Gordon Sick

Valuing long-term leases: The option to redevelop

Long-term leases on property are popular in many jurisdictions, both with private vendors and with local governments who want to retain future control over land use. A puzzling issue for vendors and purchasers has been how to value these leased properties relative to fee-simple properties. Simple present-value models suggest that there should be little difference between the price of fee-simple land and the price of long-term leases. Transaction prices in Canada on 80-year to 100-year residential leases, however, are 20 percent to 40 percent less than comparable fee-simple properties. We outline a financial model for valuing leased properties. The value of the option to upgrade or redevelop is considered. We show that the large part of the discount of leased properties from fee-simple properties can be explained by this option to redevelop.

Scale economies and cost complementarities in commercial banks: On-and off-balance-sheet activities

Bank off-balance-sheet (OBS) activities have grown dramatically and have become significantly important, especially at large banks. We investigate whether failure to incorporate OBS products may lead to a misspecification problem. Models that exclude deposits from the output specification suggest economies of scale, which vanish when deposits are included. We find that an inclusion of OBS products has little or no significant effect on the scale economies measures. With only a few exceptions, the results provide no evidence of cost complementarities in joint production. The tremendous growth of bank OBS activities in the 1980s may be explained by the very small (approximately zero) pecuniary cost of these activities.

A Certainty-Equivalent Approach to Capital Budgeting

The popular textbook treatment of capital budgeting under uncertainty requires a risk-adjusted discount rate (RADR), which is typically calculated as the expected rate of return for a project under the Capital Asset Pricing Model (CAPM) or Arbitrage Pricing Theory (APT). The RADR is then used to discount expected flows from the project to compute a market value. This approach has gained popularity in practice, but has some limitations, both practical and theoretical. This paper proposes an alternative approach that overcomes some of these limitations.

Real Options and Follower Strategies: The loss of real option value to first-mover advantage

ABSTRACT The value in real options comes from the firms ability to wait until conditions are optimal before moving forward with a project. There may be a loss of this optimal value if decision-makers anticipate preemptive entry by a competitor. Pioneers that enter markets early might ignore or spoil the real option value from delay. Although market pioneers may gain first-mover advantages, followers have important advantages as well. In this paper we discuss these follower advantages, providing examples of successful delay in the context of a real option on innovation.

Chapter 21 Real options

Publisher Summary This chapter discusses the basic techniques and ideas of real options analysis, as it extends the capital-budgeting literature beyond the discounted cash-flow technique. The basic techniques in asset pricing are reviewed, with a focus on the risk-neutral martingale and generalized capital asset pricing model (CAPM) approaches. These techniques are based on very broad economic principles, and are likely to stand the test of time. Little emphasis is placed on arbitrage analysis, because real assets often cannot be traded or sold short, as in financial option analysis. A real option can derive risk from an economic variable such as an interest rate that does not correspond to an asset price. The chapter also describes the discounting of the certainty-equivalents in real options by a tax-adjusted riskless bond return. The chapter concludes with a discussion of various real-option models. The first model is interest-rate uncertainty that shows how the underlying economic variable need not be the price of a traded asset. In this model, the unusual result can obtain in which a reduction in interest rates can deter rather than encourage the adoption of projects. A series of examples of applications of real options analysis in the real estate and mineral industries from the literature is discussed in the chapter. Real options can be used to analyze abandonment decisions, production decisions and to determine the opportunity cost of excess capacity.

Investment under Uncertainty, Debt and Taxes

It is common practice in financial derivative valuation to use a discount factor based on the riskless debt rate. But, to what extent is this discount factor appropriate for cash flows emerging in capital budgeting? To answer this question, we introduce a framework for real asset valuation that considers both personal and corporate taxation. We first discuss broad circumstances under which personal taxes do not affect valuation. We show that the appropriate discount rate for equity-financed flows in a risk-neutral setting is an equity rate that differs from the riskless debt rate by a tax wedge due to the presence of personal taxation. We extend this result to the valuation of the interest tax shield for exogenous debt policy with default risk. Interest tax shields, which accrue at a net rate corresponding to the difference between the corporate tax rate and a tax rate related to the personal tax rates, can have either positive or negative values. We also provide an illustrative real options application of our valuation approach to the case of an option to delay investment in a project, showing that the application of Black and Scholes formula may be incorrect in presence of personal taxes. Copyright 2008 The Authors Journal compilation 2008 Banca Monte dei Paschi di Siena SpA.

Valuation of a spark spread: an LM6000 power plant

This paper analyzes a power plant powered by two General Electric LM6000 gas turbines combined with a steam generator that allows combined cycle operations. We consider four distinct operating modes for the plant. Such a plant can be characterized as a real option on a spark spread: optimally converting natural gas to electricity. We use a Margrabe approach by using the market heat rate (the ratio of the electricity price to the natural gas price) as our underlying stochastic variable. We estimate a stochastic model for market heat rates that incorporates time of day, day of week, month, and the incidence or otherwise of a spike in heat rates. We use the model and its residuals in a bootstrap process simulating future market heat rates, and use a least-squares Monte Carlo approach to determine the optimal operating policy. We find that the annual average market heat rate is a good explanatory variable for the time integral of the plant operating margin, denominated in the natural gas numeraire. This allows us to express plant values in terms of the numeraire and convert to dollars by multiplying this by the natural gas forward curve and a forward curve of riskless discount rates. We also provide information about the optimal operating modes selected, the number of transitions between modes and how they relate to transition costs and the average heat rate for the year.

Discussion: Asymmetric Information, Signaling, and Optimal Corporate Financial Decisions

This paper generalizes the past signaling literature from one variable to many. Multivariate models have been studied in the general rational expectations literature (e.g., Allen [1], Kraus and Sick [3]), but this appears to be the first multivariate signaling application. (Here, I distinguish signaling from rational expectations literature by the fact that agents may attempt to promulgate, suppress, or add noise to signals.) Talmor studies signaling models which are fully revealing (i.e., for which, in equilibrium, the values of the signaled parameters are correct).

Communication of Aggregate Preferences through Market Prices

In a dynamic economy with a sequence of markets over time, there are generally goods or securities that will be traded in the future at currently unknown prices. Individuals require some notion of what these future prices will be since knowledge of future investment opportunity sets is relevant when making current portfolio allocation decisions.

The Turn-of-the-Month Effect in the U.S. Stock Index Futures Markets, 1982–1992

The mean return for small and large capitalized stocks in the cash and futures markets was positive in the first half of the month and negative in the second half of the month during the 10-year period of futures trading from May 1982–April 1992. The mean return in the cash and futures markets for small and large capitalized stocks at the turn-of-the-month fiveday trading period was significantly greater than average. There was partial anticipation of the cash turn-of-the-month effect in the futures markets on the previous three trading days. There was seasonality in the monthly return patterns, with the first and last quarter exhibiting higher returns at the turn-of-the-month and in the first half of the month. These results are an out-of-sample confirmation of the turn-of-the-month anomaly Ariel (1987) reported for the cash market in the earlier period 1963–1981. The anomaly appears in the cash and futures markets, ruling out many explanations of the cash market anomaly that are based on trading frictions.