Forum Archive Index - November 1999

["Brent Wheeler" <brentw@bwcl.co.nz>]

Further to our discussion of valuation, recent literature has pointed out
that DCF/dividend discount models etc from orthodox theory has problems
accounting for various factors.  For example the "hurdle rate" used by many
companies is well above the cost of capital to the company.  It also seems
the market quite regularly applies a greater discount rate than would be
suggested by models such as the CAPM (Capital Asset Pricing Model).  Why is
this?

Two professionals, Dixit and Pindick, have a very plausible explanation
which I believe, having looked at the evidence, to be important.  They point
out that "not investing" is often a useful strategy since new information
may come to light further down the track. E Commerce would be a classic
example - or the Beta format with videos.  Where large sunk costs are
involved (e.g. infrastructure investments) waiting may also be a valuable
strategy.

Where does all this take us.  Well, the effect is to create a call option,
ie a call on a better decision in the future.  That call option has a
premium/discount accordingly due to its value.  Net effect is we should
discount new (additional if you like) investments at a higher rate - which
is what companies do when they set a higher hurdle rate for investment than
their cost of capital.

Cutting to numbers - we have a formula to calculate how much to increase the
cost of capital by to get to the "option adjusted discount rate" which I am
happy to share along with our writings on this subject.  E mail me at
bwheeler@xtra.co.nz if interested.

In the meantime an example is a recent company we valued had an estimated
WACC of 14% but once this was adjusted to account for "call option" value
the rate rose to some 18% - so the difference can be significant.

Forgive the slightly rambling and academic nature of this morning's lecture
but there you are.


Dr Brent Wheeler
Director
Brent Wheeler & Co. Limited
AUCKLAND


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