Disinvestment Decision
A simples disinvestment decision: Optimal timing
The logic and the tools of Real Options Valuation (ROV) apply as well to the decision to disinvest in an ongoing business. Again, standard valuation techniques suggest decision makers should disinvest whenever DCF (discounted cash flow) < 0. But, as in the investment decision, this is not followed in practice. We also show this in a simple analytical aplication of a disinvestment.
In a disinvestment decision, if the Liquidation Value (value of assets in case of liquidation of the firm) exists, the DCF rule becomes: DCF < Liquidation Value. In this case, we assume the Liquidation Value is zero. The conclusions that follow, however, could easily be adapted to accommodate the Liquidation Value.
The reason why the DCF rule is not applied in practice is that business conditions can revert. A business with a negative DCF can start generating positive cash flows. Let’s consider the case of a business which has now a negative DCF. In Figure 3, it is plotted 5 possible paths of cash flows from today onwards. Two paths are positive, one is average, and other two are bad. If the firm disinvests today, it loses the opportunity to check how the business evolves: it loses the Real Option to Wait for further information. Thus, what is the best choice? Disinvest today or wait?
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Figure 3
Time
Moment of decision
A simple disinvestment: Other Decisions that Matter
Other decisions also matter when disinvesting. For example, if by disinvesting the firm loses the option to make other profitable business endeavors, the firm loses a Real Option.
Consider two examples of such Real Options.
The firm is considering two businesses (A and B) with the same negative DCF and the same risk but that differ geographically: Business B is a recent business in a foreign country, while Business A is a business in the home country.
Business B allows the firm to test the demand in a foreign country, while Business A is a business in a geographical area well exploited by the firm. In other words, while Business A does not provide any Real Option to the firm, Business B provides the firm a Real Option to Expand in a foreign country. Is the firm indifferent between disinvesting in both businesses?
An experienced decision maker would consider the possibility that Business B can generate a huge return to the firm in case the firm obtains greater brand recognition in the foreign country. Thus, Business B seems more attractive, and thus, less likely a good candidate for disinvestment than Business A.
This, however, may not be the case if the firm considers that Business A is set in a more well known environment and thus more likely to reverse its condition. It may also not be the case if the DCF and/or the liquidation value of the projects differ. The best method to weigh the importance of all these factors and value drivers is Real Options Valuation.
Another Real Option that may matter when disinvesting is the Real Option to expand the scale of operations. Let’s consider two factories (A and B) that are used to produce the same widget. Factories A and B have the same costs and cost structure, have the same liquidation value, but Factory B has a maximum production capacity above Factory A. The overall demand is now scarce for the firm to keep both factories producing. So which factory should be closed?
In case business conditions improve, the firm has the Real Option to rescale operations without further expenses if it keeps Factory B. It does not have this option if it keeps Factory A. Thus, the higher flexibility of Factory B makes it a better alternative to keep open.
But what if Factory B has larger costs? Or what if the liquidation value of factory B is larger? In such a case, the decision depends on the probability that demand rises, on the difference between the liquidation values of the two factories, and on the financial requirements of the firm, as well as other factors. The goal of Real Options Valuation is to determine the relative
importance of these factors to determine the best decision.
The Real Options to wait for information, and the Real Options to Expand, and other Real Options are part of the strategic thinking of an experienced decision maker. Real Options Valuation creates value by accurately translate strategic thinking to numbers. The goal of Watson & Noble is to apply our knowledge of Real Options Valuation to help our clients
make better and more informed decisions.
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Figure 4
Time
Moment of decision
In this case, it seems reasonable to wait for further information. Yet, to make an accurate analysis of this decision it is required a Real Options Valuation. Real Options Valuation contrasts the losses to maintain the business open with possibility of value gains if the business reverses and start generating positive cash flows.
The golden rule of ROV in case of disinvestment is, then: a firm should only disinvest if the gain to avoid negative cash flows exceeds the value of the option to wait for further information; that is, the firm should only disinvest if the negative payoffs are large enough such that the probability of reversion is low.
Figure 4 considers another business that is also generating negative payoffs that are more negative than the ones of the business in Figure 3. In this case, the probability of reversion is smaller and the costs to keep the business open are higher. This is thus a better candidate for a good disinvestment. But to be sure the best option is to disinvest, it is required more advanced techniques that accurately weigh all the ups and downs of disinvestment. These tools are employed at Watson & Noble.
