Patent Valuation, Foreign Exchange Risk and Time Value of Money

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1 Patent Valuation, Foreign Exchange Risk and Time Value of Money Jonah, Udeme Inyang Msc Finance and Accounting (University of Wales, UK) Abstract The purpose of this paper is to critically value patent right by using real option theory (Black-Scholes-Merton Model) to determine the valuation of patent and the assumptions of Black and Scholes option pricing model, the second part will be on foreign exchange risk, participating forward contract, its advantages and disadvantages of participating in forward contract, foreign exchange risk hedging. The third part will be on time value of money, while the last part will be on advantages and disadvantages of high tech companies. This paper will provide critical understanding of international financial management topic. Conceptual grasp of issues, Analytical skills and techniques of international financial management. Furthermore, apply financial tools of risk analysis. Keywords: Patent Valuation, Foreign Exchange, Time Value of Money Introduction A patent is an intellectual property right granted by the Government of the United States of America to an inventor to exclude others from making, using, offering for sale, or selling the invention throughout the United States or importing the invention into the United States for a limited time in exchange for public disclosure of the invention when the patent is granted (Uspto, 2012). The term word patent originates from the Latin patere, which means "to lay open" (that is, to make available for public inspection) A patent is a grant by the U.S. Patent and Trademark Office (USPTO) that allows the parent owner to maintain a monopoly for a limited period of time on the use development of an invention (Stim, 2012, p.17). The term patent usually refers to the right granted to anyone who invents any new or useful and non-obvious process, machine, article of manufacture, or composition of matter. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 401

2 VALUATION OF PATENT The most common patent-valuation method is the economic-analysis method. But I m going to use the real option theory (Black-Scholes-Merton model) to determine the valuation of the patent. The real option is also known as option pricing. Real options theory begins by drawing an analogy between real options and financial options. A financial option is a derivative security whose value is derived from the worth and characteristics of another financial security, or the socalled underlying asset. By definition, a financial option gives its holder the right, but not the obligation, to buy or sell the underlying asset at a specified price in other words (the exercise price) on or before a given date that is (the expiration date) (Tong and Reuer, 2007). Financial economists Black and Scholes (1973) and Merton (1973) pioneered a formula for the valuation of a financial option, and their methodology has opened up the subsequent research on the pricing of financial assets and paved the way for the development of real options theory. The Black-Scholes model is one of the most outstanding models in financial economics. The Black-Scholes Option Pricing Models based on stochastic calculus (Sudarsanam et al. 2006, p.299). Real options allow for flexibility to exist in investment decisions. They provide options to defer, time to build, alter operating scales, abandon, switch, grow, and so on (Chang et al. 2005). The Black and Scholes option pricing model (OPM) was developed in 1973, helped give rise to the rapid growth in option trading. This model, which has even been programmed into some handheld and web-based calculators, is widely used by option trader (Ehrhardt and Brigham, 2010). Strengths and drawback of Merton (1974) model for default risky bonds and swaps According to Ali (2004) the model is simple to implement, but the drawback is that it requires inputs from value of the firm, it Default occurs only at the maturity of the debt. Furthermore, the Information in the history of defaults and credit rating changes cannot be used. DETERMINATION OF PATENT The inputs to the option price model are as follows; Value of the underlying asset = PV of inflows (current) = $1 billion. Exercise price = PV of cost of the developing product = $1.5 billion. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 402

3 Time to expiration = life of patent = 20 years Variance in the value of the underlying asset = Variance in PV of inflows = 0.03 Risk-less rate = 10 % Dividend yield = = = 0.05 Based on the input Black and Scholes model provides the following value for the call which are; d1 = , N(d1) = , d2 = , N(d2) = Cash value = $1billion exp(-0.05)(20)(0.8759) - $ 1.5 billion exp(-0.10)(20)(0.6481) = $ billion The cash value is $ billion However Value of the call option Where; Where; T= time to expiration N= (.)- Cumulative normal probability C = fair value of the option S = the current price of the stock R = the risk free rate of interest X = exercise price of the option = annualised standard deviation of the stock Continues dividend rate on the stock Therefore COPY RIGHT 2013 Institute of Interdisciplinary Business Research 403

4 d1 = From the normal distribution, by using excel we will have the following below N(d1) = N(d2) = While for the put options NB: From the normal distribution, by using excel N(-d1) = N(-d2) = Now we can now calculate how put option P = P = P = $25,787, COMMENT From the calculation above the call option is $1,906,639,357 while for the put option is $2,578,741,939. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 404

5 However, the dividend yield shows the return of the business which is 0.05 which gives the yearly return, the black and schools model do not take consideration of dividend yield. Generally the Merton model can only be applied to European option. Thus, there are some limitations of Merton model. Limitation of Merton model Firstly, how will you price the bond that is not been sold, secondly the riskless bond and borrowing is impossible and the future dividend cannot be accurate which is impossible because sales might go up or down and the variance cannot be fixed in the riskless bond. Finally difference between high tech and patent valuation, because innovation is been increased every year. OPTION PRICING MODEL ASSUMPTIONS According to Ehrhardt & Brigham (2010), in deriving their option pricing model, Fischer Black and Myron Scholes made the following assumptions. 1. The stock underlying the call option provides no dividends or other distributions during the life of the options. 2. There are no transaction cost for buying and selling either the stock or the options 3. The short-term, risk-free interest rate is known and is constant during the life of the options. 4. Any purchaser of a security may borrow any fraction of the purchase price at the short-term, risk-free interest rate. 5. Short selling is permitted, and the short seller will receive immediately the full cash proceeds of today s price for a secure sold short. 6. The call option can be exercised only on its expiration dated 7. Trading in all securities takes place contentiously, and the stock price moves randomly CRITICISM OF REAL OPTION MODEL Real Option Models has its limitations when applied to the real world. Patents contain adverse rights which run counter to the notion of having an option. Furthermore, the option value of a patent can be reduced or eliminated by a third party filing and contesting the claim (Chang et al. 2005). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 405

6 The principal deficiency in using the Black Scholes Merton model to value executive stock options is that the model assumes that the option is liquid while executive stock options are essentially illiquid. Models that account for liquidity are typically based on utility functions and require personal information about the executive (Chance and Yang, 2007). The problem in option theory is to estimate the option price when the strike price, as well as several other parameters, is given. For a business project, irreversible fixed investment is determined at the beginning of a project. The problem in project investment is to estimate variable costs when fixed costs as well as other factors are given. Mathematically speaking, the problem in option theory is to solve a backward equation derived from a lognormal process for option prices with a known end condition the strike price. The problem in project investment is to solve a forward equation derived from a lognormal process for variable costs with a known initial condition the fixed investment. The similarity between these two problems explains why option theory becomes so important in understanding project investment and other economic problems (Chen, 2006). Introduction Foreign exchange is the process were two more parties do business from one country to another. Thus foreign exchange is also called forex. Forex is a process of conversion of one country s currency into another country s currency. A currency s value can be pegged to another country s currency. Examples of this were seen during the financial crisis in Asia during the year 1997, when the Chinese renminbi and the Malaysian Ringgit were able to come out of critical financial crises. The Chinese renminbi fixed its rate and the Malaysian Ringgit pegged itself to the US dollar, which helped revive its economic fortunes (Economy watch, 2010). The market force do determined the value of the currency at any particular time. ADVANTAGES AND DISADVANTAGES OF FOREIGN EXCHANGE RATE Advantages According to Carbaugh (2010) foreign exchange rate advantages are as follows; Simplicity and clarity of exchange rate target Automatic rule for the conduct of monetary policy COPY RIGHT 2013 Institute of Interdisciplinary Business Research 406

7 keeps inflation under control Continuous adjustment in the balance of payments Operate under simplified institutional arrangement Allows governments and fiscal policies. Disadvantages According Carbaugh (2010) disadvantages of foreign exchange rate are as follows; Loss of independent monetary policy Vulnerable to speculative attacks Conducive to price inflation Disorderly exchange markets can disrupt trade and investment patterns Encourage reckless financial policies on the part of the government. Forward Contract A forward contract or forward outright is a transaction executed today in which one currency is bought or sold against another for delivery on a specified date that is not the spot date, for example three month from the commencement date (Shamah, n.d). Foreign Exchange Risk Foreign exchange risk is the risk that an entity will be required to pay more (or less) than expected as a result of fluctuations in the exchange rate between its currency and the foreign currency in which payment must be made (Abor, 2005). Foreign exchange risk is commonly defined as the additional variability experienced by a multinational corporation in its worldwide consolidated earnings that results from unexpected currency fluctuations. It is generally understood that this considerable earnings variability can be eliminated partially or fully at a cost, the cost of foreign exchange risk management (Jacque, 1981). Foreign exchange risk is also known as exchange rate risk or currency risk is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies (Levi 2005; Moffett et al, 2009) COPY RIGHT 2013 Institute of Interdisciplinary Business Research 407

8 Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately Homaifar (2004), Moosa (2003). FOREIGN EXCHANGE HEDGE Many firm attempts to manage their currency exposure through hedging. Hedging is the tacking of a position either acquiring a cash flow, an asset or contracts (including a forward contract) that will rise (or fall) in the value and off set a fall (or rise) in the value of an existing position (Eiteman et al, 2010). This is a process which companies use to eliminate or hedge foreign exchange risk. There are methods used in hedging. This is fair value method or cash flow method. Hedging protect the owner exiting asset from loss. And the reasons for hedging is to reduce risk in the future Forward Market Hedge A forward market hedge involves a forward (or futures) contract and sources of funds to fulfil that contract. The forward contract is entered into at the time transaction exposure is created (Eiteman et al, 2010). PARTICIPATING FORWARD CONTRACT Participating forward is also called a zero cost ratio option and forward participation agreement is an option contribution that allows the hedger to share in potential upside movement while providing option based downside protection, all at a zero net premiums (Eiteman et al, 2010). ADVANTAGES AND DISAVANTAGES OF PARTICIPATING FORWARD CONTRACT Advantages The followings are advantages of participating forward according to Qfinance, (2010); Total protection against currency falls No premium A guaranteed worst-case rate A practical benefit from currency gains COPY RIGHT 2013 Institute of Interdisciplinary Business Research 408

9 Disadvantages The followings are disadvantages of participating forward according to Qfinance, (2010); If the currency weakens the rate will not as good as the forward exchange contract The spot rate will be better if there is a positive move in currency. Foreign exchange calculation Investment amount = SF 1,000,000 which is payable in six month Forward rate = SF / $ for six month Foreign exchange broker rate = SF / $ Option1. For instance if the US dollars strengthen to SF we will buy half at SF / $ and the remaining at the prevailing market price which is SF / $ From the option we look at the benefit or otherwise of buying the whole contract at the broke rate Option to buy from the broker = = $862, GoodPharma will have to buy entire contract at $862, under a normal forward contract. But GoodPharma is involved in participating forward contract which will allow them to enjoy the benefit of spot rate. Option to buy half from the broker before the completion = = $431, Option to buy from the market after completion = = $400,000 GoodPharma will pay $431, $400,000 = $831, Option 2 Buy all at the broker rate = = $862, The broker rate is high than the forward rate, because if GoodPharma do not enter the contract they will save $62, which will be better for the company. The Participating forward contract provides full protection against downside. Rather than apply the rule as below: COPY RIGHT 2013 Institute of Interdisciplinary Business Research 409

10 Buying half from the broker = $431, Buying half at Spot rate = $434, The total will be $431, $434, = $865, By the participating forward contract and buying at broker rate of SF1.16 the savings will be $865, $862, = $3, Introduction The time value of money approaches that will be used are NPV and IRR. For better understanding we will need to know the basic terms which are as follows; Double Taxation Agreement This is an agreement which concluded between to state in order to prevent a person who is fully liable tax in one of the States (or sometimes in both states) from being taxed on the same income (or capital) in both States (Rasmussen, 2011). Tax Holiday Tax holiday is an exclusion or elimination or reduction temporary from tax. It s a way of creating an incentive for business investment. Which is called tax subside Capital allowance According to Venture line (n.d) corporation tax refers to direct taxes charged by various jurisdictions on the profits made by companies or associations. As a general principle, this varies substantially between jurisdictions. In particular allowances for capital expenditure and the amount of interest payments that can be deducted from gross profits when working out the tax liability vary substantially. Also, tax rates may vary depending on whether profits have been distributed to shareholders or not. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 410

11 Withholding tax Withholding tax is an amount withheld by the party making payment to another (payee) and paid to the taxation authorities. The amount the payer deducts may vary, depending on the nature of the product or service being paid for (Withholding tax, 2012). Investment A The initial investment was $200,000 the unit of sales is $60,000 3=$180,000 is the revenue. The asset is value at $200,000/10= $20,000 which is the depreciable value $20,000. The operating expense of $80,000, the EBIT is the summation of revenue, operating expenses and depreciation which is $80,000. Tax was charge at 34 % which is $27,200. The profit after tax is $52,800 the depreciation was added back which is $20,000. The working capital was added back only at year 10 which is $ 10,000, the net cash flow for year 1 to year 9 is $72,800, while year 10 was $82,800, because of the working capital that was added back. Using excel the NPV is $234,909 and the IRR of 33% Table 1: Project A YEARS ZERO ONE TWO THREE FOUR FIVE SIX SEVEN EIGHT NINE TEN $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) CAPITAL INVESTMENT WORKING CAPITAL REVENUE ($3*60,000) OPERATING EXPENSES DPRECIATION EBT TAX PAT WORKING CAPITAL 10 ADD BACK DEPRECIATION NET CASH INFLOW NPV= (1+r)^-n IRR 33% NPV OF INVESTMENT NPV OF INVESTMENT NPV OF INVESTMENT($) 241, Investment B The capital invested was $1,000,000 and working capital of $30,000, the revenue of $600,000, operating expenses of $260,000. The EBIT of $240,000, Tax (Brazil tax exempt 30%) which is $240, =$72,000 it was charge at year 6 year 10. The profit after tax for year 1-5 is $240,000 while for year 6-10 is $168,000. The withholding COPY RIGHT 2013 Institute of Interdisciplinary Business Research 411

12 tax for year 1- year 5 $240, = $24,000 while for year 6-10 $168, =$16,800, the net income returned to US is $216,000 while for year 6-10 is $151,200. Using excel the NPV is $441, and the IRR of 22% Table 2: Project B YEARS ZERO ONE TWO THREE FOUR FIVE SIX SEVEN EIGHT NINE TEN $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) $ ('000) CAPITAL INVESTMENT WORKING CAPITAL -30 REVENUE ($3*60,000) OPERATING EXPENSES DPRECIATION EBT TAX (@ 30%) TAX HOLIDAY PAT WITHHOLDING TAX PATOSH ADD BACK DEPRECIATION NET CASH INFLOW US 34% TAX RELIEF IN US WORKING CAPITAL 30 SALVAGE VALUE 50 NET CASH FLOW NPV= (1+r)^-n IRR 22% NPV (PROJECT B) NPV (PROJECT B)($) Decision According to Financial modelling guide (2007) the formula for NPV is PV of the cash flow of year n = Actual cash flow of year n / (1+r) ^ n. which is what we used to get $243,909 for the first of the calculation while the second NPV is $441, The NPV decision rules are: Projects with positive NPV should be accepted Projects with negative NPV should be rejected In case of mutually exclusive projects, the one with higher NPV should be selected COPY RIGHT 2013 Institute of Interdisciplinary Business Research 412

13 However, when the project NPV is zero, the rate at that point of time is considered to be its Internal Rate of Return (IRR). A rule of the IRR also state that accept the project with higher IRR but that where NPV and IRR conflicts, NPV should be the decision criteria. Since we are dealing with two projects, we will use the mutually exclusive project. So project B is chosen as it has the higher NPV of 441, Limitations of NPV Analysis The main limitation of net present value analysis is the difficulty of accurately forecasting future costs and benefits. In particular, benefits are often non tangible (but real) improvements to the community. Programs can have unanticipated costs or generate less revenue than expected. Another limitation of net present value analysis is that there is no universal discount rate or standard method of setting a discount rate. Because there is no standard in this area, net present value analysis is vulnerable to manipulation through selecting a high or low discount rate; however, both of these weaknesses may be addressed by conducting a sensitivity analysis (Michel, 2001). IRR decision rules are: Projects with an IRR which is better than that of the firm should be accepted Projects with an IRR which is less than that of the firm should be rejected According to Clayman, et al (2012) for mutually exclusive project, if the project with the Highest NPV should be accepted Project B is a foreign direct investment Foreign direct investment (FDI) is a term used to denote the acquisition abroad of physical asset, such as plant and equipment, with operational control ultimately residing with the parent company in the home country (Buckley, 2004). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 413

14 The economy of Brazil is the world's sixth largest by nominal GDP and is expected to become fifth by the end of 2012 (Cia, 2007). Brazil has moderately free market and an inward-oriented economy. Its economy is the largest in Latin American nations and the second largest in the western hemisphere (Forbes, 2010). A tax haven is a state or a country or territory where certain taxes are levied at a low rate or not at all while offering due process, good governance and a low corruption rate (Dharmapala and Hines, 2009). The Advantages of Foreign Direct Investment Location advantages Location advantages is defined as benefits arsing from host country s corporative advantages accrued to foreign direct investors (Shenkar and Luo, 2008 p.63). On the other hand, because of some specific resources at lower real costs, also benefits resulting from economic liberation. Expands the market Foreign direct investment expands the market domain in which a multinational economy (MNE) capitalise on its core competencies, generating more income from existing resources capabilities or knowledge (Shenkar and Luo, 2008). Organisation learning Foreign direct investment is also a vehicle for organisational learning. Being actively involved in foreign direct investment grants the multinational enterprise (MNE) learning opportunities that would not have been available to otherwise (Shenkar and Luo, 2008). Cost factors Foreign direct investment Reduced transport cost, scale economies, host government incentives, reduced packaging cost, tariff and duties elimination access to resources (Bradley, 2005 P.277). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 414

15 The Disadvantages of Foreign Direct Investment Product-Market factors The product market factors are one of the disadvantages of foreign direct investment which are Management constraints, loss of flexibility, increased marketing, complexity (Bradley, 2005 P.277). Cost factors This is another disadvantage of foreign direct investment. High initial capital investment for example project B capital investment is 1,000,000 which is higher than project A. high information and search cost not nationalisation or expropriation (Bradley, 2005). ADVANTAGES AND DISAVANTAGES OF OFFSHORE MANUFACTURING ADVANTAGES Large size and economic of scare Lower input costs Brand image and good will DISADVANTAGES Host country regulation/political Natural risk BENEFITS OF OFFSHORE MANUFACTURING The primary factor which attracts manufacturers to outsource manufacturing offshore is the reduction in their cost of production. There are various key factors which have led the growing trend of offshore manufacturing. For instance, lack of well experienced and skilled labour available in domestic market or availability of cheap labour in international markets forces the manufacturers to outsource their manufacturing to the other countries to keep their costs of manufacturing within their budgets (Allbestarticles, 1987). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 415

16 Conclusion From the calculation above in part A. we can the patent valuation and the limitation for part B. we can see the calculation about foreign exchange. Part C, the mutually exclusive investment. Finally we could say it s safer to manufacturing in an offshore location. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 416

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