Disinvestment Example

 

Real Options Valuation (ROV) is a powerful methodology to assess disinvestment decisions. Herein, we show a simple application of ROV, by valuating a firm’s decision to disinvest in a factory. 

 

In this example, we show how it may be optimal to keep an unprofitable business open even when the Discounted Cash Flow (DCF) is negative. This is the case because by keeping the factory open, it is possible that business conditions recover and the Net Present Value (NPV) becomes positive. 

 

Assumptions:

 

As for the other examples, the assumptions we make are only for exposition purposes. Our objective is to offer the reader an insightful perspective of ROV for disinvestments. In our daily work, we consider much more complex and realistic contexts to improve efficiency and create value for our clients.

 

  • Disinvestment is completely irreversible. Once the firm closes its factory, it cannot recover it.

  • The firm can postpone disinvestment. It can disinvest now, or next year.

Disinvest this

year

VS

Wait for next year

  • The factory is now generating a negative cash flow. The expected discounted cash flow (DCF) is -5M€.

  • In the next year, there is a possibility of reversion. There is a 50% probability that economic conditions improve, and the factory starts making a positive cash flow. If economic conditions improve, the firm would have a DCF of 5M€.

  • There is also a 50% probability that economic conditions do not improve, and the factory generates an even worse cash flow: in this case, the factory has a DCF of -15M€.

This Year

Next Year

5M€

-15M€

50%

-5M€

50%

  • Discount rate = 10%. Thus, the present value of the DCFs is:

     

This Year

Next Year

5M€

1.1

50%

-5M€

50%

= 4.55M€

= -13.64M€

-15M€

1.1

  • The liquidation value is assumed to be 0€. The liquidation value comprises any remaining value of the infrastructure and machinery, but also includes any costs related with firing the workers as severance payments. For that matter, and to make the exercise easier, we consider that both effects cancel each other, and the liquidation value equals 0€.

 

Analysis:

 

The Net Present Value (NPV) rule is that once a factory is expected to generate a DCF lower than the liquidation value, the firm should disinvest in the factory. In this case, the DCF is -5M€ and the liquidation value is 0€. Thus, the NPV suggests that the firm should disinvest immediately, avoiding negative cash flows and attaining a value of 0M€. Is this, however, the best alternative? Or should the firm wait another year to make the decision?

 

If the firm waits another year, it will have to endure negative cash flows in the factory. Those cash flows in present terms equal 10%*(-5M€)/1.1 = -0.46M€. By enduring these negative cash flows, the firm has the option to check how economic conditions evolve. In a sense, the firm has the option to invest 0.46M€ to check if economic conditions improve.

 

If economic conditions do not improve, the firm closes its factory. But if the economic conditions improve, the firm has now a profitable asset.

How much worth is the option to delay disinvestment? There is a 50% probability to attain a DCF of 5M€ in the second year. In present value terms, this equals the probability that economic conditions improve multiplied by the present value of DCF: 50%*5M€/1.1 = 2.27M€. There is also the cost to have this option which is 100%*(-0.46M€) = -0.46M€. Then the value of the option to wait and see how economic conditions evolve is 1.81M€. 

The value to disinvest next year exceeds the value to disinvest now. Because there is the possibility of reversal of economic conditions, the firm is better off keeping an unprofitable factory open for another year than disinvesting now. This example shows how the NPV rule can be wrong for disinvestment: the NPV rule suggests firms should disinvest businesses that are worthwhile keeping open.

 

In sum, the ROV rule is consistent with managers' intuition: the firm should only disinvest when the possibility that economic conditions improve does not compensate for the costs to keep an unprofitable business open for further time. In this case, it is worthwhile. Next, we recalibrate the problem to show a possible case where it is not worthwhile to wait for business conditions to reverse.

 

What if the possible DCFs in the next year are 1M€ and -11M€?

In this case, two conclusions from the previous example still hold: the firm has a value of 0M€ by disinvesting now, and the firm will disinvest in the factory if economic conditions do not improve.

What about the value to delay disinvestment? The firm still has to endure a 0.46M€ cost to have the option to check how economic conditions evolve. What about the potential gain? In this case, the probability that economic conditions improve is still 50%, but the DCF is smaller: the expected gain is 50%*1M€/1.1=0.45M€. 

The value to wait for further information is negative because the costs of enduring current negative cash flows exceeds the potential benefit that economic conditions improve. For that matter, the firm would optimally disinvest now.

This Year

Next Year

5M€

1.1

50%

-5M€

50%

= 4.55M€

= -13.64M€

-15M€

1.1

Value to disinvest now

= 0M€

Value to wait

= 1.81M€

VS

This Year

Next Year

1M€

1.1

50%

-5M€

50%

= 0.91M€

= -10M€

-11M€

1.1

Value to disinvest now

= 0M€

Value to wait

= -0.01M€

VS