Distortions in Capital Asset Acquisition and Financing under Cost-Based Reimbursement

The paper examines distortions in the acquisition and financing of capital assets under a cost-based reimbursement system within an adjusted present value (APV) framework. For a not-for-profit (NFP) vendor the acquisition, when internally financed, is typically a negative-NPV investment. But when financed through debt with reimbursed interest payments, the combined decision becomes worthwhile (positive APV). This can explain why NFP firms resort to substantial debt financing even though internal funds may be available and any tax benefits are absent. Policy implications and suggestions for improving unintended inequities in the system are also discussed.     

Managerial discretion in distressed firms

This study examines the earnings management behaviour of 455 distressed US firms that filed for bankruptcy during the period 1986–2001. We examine (a) possible earnings management during the years prior to bankruptcy-filing, (b) whether qualified audit opinions cause conservative earnings management behaviour, (c) whether earnings management differs between firms that discontinued operations and firms that survived thereafter, and (d) the effect of earnings management on subsequent stock returns. Our results are consistent with downwards earnings management 1 year prior to the bankruptcy-filing. Results also show that (a) firms receiving unqualified audit opinions 4 or 5 years prior to the bankruptcy-filing event manage earnings upwards in subsequent years, consistent with Rosner [2003. Earnings manipulation in failing firms. Contemporary Accounting Research 20, 361–408], (b) more conservative earnings management seems to be related to the qualified audit opinions rendered in the preceding year, (c) firms with long-term negative accruals the year of bankruptcy-filing have a greater chance to survive thereafter, and (d) more pronounced (negative) earnings management is associated with more negative (next year's) subsequent returns.     

Assessing the Value of Growth Option Synergies from Business Combinations and Testing for Goodwill Impairment: A Real Options Perspective

Goodwill is an intangible asset, and therefore hard to measure and difficult to account for. This article argues that the two‐stage impairment test for acquired goodwill under SFAS 142 has several limitations. Most important, it measures aggregate rather than acquired goodwill, making it very difficult to separate acquisition‐related goodwill from aggregate enterprise goodwill after a business combination. As a consequence, any potential deterioration of acquired goodwill value could be concealed by increases in internally generated goodwill. As an alternative, the authors propose a real options approach to managing a business unit portfolio as a better framework for conducting the goodwill impairment test. A real options approach to testing goodwill for impairment—as opposed to the standard fair value assessment based on DCF analysis—not only accounts for deterioration in the value of goodwill, but also captures upward potential. It enables tracking of the changes in goodwill value from one period to the next, providing a less biased estimate of its real value at each point in time.     

Strategic planning: valuing and managing portfolios of real options

This article presents a value-based strategic planning framework suitable for valuing and managing portfolios of corporate real options. The proposed framework combines insights from strategic management theory with novel quantitative valuation tools from finance. Strategic planning is viewed as a process of actively developing and managing portfolios of corporate real options in the context of competitive interactions. As such, the expanded valuation framework recognizes that future growth opportunity value deriving from the firm's resources and capabilities must explicitly account for uncertainty, adaptability, and competitive responsiveness. The resulting expanded valuation framework is able to capture the value of the adaptive resources and capabilities that enable a firm to adapt and re-deploy assets, develop and exploit synergies, and gain competitive advantage via time-to-market and first- or second-mover advantages. We show how two basic metrics in this value-based framework, current profitability of assets in place and future growth option value, can be obtained from financial market data and how they can be used in active portfolio planning.     

Valuing a high-tech growth company: the case of EchoStar Communications Corporation

This article uses real options to value a high-tech company with significant growth option potential. The case of EchoStar Communications Corporation is used as an illustration. The company's growth opportunities are modeled and valued as a portfolio of growth options, namely options to expand its pay television, equipment, and internet services. Expansion of the main business can occur geographically (in the USA, internationally, and through partnerships) or through cross-selling of new products and services to its customer base. The internet business can expand via switching to digital subscriber line and through partnerships. The underlying asset (business) for the expansion options is the ‘base’ discounted cash flow (DCF), after removing the constant growth rate in the terminal-value DCF assumption. The options-based estimate of present value of growth opportunities (PVGO) value substitutes for the terminal growth DCF estimate. We show that our options-based portfolio PVGO provides a better estimate of the firm's growth prospects than the terminal growth DCF assumption.     

Short-term Dynamics in the Cyprus Stock Exchange

Abstract

This paper investigates the short-term dynamics of stock returns in an emerging stock market namely, the Cyprus Stock Exchange (CYSE). Stock returns are modelled as conditionally heteroscedastic processes with time-dependent serial correlation. The conditional variance follows an EGARCH process, while for the conditional mean three nonlinear specifications are tested, namely: (a) the LeBaron exponential autoregressive model; (b) the Sentana and Wadhwani positive feedback trading model; and finally (c) a model that nests both (a) and (b). There is an inverse relationship between volatility and autocorrelation consistent with the findings from several other stock markets, including the US. This pattern could be the manifestation of a certain form of noise trading namely positive feedback trading or, momentum trading strategies. There is little evidence that market declines are followed with higher volatility than market advances, the so-called ‘leverage effect’, that has been observed in almost all developed stock markets. In out of sample forecasts, the nonlinear specifications provide better results in terms of forecasting both first and second moments of the distribution of returns.     

Earnings Behaviour of Financially Distressed Firms: The Role of Institutional Ownership

Using a sample of 859 U.S. bankruptcy-filing firms over the period 1986–2004, we examine the earnings behaviour of managers during the distressed period by looking at sources of abnormal accruals prior to the bankruptcy-filing year. Results show that managers of highly distressed firms shift earnings downwards prior to the bankruptcy filing. We test and provide evidence in support of two potential contributing factors. First, top-level management turnover among distressed firms leads new managers to earnings bath choices during the distressed period. Second, qualified audit opinions exert pressure on managers to follow more conservative earnings behaviour during the distressed period. Evidence is also provided that the management of distressed firms with lower (higher) institutional ownership has greater (lesser) tendency to manage earnings downwards. Results also show that higher institutional ownership mitigates the negative abnormal returns of firms with top management turnover. To the authors' knowledge, this is the first study that attempts to examine whether institutional ownership relates to market reaction in conjunction with a top management turnover or a qualified audit opinion during the distressed period. Prior studies focused on the investigation of earnings management or institutional ownership (separately) during the distressed period, but did not examine if the effect of institutional ownership on earnings behaviour also influences subsequent returns. Thus, the results of this study should be of interest to analysts, standard setters and regulatory bodies since our results show that management turnover, qualified audit opinions and firm governance mechanisms affect the quality of earnings and the level of abnormal returns.     

Alternative bankruptcy prediction models using option-pricing theory

We examine the empirical properties of the theoretical Black–Scholes–Merton (BSM) bankruptcy model. We evaluate the predictive ability of various existing modifications of the BSM model and extend prior studies by estimating volatility directly from market-observable returns on firm value. We show that parsimonious models using our direct market-observable volatility estimate perform better than alternative, more sophisticated, models. Our findings suggest the adoption of simpler modelling approaches relying on market data when implementing the BSM model.     

MAKING USE OF REAL OPTIONS SIMPLE: AN OVERVIEW AND APPLICATIONS IN FLEXIBLE/MODULAR DECISION MAKING

This article focuses on how the use of real options can be made simple, providing an overview of the power of flexible and modular decision making and its use in various applications across industries. After common real options are discussed through a comprehensive example, the article reviews the key lessons and implications of real options thinking for flexible decision making. It then proceeds to propose a modular problem structuring approach that allows simplifying of complex real option problems by decomposing them into a few basic building-block option types (reviewed) connected by some basic decision operators. The resulting problem-structuring option map is depicted in a range of illustrative applications in various industries. Past areas of application of real options as well as research challenges ahead are also discussed.