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My Thesis on Real Options Valuation
Executive summary:
Subject: Optimization of the capital structure and Valuation of the management’s flexibility with the Real-Options’ approach
The capital structure decision is a permanent topic of any company. It is in fact very important for the management to know the debt level of his company, compare to its optimal level, in order to take the right decision, for financing new investments. The optimal capital structure of a company give the maximum valuation’s level for the company, because it gives the lowest WACC of the company. It gives also the information about the financial flexibility of the company.
This question is not a new one: starting form the Modigliani & Miller’s work, a number of theories have emerged and have been developed. And now, it is possible to obtain this optimal level of debt with the real problems of the capital markets.
It is now possible to calculate the optimal capital structure of any company!
This development has significant consequents, because these allow shareholders to value, to appreciate and to judge the decisions that are taken in their companies and the work that is done by those managers.
More over the Real-Options approach allow the valuation of the financial flexibility, owned by each company (differential between the real level and the optimal level), and by that way to value more precisely the whole company. In fact, the Real-Option approach allows the valuation of the flexibility, existing inside the company. The capital structure and its optimization implicate the existence of a real option, which represents the financial flexibility of the company. This option has a value, which should be valued, otherwise your valuation based on the DCF approach in not correct. To be unaware of the existence of such an option means that you are not correctly estimating the value of your investment or of your company.
The implementation in 2005 of those concepts to the PPR’s group shows that the company is currently overextended, compare to its optimal level; but not so much (a sign of the management qualification…). This capital structure has a negative impact on the group’s valuation: the enterprise value is miss-valued by 1% (which is not so much but…). Because of this level of debt, the company does not have any financial flexibility, and therefore the value of the real option is negative. In this case the real option is 3.2% negative on the Enterprise value. This means a negative impact on the valuation of approximately 4%, only identified with one real option… (… did you see what I mean, if you think and value the others real options…?).
The Real-Options approach, a new tool to help managers to take decisions in our changing world…: The question of: Is the market really going to value those real-options?, is not the most important. I really think that we have to take care about the vision that this approach gives more generally: here again, it is the global corporate strategy that will suffer from this lack of financial flexibility.
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