Saturday, February 20, 2010

Equity Near Bankruptcy (or NPV = 0) Behaving as Call Options

This might be one of the most brilliant finance things I've ever seen taught a few days ago by our finance prof. I've always been interested in options thinking about how they behave and how to value them (and with the current financial crisis, have been taking more looks at bankruptcy).

First consider an oil company which can extract oil out of the ground for $70 per barrel with 1M barrels in the ground. The current cost of oil is $60. It costs more to get the oil out of the ground than it does to sell it on the open market, so the project is negative NPV right?

Well what happens if the oil prices rise to $80 a year from now? Then with a return of 10% (assume that it takes a year to get the oil out), you can make $10 per barrel on 1M barrels. The NPV works out to be about $9.1M.

But there is some inherent risk in this position which relies on the price of oil moving up. Sound familiar? It is the exact same behaviour as a call option.If the value of oil drops, the land is worth nothing, but if the value of oil appreciates, the value of oil appreciates accordingly also. The analogy holds up if you replace Exercise Price with Extraction Cost.

Here is another example of option like behaviour: Companies near bankruptcy.

Scenario 1: Healthy
Net Debt = $5M
Enterprise Value = 11M (Enterprise value calculated based on DCF)
Market Cap = 6M

Scenario 2: Near Bankruptcy / Highly leveraged:
Net Debt = 5M
EV = 6M
Market Cap =1M

Scenario 3: Bankruptcy
Net Debt = 5M
EV = 4M
Market Cap = 0

Because of the nature of capital at risk for corporations, the equity cannot fall below zero. A company in this position might also take on excessive risk (deliberately stir volatility on extremely risky projects) because there is nothing to lose.

However, in the absence of that, a company's equity at or near bankruptcy will be have much like a call option. Because of this relationship, a vulture fund might use the Black-Scholes model could potentially apply as an appropriate valuation metric to value the time value of the equity.

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