Chapter 8

Valuing Entry and Exit Options


8.1.1 Accounting for Flexibility

The timing of an acquisition or the starting of a new venture is not often predetermined. In many cases, the investor has the choice between deciding right away whether to invest, not to invest, or postpone the decision until more information is obtained and more favorable conditions are attained. Similarly, once the investment has been made, it is usually possible to exit it when conditions become sufficiently unfavorable. There are cases in which a firm may enter a new product market or region by making a relatively small investment in order to establish a foothold and acquire the option to expand in the future if and when appropriate conditions are attained. While these cases can be and are usually valued using the discounted cash flow (DCF) method presented in previous chapters, such valuations commonly ignore the value of the options involved. As usually applied, DCF valuation discounts expected free cash flows at a risk adjusted cost of capital and is therefore unable to capture the effect of altering the cash flows contingent on the occurrence of future events. In this chapter, we present a valuation approach, based upon option pricing techniques, that allows for the explicit valuation of waiting for entry, acquiring growth options, and exiting a business under unfavorable conditions.

Let us begin with a simple illustration of the approach and its difference from traditional ...

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