Real Options and Their Impact on M&As
The increasing volume of merger and acquisition (M&A) activity both domestically and cross-border has brought increased attention to the valuation process, particularly with regard to existing embedded options. The overall complexity of M&A activity has also increased in recent years as financial systems have become more open with firms expanding not only domestically but also globally. Cross-border mergers in particular tend to be much more complex, and the valuation of such M&As are more involved with additional elements of risk exposure. The analysis of any merger or acquisition goes far beyond the simple stand-alone value of the target firm, given that the acquirer now has many decision points that can be modeled in the framework of real options.
Traditionally, M&A valuation closely followed capital budgeting methodology, predominantly the discounted cash flow (DCF) method with the focus on free cash flow. That is, cash flows are developed for a forecast period for the target firm, and then a terminal or horizon value is calculated at whatever is deemed a reasonable time period. This process involves the following: determining the appropriate time horizon, estimating free cash flows, considering growth opportunities, and specifying an appropriate risk-adjusted rate of discount. All of these parameters ...