaptation of the capitalbudgeting rule, which simply compares the


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If the value NPV (pre-loss abandonment) ispositive, then value is added by selling of theasset; otherwise there is greater value in use.

Notice that even if the expected cash flowswere to fall dramatically between time 0 andtime L-. it might still make sense to continueproduction if the resale value , KS,L- , where

sufficiently small.

On the other hand, if sometimes makessense to abandon assets.


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If post-loss abandonment is selected, it wouldappear that important changes have arisen inthe economic circumstances of the project.

Some factors that might have changed sincethe original investment was undertaken are

1. appreciation of abandonment values,

2. revision of cash flow estimates,3. revision of risk costs, or

4. phasing out of an old project.


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Factors that might have changed since theoriginal investment was undertaken are: Appreciation of abandonment values Revision of Cash flow estimates Revision of the cost of capital Phasing out of old projects

What is the post-loss investment decision?

Post-loss c/f Ct, exceeds the post-loss replacement cost of the destroyed asset KR,L+


n

1t

LR,K

t)tk(1

tC

LEstment)NPV(Reinve

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Damaged/destroyed assets may generate salvageor disposal costs.

Where salvage is not realised independently butdepends on the reinvestment decision the valuation

is given as

Where: D A refers to avoidable disposal values.

Unavoidable disposal cost don’t have any bearing onreinvestment decision.


n

1t

LR,K ADt)

tk(1t

CLEstment)NPV(Reinve

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DETROIT (Reuters) - Ford Motor Co. (F.N) said on Friday it would cut35,000 jobs worldwide -- 22,000 of them in North America -- and closethree assembly plants in North America.

Ford Chief Operating Officer Nick Scheele said the world's second-largest automaker would close assembly plants in Edison, New Jersey;Hazelwood, Missouri; and Oakville, Ontario. The Canadian and New

Jersey plants build pickups, while the Missouri plant builds the FordExplorer sport utility vehicle.

Scheele also said Ford would close two parts plants in Cleveland, Ohio,and Dearborn, Michigan. In addition, 11 plants will undergo major restructuring, including shift cuts, with production cuts at nine additionalplants.

The cuts come as part of an overhaul of the company aimed atimproving profits by $9 billion by the middle of the decade. Ford said itwould take an after-tax charge of about $4.1 billion in the fourth quarter of 2001 in the restructuring drive.

It said it would cut North American production capacity by 16 percent, to4.8 million vehicles from 5.7 million vehicles, and cut four vehicles -- the

Ford Escort, the Mercury Cougar, the Mercury Villager and the Lincoln-- -


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The “q” ratio was derived by Nobel Laureate JamesTobin.

It’s the ratio of the market value of a firm over the

replacement cost of its assets.

For reinvestment, there is need to compare thecapitalised value of the income stream with thereplacement cost of the assets.

If the ratio is

unity, the NPV is positive andreinvestment is the optimal decision.

Q, provides a rough guide to structuring a riskmanagement strategy.


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The “q” ratio has many uses, e.g. Used as measure of the management’s efficiency

of firm’s resources, a management evaluation tool.

Measure of the efficiency of alternative uses of

capital.

To identify targets for take over.

A close relationship with NPV, which is cost of asset

and the cash flow generated from its use. “q” is a ratio of properties of assets in current use,

where as NPV is a relationship about assets inprospective use and “q” uses market values.


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Reinvestment decisions are based on post loss estimates of cash flows, where as “q” is based on current estimates.

Post loss reinvestment decisions address a particular assetnot the total loss of firm. The “q” is a rough average of the

(imputed) market to replacement values of assets withallowance for synergies. Thus the overall ratio may not beappropriate for any one destroyed asset.

Management may have information advantage over outsideinvestors in estimating post loss expected cash flows from a

particular asset replacement.

Reinvestment decision should include all cash flows, includingsalvage and disposal costs. These may not be included in “q”

denominator.Dr. Tahir Khan Durrani

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Identification and measurement of changes in firm value following somerisky event.

Examination of optimal investmentchoices faced by the firm after the lossevent.

The attention to post-loss investmentanticipates a potential need for financing.


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Plastique suffers the property loss described earlier; Plant Bis destroyed in a fire. Using the reinvestment options derivedearlier, determine the optimal post-loss investment decision.

Additional information: Plastique was formed three years ago when it raised £15m in

equity. This money was used to construct the two plants andfor working capital. The investment parameters facingPlastique at inception were that it could make an estimated£3m per annum for 13 years. Calculate NPV

Shortly before the loss, Plastique had identified a new

investment opportunity that would involve a capital outlay of £8m and generate an income stream of £1.35m (16.875%) per year. The opportunity was to be undertaken at the end of thecurrent year (projected income £3m & £5m in cash).

Calculate the pre-loss and post-loss value of the firm.

l 06 adding value by post loss financing

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