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Real options: valuing flexibility in strategic mergers and acquisitions as an exchange ratio swap

Hemantha S.B. Herath (Assistant Professor, Business Program, University of Northern British Columbia, 3333 University Way, Prince George, British Columbia, Canada V2N 4Z9)
John S. Jahera Jr (Colonial Bank Distinguished Professor & Interim Dean, College of Business, Auburn University, 303 Lowder Business Building, Auburn, Alabama – 36849‐5247, USA)

Managerial Finance

ISSN: 0307-4358

Article publication date: 1 December 2002



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 optimize 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.



Herath, H.S.B. and Jahera, J.S. (2002), "Real options: valuing flexibility in strategic mergers and acquisitions as an exchange ratio swap", Managerial Finance, Vol. 28 No. 12, pp. 44-62.




Copyright © 2002, MCB UP Limited

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