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Contingent Claims Analysis

Contingent Claims Analysis. CCA A technique for determining the price of a security whose payoffs depend upon the prices of one or more securities. E.g., The value of a convertible bond in terms of the price of the underlying stock into which the bond can be converted.

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Contingent Claims Analysis

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  1. Contingent Claims Analysis • CCA • A technique for determining the price of a security whose payoffs depend upon the prices of one or more securities. E.g., • The value of a convertible bond in terms of the price of the underlying stock into which the bond can be converted. • The value of flexibility associated with a multipurpose production facility. • A number of tactical and strategic corporate financial decision problems • Corporate liabilities, in general, can be viewed as combinations of simple option contracts.

  2. If the debt receives coupon payments, equity can be thought of as analogous to a European call option on a dividend paying stock. The firm pays “dividends” to its creditors. If the coupon bond is callable under a schedule of prices K, the equity is analogous to an American call option on a dividend paying stock where the exercise price changes according to the schedule K. The value of the call provision can be characterized as the difference between the value of an American and European call option where the exercise price changes according to K. A evaluation technique to simultaneously price the individual components of the capital structure Rather than (inconsistent) diverse methodologies. Takes into account the interactive effects of the securities on the prices of all the others. The cost in terms of reduced flexibility caused by the terms and covenants of financial instruments can be explicitly evaluated.

  3. The trade-off between tax shields, financial distress, and the corporate need for additional funds under various contingencies can also be analyzed. The most important application of CCA will turn out to be in the strategy and planning activities surrounding the combined capital budgeting and financing decision problem. DCF causes a systematic undervaluation of projects because, among other reasons, the strategic value (flexibility) of projects is ignored (shortcoming of the particular evaluation, not DCF itself). Flexibility is nothing more (or less) than a description of the options made available to management as part of the project. Weighing the value of the operating options against its cost. Flexible manufacturing vs. single-product manufacturing Multiple-fuel vs. single-fuel power plants (cars).

  4. It may not be optimal to operate a plant in a given year because project revenue is not expected to cover variable cost. Explicitly recognition of this type of management flexibility is particularly important when choosing among alternative production technologies with different ratios of variable-to-fixed costs. Committed costs (idle capacity) vs. engineering costs (outsourcing).# Option to expand or contract the scale of the project. Excessive capacity; higher durability; higher maintenance costs (abandon) Option to temporarily shut down the project or to terminate it (退場機制: 高鐵). Important for large capital-intensive projects and projects involving new products where their acceptance in the market is uncertain. Option to choose when to initiate a project. Development of a property; introduction of a new product, exploration activities*

  5. Sequencing of investments in projects Resolve at least some of the uncertainty and determine the likelihood for subsequent development. Has the option to proceed or not.* Creation of options on one or more projects as the direct result of undertaking another project. Whenever management makes an investment that places the firm in a position to use new technology or to enter different industry.* Growth opportunities. Financial flexibility Value of financial options made available to the firm by its choice of capital structure (cyclical companies’ huge amount of cash buffer) The interactive effects between financial and operating flexibility can be quite strong for major long-term investment projects involving considerable uncertainty.

  6. Overvaluation of projects also possible The value of some projects may be overestimated by failure to recognize the losses in flexibility to the firm caused by their implementation. Definition: be flexible Keep tack of all options open and revive valuable closed options.

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