Firm Valuations and Real Options

1
Firm Valuations and Real Options

• The Shutdown Decision in Chapter 11

2
The Shutdown Decision in Chapter 11

• A firm enters Chapter 11 as an operating business
• At one or more points, someone asks the judge to
  pull the plug
• How should the judge approach this question?

3
The Shutdown Decision in Chapter 11

• Timing is everything
• Shut down the firm too soon, and a viable
  business is lost forever
• Wait too long, and you have made a bad situation
  worse

4
The Shutdown Decision in Chapter 11

• Judges must make the right decision at the right
  time
• The judge is exercising what economists call a
  real option
• This real options idea should be incorporated
  into net present value calculations
• It provides a powerful intuition for analyzing
  many issues in Chapter 11

5
Measuring Present Value

• Casual net present value calculations assume that
  you have to make an up-or-down decision today
• The ability to wait itself affects the net
  present value calculations in Chapter 11 and
  elsewhere

6
Hypo
Creditors 100
Debtor Firm
We can sell the assets for 100.
If we operate
7
Should We Liquidate the Firm?

• Casual Net Present Value Calculation
• Assume 10 Interest Rate

8
Wrong! Ignores Choices and Benefits of More Info

• Try a Different Approach
• Key Assumption After operating one period, firm
  can still be liquidated for 100
• Operating does not reduce liquidation value
• Think of perhaps real estate or intellectual
  property

9
Better NPV Calculation
10
Controlling Timing v. Now-or-Never Decisions

• The Now-or-Never Decision
• Liquidate Now with NPV of 100
• The Value of a One-Period Option to Wait
• 4.54
• By operating the firm for one period, we increase
  PV by 4.54
• We gain info, and learn whether the firm can
  succeed

11
From The Paper

• Some firms should be kept intact even though the
  expected earnings of the firm over time are less
  than the cash that can be realized from the
  piecemeal sale of its assets today.

12
Core Idea

• Sample operations to try to grab the high end
  of the distribution and, if not, exit to
  liquidation
• Sampling requires waiting
• Waiting is costly, even when the assets dont
  decline in value
• But uncertainty makes some waiting desirable

13
Searching for the Perfect Cup of Coffee
Store B
Store C
Store A
Store D
We know, but X doesnt know, that the coffee is
worth at A 10, B 9, C 8, D 7
Price for Coffee 6
X knows distribution of values It costs X 1 to
visit a store Return to store for free
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What Should X Do?

• X should go to at least one store
• Worst outcome is find coffee worth 7
• Pay 6 for coffee 1 for search and break even
• 3 of 4 times find coffee worth 8, 9 or 10 and do
  better than that

15
When Should X Stop?

• X finds A in 1st Search
• Suppose X stumbles on to A in her first search
  and finds coffee worth 10
• X cannot do better than A
• She should should stop, pay 6, plus 1 search
  cost, and be 3 to the good

16
Suppose X finds B in 1st Search

• X has coffee worth 9 in hand
• X could only do better by finding store A, with
  coffee worth 10
• She would have to pay 1 to look again, and could
  gain only 1, and 2/3 of the time she will not
  find A on her next search
• X should stop if she finds B in her first search

17
Suppose X finds C in 1st Search

• X has coffee worth 8 in hand
• X could only do better by finding store A or B,
  with coffee worth 10 or 9
• The cost of another search is 1
• The expected gain is (1/3) x 2 (1/3) x 1
  (1/3) x 0 1
• She is indifferent between searching and not
  searching?

18
Wrong!

• After we find D on the second search, we know
  where A and B are and have the option to search
  again.
• Once we know C and D, the expected gain from
  searching is (1/2) x 2 (1/2) x 1 1.5
• The cost is 1, so the expected net gain from the
  search is 0.5
• So our calculation for C is (1/3) x 2 (1/3) x
  1 (1/3) x 0.50 1.16 against a cost of 1,
  so we should search again if we find C on the
  first search

19
Suppose X find D in 1st Search

• X has coffee worth 7 in hand
• X knows she will do better by going to another
  store.
• The cost of another search is 1
• The expected gain is (1/3) x 3 (1/3) x 2
  (1/3) x ??? gt 1
• X should should look again if she finds D

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Search Rule So Far

• Undertake first search
• If find A or B, stop
• If find C or D, search again

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The Rest of the Search Rule

• After Finding C or D in First Search, in Second
  Search
• If X finds A or B, stop.
• If X finds C or D, expected gain from further
  search is (1/2) x 2 (1/2) x 1 or 1.5, so search
  again
• After Finding C or D in Second Search, after
  Third Search
• Stop

22
Tying this to Bankruptcy and Shutdown Decisions

• The bankruptcy judge is presented with a proposed
  disposition of the assets of the estate
• What is the likely distribution of better
  proposals?
• What is the cost of considering each proposal?
• When should the judge stop considering proposals?

23
Pricing the Option to Wait

• We wait to learn if we are certain, there is
  nothing to learn, and no reason to wait
• The more uncertaintythe more volatilityassociate
  d with the operations of the firm, the more
  valuable it is to wait
• The Black-Scholes Option Pricing Formula gives us
  a formal way to value real options
• But we dont have the same amount of information
  that exists for financial options

24
Real Options in Chapter 11

• What is the use of real options, given this
  absence of information?
• We become more cautious about simple NPV
  valuations
• We have a different benchmark by which to look at
  the shutdown decision

25
Real Options in Chapter 11

• How long should a bankruptcy judge take to decide
  whether to shut a firm down?
• The Morrison Conjecture
• Real options, when sensibly exercised, leave a
  distinct footprint
• The shutdown decisions of good bankruptcy judges
  should follow the same pattern

26
The Footprint of a Real Option

• How long do you stay in a job before looking for
  something better?
• At the start, you dont know enough to stop
• As you continue, you get more and more
  information
• The job is bad and is not getting better
• The job is great and other jobs are not going to
  be better

27
The Footprint of a Real Option

• It doesnt make sense to quit until you have
  enough information
• As time goes on, you know more and more
• After a certain point, you know enough so that if
  you have not left already, you arent going to

28
The Footprint of a Real Option

• We can translate this idea to a graph
• The number of people who quit their new jobs is
  low initially
• It rises as they learn more
• It then falls as the only people left are those
  who like the job.
• The graph is hump-shaped
• The middle of the hump is the average amount of
  time it takes to learn whether the job is right
  for you

29
The Footprint of a Real Option

• This patternthis inverted U-shaped graphcan be
  observed empirically when real options are
  sensibly exercised
• The Morrison Conjecture
• We should find the same pattern in shutdown
  decisions
• The hump in the graph should peak at 3 months

30
Why Three Months?

• In assessing a firm and its prospects, the
  bankruptcy judge gathering information in the
  same way as an auctioneer
• Auctioneers of firms take about three months to
  orchestrate a sale
• The reorganization regime in Sweden uses auctions
  and they take place in about 3 months on average
• The Bankruptcy Code itself posits that a plan can
  be assembled with 120 days

31
The Morrison Conjecture
Probability of Shutdown
Months in Chapter 11
5
10
15
32
Reality Check

• Survey of Chapter 11 in N.D. Ill. (Eastern
  Division)
• Corporations
• Operating at time of petition
• Filing in calendar year 1998

33
The Morrison Conjecture
Probability of Shutdown
Months in Chapter 11
5
10
15
34
The Baird-Morrison-Picker Conjecture
Probability of Shutdown
Months in Chapter 11
5
10
15
35
Cumulative Shutdowns
100
Firms Shutdown
50
Months in Chapter 11
15
5
10
36
The Real Options Approach to Chapter 11

• Standard critiques of Chapter 11 ask how long
  they take and how many succeed
• The real options approach says that this is wrong
• If the shutdown decision is made sensibly, the
  losers are dismissed quickly at low cost
• The firms that remain in Chapter 11 after a few
  months are winners

37
The Real Options Approach to Chapter 11

• A Chapter 11 regime in which only a few firms
  emerge intact may be good if shutdown decisions
  are made well
• Failures are OK if they are quick
• The time it takes matters less if chances of
  success are high

38
Firms with Debt Over 1 Million
39
Fate of Reorganized Firms
40
Do Judges Use Stochastic Calculus?

• How do bankruptcy judges actually make shutdown
  decisions?
• The bankruptcy judge uses different rules of
  thumb
• These are all different ways of asking, Have I
  seen enough to know that this firm isnt going to
  make it?

41
Rules of Thumb

• 13 OClock Rule
• Cash-Flow Rule
• Three Strikes (Maybe Two) and Youre Out
• Meeting Milestones
• The Company You Keep

42
What Firms Reorganize Successfully in Chapter 11?

• There must be a sound core business.
• A well-established firm that has experienced a
  one-time shock is likely to succeed.
• New businesses and those that cant meet new
  competition are not.

43
Why couldnt you reach a deal outside of Chapter
11?

• A firm with only one large institutional creditor
  is less likely to succeed.
• A firm with non-financial judgment creditors and
  tax collectors is.

44
Filings (by firm type)
45
Precipitating Event
46
Real Options in Action

• There are many different motions, brought by many
  different parties that implicate the shutdown
  decision.
• But all of them raise the same set of questions

47
Real Options in Action

• Consider a standard scenario
• The operating statement shows a negative cash
  flow for your debtor
• The U.S. Trustee brings a motion to dismiss
• What is the judge thinking as you start to make
  your argument?

48
Real Options in Action

• Viable businesses dont keep losing money
• If things dont change, I have to grant this
  motion (or another one just like it) sooner or
  later
• I dont want to find myself here a month from now
  doing then what I can do now
• Unless this guy can tell me what is going to
  change, I might as well grant the motion now