Real Options: Valuing Flexibility in Strategic Mergers and Acquisitions as an Exchange Ratio Swap

Managerial Finance, Vol. 28, No. 12, 2002

Posted: 21 Jul 2003

See all articles by Hemantha Herath

Hemantha Herath

Brock University - Faculty of Business

John S. Jahera

Auburn University - Harbert College of Business

Abstract

In recent years, practitioners and academics have argued that traditional discounted cash flow (DCF) valuation models do not adequately capture the value of managerial flexibility to delay, grow, scale down or abandon projects. The insight is that a business investment opportunity can be conceptually compared to a financial option. The purpose of this paper is to develop a theoretical model based on option pricing theory to value managerial flexibility arising in stock for stock exchanges. The paper shows how a mergers and acquisition (M&A) deal may be optimally structured as a real options swap by including managerial flexibility of both the acquiring and target firms when stock prices are volatile. Using a recent acquisition case example from US banking industry the paper illustrates how the proposed exchange ratio swap optimizes deal value and avoids earnings per share (EPS) dilution to both parties. Appropriate valuation of managerial flexibility is important given the historical premiums paid in takeovers. While the fact that such premiums exist lends some credibility to the idea that at least implicitly managerial flexibility is valued, the real options approach allows for more explicit valuation of such flexibility.

Keywords: mergers and acquisitions, stock for stock exchanges, stock price variability, real options, swaps

JEL Classification: G13, G24, G34, M41, M43

Suggested Citation

Herath, Hemantha and Jahera, John S., Real Options: Valuing Flexibility in Strategic Mergers and Acquisitions as an Exchange Ratio Swap. Managerial Finance, Vol. 28, No. 12, 2002, Available at SSRN: https://ssrn.com/abstract=424004

Hemantha Herath (Contact Author)

Brock University - Faculty of Business ( email )

Department of Accounting and Finance
500 Glenridge Avenue
St. Catherines, Ontario L2S 3A1
Canada
905-688-5550 Ext. 3519 (Phone)
905-688-9779 (Fax)

John S. Jahera

Auburn University - Harbert College of Business ( email )

415 Magnolia Ave.
Auburn, AL 36849
United States
334-844-5344 (Phone)

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