Müller Real Option Valuation in Service lndustries

Transcription

1 Müller Real Option Valuation in Service lndustries

2 GABLER EDITION WISSENSCHAFT

3 Jürgen Müller Real Option Valuation in Service lndustries With a foreward by Prof. Dr. Hellmuth Milde Springer Fachmedien Wiesbaden GmbH

4 Die Deutsche Bibliothek - CIP-Einheitsaufnahme Müller, Jürgen: Real option valuation in service industries / Jürgen Müller. With a foreward by Hellmuth Milde. (Gabler Edition Wissenschaft) Zugl.: Trier, Univ., Diss., 1999 ISBN ISBN (ebook) DOI / Alle Rechte vorbehalten Springer Fachmedien Wiesbaden 2000 Ursprünglich erschienen bei Betriebswirtschaftlicher Verlag Dr. Th. Gabler GmbH, Wiesbaden, und Deutscher Universitäts-Verlag GmbH, Wiesbaden, 2000 Lektorat: Brigitte Siegel / Viola leuschner Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Das gilt insbeson dere für Vervielfältigungen, Ubersetzungen, Mikroverfilmungen und die Ein speicherung und Verarbeitung in elektronischen Systemen. / / Höchste inhaltliche und technische Qualität unserer Produkte ist unser Ziel. Bei der Produktion und Verbreitung unserer Werke wollen wir die Umwelt schonen. Dieses Buch ist deshalb auf säure freiem und chlorfrei gebleichtem Papier gedruckt. Die Einschweißfolie besteht aus Polyethylen und damit aus organischen Grundstoffen, die weder bei der Herstellung noch bei der Verbren nung Schadstoffe freisetzen. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. ISBN

5 Foreword V Foreword It is useful to apply the net present value (NPV) rule when making capital budgeting decisions. However, there are two complications: uncertainty with respect to operating cash flows flexibility of managerial decision making It is easy to resolve the first complication: Smart financial managers and smart financial economists had no problern to adjust for uncertainty in capital budgeting. The second complication is more difficult to resolve: Developing a decision rule when managerial flexibility is explicitly taken into consideration has been an unsolved problern for many years. Recently, the real option approach has emerged as tool to integrate the aspects of uncertainty and flexibility. For example, consider a company that is planning to invest some money in a project and has an option to expand in the future. Consider a second company with an identical project but no option. In such cases, it is important to take the value of the option explicitly into account. The basic flaw of the standard NPV rule is ignoring the existence of the option when calculating the present value of the project. For years, the ideas and concepts of the real option approach had been successfully applied to many real world problems. However, the following three gaps had been existing ever since in all investigations: application of the approach to service industries empirical support for the approach simplification of applicability in practical decision making In his book, Jürgen Müller conducts an in-depth analysis on all three aspects mentioned above. I am glad to say that Jürgen Müller was successful in closing the gaps. His dissertation is a perfect example for an integration of theoretical and application-type argumentation. In his first chapter Jürgen Müller is presenting the case of a Polish retail banker. Using the standard NPV rule, the Polish project would have been rejected because of a negative NPV. However, according to the empirical evidence the project was accepted. In a detailed analysis, Jürgen Müller applies the real option concept and quantifies the positive strategic value embedded in the decision. The real option valuation is performed using a simplified six-step approach, based on a binomial option pricing model.

6 VI Foreward Jürgen Müller's six-step valuation framework facilitates a thorough structuring of the investment problem, thus increasing the transparency of the real option approach. As a result, an increase in the application of the approach seems possible. From a theoretical point of view, the approach is vital to long-term corporate success in an uncertain and changing marketplace. The thesis submitted by Jürgen Müller is highly relevant to both academia and corporate decision making. Univ.-Prof. Dr. Hellmuth Milde

7 Preface VII Preface This book has been presented as doctoral thesis to the department of business administration (Fachbereich IV) of the University of Trier. It has been my pleasure to have Prof. Dr. Hellmuth Milde as my advisor for this dissertation. I am grateful for his openness to the topic and his support during the evolution of the thesis. I would also very much like to thank Prof. Dr. Gunter Dufey for co-chairing my thesis and Ulrich Hommel Ph.D. for the numerous, intellectually challenging discussions and the valuable guidance throughout my doctoral studies. During my stay at the University of Texas at Austin, I would like to thank Prof. Robert Parrino and Prof. John Martin for all the instructive and enlightening discussions. Murat Binay Ph.D., Stefan Harfich, Dr. Christoph Israng, Thomas Kredatus, Dr. Hagen Lindstädt and Annette Zeipel reviewed the first draft of my thesis. I thank them for their valuable comments, as weil as for their effort, time and patience. Stanislaw Slubowski was an invaluable source for getting access to data on the Polish banking market. J ürgen Müller

8 T.tblt. ot nmtents IX Table of contents Foreword... V Preface... VII Table of contents... IX Index of tables... XV Index of figures... XVII Symbols... XXI A bbreviations... XXIII 1. lntroduction Motivation Objective and results Delineation and scope Approach Structure Retail Banking in an ernerging market: The case of Po land lntroduction and overview General trends and success factors in retail banking Retail banking in Poland General background Banking: lnstitutional framework Historical development Regulatory framework Capital markets Retail banking: lndustry analysis Retail banking market attractiveness Volume Profitability Competitive dynamics in the retail banking market Direct competition Substitute competition Market entry potential Summary of chapter

9 X Table nl cnntcnh 3. The evaluation of capital investment decisions Introduction and overview... : Traditional capital budgeting methods... :\1' The net present value criterion... :IS Criticism and shortcomings of the net present value criterion... 4: Other approaches... 4h The need for the expanded net present value criterion... 4S 3.3 The real options approach Basic concepts Necessary conditions for the existence of real options Categorization of real options Financial option pricing theory... 5S Valuation techniques... 5S Introduction... 5S Standard assumptions for financial option pricing models... 5S No-arbitrage condition and risk-neutral valuation.... ho Continuous time: Black-Scholes option pricing model... h I Discrete time: Binomial option pricing model.... h Extensionsand properties of standard models.... h] Dividend payments and early exercise Comparative statics... h Translation of the methodology from financial to real option valuation.. hh Theoretical foundations... hh Key areas of analysis... hh Frictionless securities markets and the no-arbitrage condition... hh Existence of a twin security... h Continuous trading... by Geometrie Brownian motion Non-traded assets and rate of return shortfall Differences in the analogy Inputparameters Different stochastic processes Form of options Ownership of option h Early exercise and sale of option h Agency considerations S Summaryevaluation of applicability of financial option pricing models to real assets... 7'1

10 XI J.:l.ö Development of a generalized real option valuation framework :l.3.ö.1 A new and simplified six-step approach to real option valuation ].: Technical extensions Multiperiod model :1.] Step size Dividend adjustments Early exercise Conceptual extensions Interaction of several real options Competitive interaction :1.7 Applications of real option valuation in practice Overview and classification of applications to date Extension of the approach to a service industry context H Critical evaluation H.1 Advantages of the real options approach H.2 Shortcomings of the real options approach Conclusion Summary of chapter Applying real option valuation to a retail banking startup in Poland lntroduction and overview Economic model of a retail banking startup in Poland Model setup Quantitativeframe Income statement Balance sheet Results and analysis Valuation of a retail banking startup in Poland using the six-step approach Step 1: Static DCF valuation Methodology Terminology Methodological issues in bank valuation Methodological issues in ernerging markets valuation Bank valuation model Static net present value calculation Static gross present value calculation Sensitivity analysis Estimation of the underlying uncertainty Step 2: ldentification of main underlying uncertainty

11 XII Table of contents Step 3: Translation to project uncertainty Methodological overview Time series modeling Simulationapproach Traded comparables... 15R Discussion of results Valuation of real options embedded in the investment project... I h Qualitative description of real options Identification of the real options embedded in the investment project Option to expand Option to abandon for salvage value Valuation approach Step 4: Asset price tree Realoption tree... 16R Steps 5 and 6: Valuation without competitive interaction Option to expand Option to abandon for salvage value Joint valuation... 17' Valuation with exogenous competitive interaction... 1H Typesand implications of competitive interaction... 1H Frequent and stochastic competitive interaction... IHJ Deterministic competitive interaction... 1H Valuation of the total real opportunity to invest... 1 H Valuation of the option component only... 1 H A new approach to decomposing the effects of competitive interaction... 1 YO Discussion of resul ts Investment decision... 1 Y Option values and sensitivities... 19H Lead times... 19' Switching costs Analysis of investment timing Valuation of the option to defer investment Valuation without competitive interaction Valuation with competitive interaction Discussion of results Investmenttiming und er endogenous competitive interartion

12 Table ot contenh XIII Analysis of the investment situation Model description and valuation Discussion of results Summary of chapter Critical review and outlook A ppendices Bibliography

13 lndl'x nt tablt s XV Index of tables Table 2.1: "Strategy for Poland: Package 2000"- Key data (Real change in% p.a.) Table 2.2: Division of tasks in Polish banking system under Communist regime Table 2.3: Twinning partner and ownership structure as of end-1997 of 9 regional banks Table 2.4: Minimumreserve requirements as of July 1997 (in%) Table 2.5: Average annual income and savings potential of private households (1996) Table 2.6: Real growth of asset/liability categories in the Polish banking sector (J une 1997 PLN billion) Table 2.7: Simulation of volume of personal financial holdings (USD billion) Table 2.8: Key data for main competitors in Polish retail banking market (1997) Table 3.1: Assumptions underlying the CAPM Tablc 3.2: Comparison of capital budgeting methods Table 3.3: Qualitative description of real options with potential industry applications and examples in the literature Table 3.4: Comparative statics of the influence of input parameters on the option value Table 3.5: Values of 11' under different seenarios concerning the underlying asset Table 3.6: First-orderinteraction- Impact of introducing a subsequent option on the value of the first option Table 3.7: Second-order interaction- Impact of the first option on the value of the subsequent option Table 3.8: Tendency statements on the degree of option interaction Table 3.9: Relation between market structure and real option model Table 3.10: Overview and classification of application of real option valuation in practice Table 4.1: Market price survey (interest in%, as of July 1997) Table 4.2: Calculation of net interest margins (in%, end of June 1997) Table 4.3: Customer product volume assumptions (PLN, end of June 1997) Table 4.4: Assumptions on real product volume growth (in % p.a.) Table 4.5: Personnel structure and cost- Full network size with 500,000 customers 121

14 XVI Index of tables Table 4.6: International comparison of new customer acquisition cost Table 4.7: Balance sheet and statement of retained earnings (PLN million) Table 4.8: Income statement (PLN million) Table 4.9: Standard free cash flow definition and applicable discount rates under the entity and the equity method Table 4.10: Definition of financing flow under the entity and the equity method Table 4.11: Definition of free cash flow and financing flow for a financial institution under the equity method... 13!i Table 4.12: Comparison of historical US market risk premia Table 4.13: Free cash flow calculation (PLN million) Table 4.14: Distribution statistics for gross present value simulation \ Table 4.15: Inputs for base asset price tree \ Table 4.16: Inputs for the asset price tree- simplified model Table 4.17: X;(A~B) for the simplified model Table 4.18: \(C~D) for the simplified model Table 4.19: Realoption values (PLN 1,000)... 19R Table 4.20: Parameters in the real option valuation in the game tree

15 Index of figures XVII Index of figures Figure 2.1: Comparison of cost per transactionindifferent distribution channels Figure 2.2: Market shares in the Polish banking market (in% of total assets, 1997) Figure 2.3: Equity market capitalization in % of GDP and turnover ratio (1996) Figure 2.4: Development of the WIG (]une June 1997) Figure 2.5: Government bond yield curve (end of March and end of June 1997) Figure 2.6: Percentage points of ROE in excess/ short of WIBOR; Main banks (1996, 1997) Figure 2.7: International comparison of distribution network density (1996) Figure 2.8: Top 10 complaints about Polish retail banking Figure 2.9: Customer satisfaction with main bankingrelationship in Poland Figure 4.1: Structure of bank simulation model Figure 4.2: Inflation rate forecasts Figure 4.3: International comparison of branch rollout schedules Figure 4.4: Customer acquisition path at branch Figure 4.5: Structure of income Statement Figure 4.6:Average annual personnel cost per employee (1997) Figure 4.7: Annual marketing budget- development over time Figure 4.8: Total setup costs- development over time Figure 4.9: Structure of balance sheet and statement of retained earnings Figure 4.10: Capital adequacy ratios of major Polish banks (1997) Figure 4.11: Number of branches and customers- development over time Figure 4.12: Total assets- development over time Figure 4.13: Break-even and payback period at bank level Figure 4.14: National composition of ß comparables portfolio Figure 4.15: Historkai Monthly CPI rates in Poland Figure 4.16: Development of free cash flows and their discounted values over time Figure 4.17: Result sensitivities expressedas change of NPV Figure 4.18: Result sensitivities indexed Figure 4.19: Real monthly growth rates for retail deposits and loans

16 XVIII Index of figures Figure 4.20: Annualized source uncertainty numbers and corresponding present values Figure 4.21: Distribution of simulated project values Figure 4.22: Volatility of bank stocks Figure 4.23: Overview of investment opportunity and embedded options Figure 4.24: Schematic representation of multiplicative binomial tree Figure 4.25: Schematic representation of valuation framewerk for exchange option Figure 4.26: Development of expansion cost X,(A~B) Figure 4.27: Translation of static PV and NPV into EPV and ENPV (PLN million) Figure 4.28: Development of salvage value X,(C~D) Figure 4.29: Sensitivity of option to expand to different types of competitive interaction Figure 4.30: Sensitivity of option to abandon to different types of competitive interaction Figure 4.31: EPV decomposition for the options to expand and abandon (PLN million) Figure 4.32: Investment decision criteria (PLN million) Figure 4.33: Sensitivity of real option values to volatility cr- proprietary option Figure 4.34: Sensitivity of real option values to risk-free rate r- proprietary option Figure 4.35: Sensitivity of proprietary option to expand to construction Iead times Figure 4.36: Development of investment costs X,(F~G) Figure 4.37: Sensitivity of proprietary option to defer to time to expiration Figure 4.38: Sensitivity of proprietary option to defer to volatility cr... 20E Figure 4.39: Sensitivity of proprietary option to defer to risk-free rate r Figure 4.40: Timeline concerning the investment timing decision... 20'i Figure 4.41: Subgames I and li-normal form (PLN million)... 21: Figure 4.42: Two-period entry game- normal form (PLN million)

17 Index of figur<'s XIX Figure 4.43: Two-period entry game with smaller first mover advantagenormal form (PLN million) Figure 4.44: Two-period entry game with technical uncertainty and symmetric technical skills- normal form (PLN million)

18 Symbols XXI Symbols Uppercase Roman letters c CF cv D E FCF I M N [ ] p s S' T V X Lowercase Roman letters c d dz e g j k In m p q American call Cash flow Continuing value 1. Market value of debt 2. Amount of discrete known dividend Market value of equity Free cash flow Investment cost Indicator for optimal operating mode Cumulative normal distribution American put Price of the underlying asset Price of underlying asset reduced by the present value of expected dividends Time to maturity 1. Option value 2. Market value of the firm Exercise or strike price European call Down-movement in price of underlying asset during subperiod Standard Wiener process Euler's number (base of naturallogarithm) Long-term real growth rate 1. Period index 2. General index parameter Nodeindex Cost of capital Naturallogarithm Indicator for operating mode 1. European put 2. Risk-neutral probability of up-move 3. Generalprobability parameter Continuous and proportional dividend yield

19 XXII Symbols r Risk-free rate Expected rate of return on the firm's debt Expected rate of return on the firm's equity Expected rate of return on the market portfolio Current time operator Applicable corporate taxrate Up-movement in price of underlying asset during subperiod Uppercase Creek letters ~ 1. Change indicator 2. Hedge ratio Sum operator Lowercase Creek letters ß ö cr t 8 Measure of systematic risk within the CAPM framework Rate of returnshortfall for the underlying asset (e.g dividend yield in the case of financial options) Market price of risk lnstantaneous expected rate of return Risk-neutral equivalent rate of return Correlation Standard deviation Time to maturity Natureoperator Specialsymbols a Partial derivative operator Mean indicator Infinity

20 Abbreviations XXIII Ab breviations APT ATM BBG BCP BDK BG BGZ BH BIG SA BIG Bank SA BIS BOS bp BPH BRE BSK BZ CAPM CEE CPI CR DCF DM e.g. EBIT EBRD ECU ed. Arbitrage pricing theory Automated teller machine BIG Bank Gdanski (private universal bank) Banco Commercial Portugues (Portuguese commercial bank) Bank Depozytowo Kredytowy (one of the NBP spinoffs, now part of the PeKaO SA group) Bank Gdanski (one of the NBP spin-offs, now part of the BBG group) Bank Gospodarki Zywnosciowej (former government agricultural and co-operative bank) Bank Handlowy (former government foreign trade bank) Bank Inicjatyw Gospodarczych (private commercial bank, now part of BBG group) Subsidiary of BIG SA Bank for international settlement Bank Ochrony Srodowiska (private commercial bankecological focus) Basispoint (1/100 %) Bank Przemyslowo Handlowy (one of the NBP spinoffs) Bank Rozwoju Eksportu (former government foreign trade bank) Bank Slaski (one of the NBP spin-offs) Bank Zachodni (one of the NBP spin-offs) Capital asset pricing model Central and Eastern Europe Consumer price inflation Competitive recovery Discounted cash flow German Mark exempli gratia Earnings before interest and taxes European bank for reconstruction and development European currency unit 1. Editor

21 XXIV Abbreviations eds. ENPV EPV EU FTE FX GDP GUS H, HBS HSB i.e. IFC IMF ING IRR IT KB/PBI LIBOR Max MOR MR MRP NBP NIM NOPAT NPV OECD ov P p.a. P/BV PBG PBKS 2. Edition Editors Expanded net present value Expanded present value European Union Full-time equivalents Foreign exchange Cross Domestic Product Glowny Urzad Statystyczny (Central statistical office) Null-hypothesis Harvard Business School Hypo Servicebank id est International finance corporation International monetary fund Internationale Nederlanden Groep (Dutch commercial bank) Interna! rate of return Information technology Kredyt Bank/PBI (private commercial bank) London interbank offerrate Maximum Matched opportunity rate Minimumreserve rate Market risk premium Narodowy Bank Polski (National Bank of Poland) Net interest margin Net operating profit after taxes Net present value Organization for economic cooperation and development Option value Page per annum Price-to-book value of equity ratio Powszechny Bank Gospodarczy (one of the NBP spinoffs, now part of the PeKaO SA group) Pomorski Bank Kredytowy (one of the NBP spin-offs,

22 Abbreviations XXV PBKW PC PeKaOSA PER PKOBP PLN PP PV PZU R&D RAROC ROAA ROAE ROE ROV SCL SLD UK us USO VAT vs. WACC WBK WIBOR WIG WSE zus now part of the PeKaO SA group) Powszechny Bank Kredytowy (one of the NBP spin-offs) Personal computer Polska Kasa Opiecki SA (former government savings bank for foreign currency) Price-earnings ratio Powszechna Kasa Oszczednosci Bank Panstowy (former government savings bank) New Polish Zloty Pages Present value Former government insurance monopalist Research and development Risk-adjusted return on capital Return on average assets Return on average equity Return on equity Realoption valuation Static competitive loss Reformed Communist party in Poland United Kingdom United States of America US dollar Value-added tax versus Weighted average cost of capital Wielkopolski Bank Kredytowy (one of the NBP spinoffs) Warsaw interbank offerrate Warsaw stock exchange index Warsaw stock exchange Polish social security