12.6Summary and Conclusions

Agood portion of this chapter focused on using the real op-	Among the intuitive lessons to remember are
tions approach to value projects with strategic options.
	•Strategic options exist whenever management has
This approach requires making a number of simplifying
	any flexibility regarding the implementation of a
assumptions that may not be particularly realistic (for ex-
	project.
ample, the assumption that cash flows evolve along a bino-
	•Options to change the scale of a project, abandon
mial tree). As a result, one should consider the calculated
	it, or drastically change its implementation in the
values as rough estimates rather than as exact quantities.
	future need to be considered. The more different a
Nevertheless, though the pricing of strategic options is still
	firm is from its competitors, the more valuable the
an inexact science, the methods described in this chapter
	options (for example, the option to expand).
provide useful intuition about the kinds of projects that are
likely to be more valuable or to have large components of	•The existence of these options improves the value
value missed by the discounted cash flow method.	of an investment project. If management ignores

¹⁵For

example, the purchaser of the comparison office building across the street might have paid too

much for the property.

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454Part IIIValuing Real Assets

such options, the project will be undervalued.

Hence, a manager who computes a zero or slightly

negative NPVfor a project with the standard

discounted cash flow method can feel confident

about adopting the project. The cash flows arising

from strategic options that were missed due to

their indirect nature will push the NPVof the

project well into the positive range.

•The values of most options increase with the

maturity of the option. This suggests that strategic

options are generally more valuable for longer-

term projects. Standard discounted cash flow

methods, which tend to ignore such options, may

underestimate the value of long-term projects more

than they underestimate the value of short-term

projects. If decision makers ignore such options in

their valuation analysis, long-term projects will be

undervalued more than short-term projects.

•The greater the uncertainty about the future value

of the underlying investment, the greater the

option’s value. This suggests that strategic options

are more valuable the higher the risk of the project,

indicating that it is probably beneficial to build

more flexibility into projects with more uncertain

future cash flows. Traditional discounted cash flow

methods that ignore strategic options are likely to

undervalue high-risk projects more than low-risk

projects, so it is important for decision makers to

be careful before rejecting high-risk projects.In addition to the real options approach, this chapter stud-ied two other methods for analyzing capital allocation: theratio comparison approach and the competitive analysisapproach.

All three valuation methods, like nearly every valuationmethod for valuing financial assets or real assets studied inthis text, are based on comparisons between assets. Each

asset is tracked, sometimes approximately, by a portfolioof other assets. Financial valuation is simply a way of con-necting the value of an asset that has a known price to theasset being valued.

What if the manager believes that the market is incor-rect? For example, if managers think that the comparableoffice building is undervalued or the underlying copperprice is too low, should they use their superior informationand accept investment projects that the market incorrectlyundervalues but which are overvalued relative to theirtracking portfolios? Generally, the answer to this questionis no. If the cost of a prospective investment exceeds thecost of its tracking portfolio, it is clearly better to buy thetracking portfolio rather than take the investment. Thisistrue regardless of the market’s assessment—correct orincorrect—of the value of the tracking portfolio.

In sum, the advantages of this chapter’s valuation meth-ods over the standard discounted cash flow method largelyhave to do with deficiencies in the way the standard dis-counted cash flow method is implemented. Two generalrules often ignored by practitioners who use the standarddiscounted cash flow method should be emphasized.

•Because decision makers are ultimately trying to

evaluate the market value of a project, financial

managers should use observable market prices as

much as possible. Don’t rely on estimated market

values when actual market prices can be observed.

•Managers should think in terms of investment

strategies instead of isolated individual investment

projects. Most projects are flexible in their

implementation and often provide the firm with

additional profitable investment opportunities in

the future. Consider these options, which add value

to an investment strategy, when evaluating

investment projects.

Key Concepts

Result 12.1:New opportunities for a firm often arise asboth the volatility of the mineral price and

a result of information and relationshipsthe volatility of the extraction cost.

developed in its past investment projects.Result 12.3:Vacant land can be viewed as an option to

Therefore, firms should evaluatepurchase developed land where the

investment projects on the basis of theirexercise price is the cost of developing a

potential to generate valuable informationbuilding on the land. Like stock options,

and to develop important relationships asthis more complicated type of option has a

well as on the basis of the direct cashvalue that is increasing in the degree of

flows they generate.uncertainty about the value (and type) ofResult 12.2:Amine can be viewed as an option todevelopment.

extract (or purchase) minerals at a strikeResult 12.4:Most projects can be viewed as a set of

price equal to the cost of extraction. Likemutually exclusive projects. For example,

a stock option, the option to extract thetaking the project today is one project,

minerals has a value that increases withwaiting to take the project next year is

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Chapter 12

Allocating Capital and Corporate Strategy

455

	another project, and waiting three years is	where
	yet another project. Firms may pass up thefirst project, that is, forego the capital investment immediately, even if doing sohas a positive net present value. They willdo so if the mutually exclusive alternative,waiting to invest, has a higher NPV.	P price/earnings ratio of the NI portfolio P i price/earnings ratio of NI istocki(i 1 or 2)
Result 12.5:Result 12.6:	(The Price/Earnings Ratio Method.)The present value of the future cash flows of aproject can be found by (1) obtaining theappropriate price/earnings ratio for the project from a comparison investmentforwhich this ratio is known and (2)multiplying the price/earnings ratio from the comparison investment by thefirst year’s net income of the project. In asimilar vein, a company should adopt a project when the ratio of its initial cost toearnings is lower than the price to earnings ratio of the comparison investment. (Alternative ratio comparisonmethods simply substitute a different economic variable for earnings.) The price/earnings ratio of a portfolio of stocks 1 and 2 is a weighted average ofthe price/earnings ratios of stocks 1 and 2,where the weights are the fraction of earnings generated, respectively, by stocks1 and 2. Algebraically	w fraction of portfolio i earningsfrom stock i Result 12.7:Assume the market value of the firm’s assets is unaffected by its leverage ratio. Also assume that all debt is risk free. Then, if the ratio of price to earnings of an all-equity firm is larger than 1/r D, where ris the interest rate on the firm’s D (assumed) risk-free perpetual debt, then an increase in leverage increases the price/earnings ratio. If the price/earnings ratio of an all-equity firm is less than 1/r,then the increase in leverage lowers D the price/earnings ratio of the firm. Result 12.8:(The Competitive Analysis Approach.) Firms in a competitive market should realize that they can only realize a positive NPVfrom a project if they have some advantage over their competitors. When other firms have a competitive advantage the project has a negative NPV.

PPP

12

w w

NI¹NI²NI

12

Key Terms

barriers to entry424	ratio comparison approach423
competitive analysis approach423	real options approach423
economies of scale424	real estate investment trusts (REITs)444
economies of scope425	strategic options423
exchange option431	unleveraged price/earnings ratio450
price/earnings ratio method444	unlevered earnings449

Exercises

12.1.Maytag merges with Whirlpool. Assume that12.2.The XYZ firm can invest in a new DRAM chip

Maytag’s price/earnings ratio is 20 andfactory for $425 million. The factory, which must

Whirlpool’s is 15. If Maytag accounts for 60be invested in today, has cash flows two years

percent of the earnings of the merged firm, and iffrom now that depend on the state of the economy.

there are no synergies between the two mergedThe cash flows when the factory is running at full

firms, what is the price/earnings ratio of thecapacity are described by the following tree

merged firm?diagram:

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456Part IIIValuing Real Assets

The cost of constructing the single-family homes

is $100 per square foot and the cost of

Year 0 Year 1 Year 2 constructing the condominium is $120 per square

foot. If the real estate market does well next year,

Very good

the homes can be sold for $300 per square foot

$1 billion

and the condominiums for $230 per square foot. If

Good

the market performs poorly, the homes can be sold

Medium

for $200 per square foot and the condos for $140

$200 million

per square foot. Today, comparable homes could

Bad

Very badbe sold for $225 per square foot and comparable

–$500 millioncondos for $180 per square foot. First-year rental

rates (paid at the end of the year) on the

comparable condos and homes are 20 percent and

10 percent, respectively, of today’s sales prices.

a.What is the implied risk-free rate, assuming

that short selling is allowed?

b.What is the value of the vacant land, assuming

In year 1, the firm has the option of running thethat building construction will take place

plant at less than full capacity. In this case,immediately or one year from now? What is the

workers are laid off, production of memory chipsbest building alternative?

is scaled down, and the subsequent cash flows are12.4.Asilver mine has reserves of 25,000 troy ounces

half of what they would be when the plant isof silver. For simplicity, assume the following

running at full capacity.schedule for extraction, ore purification, and sale

An alternative use for the firm’s funds isof thesilverore:

investment in the market portfolio. In the states that

correspond to the branches of the tree above, $1

invested in the market portfolio grows as follows:Extraction and Troy

Sale Date Ounces

Today

10,000

	Year 0 Year 1 Year 2	One year from now10,000
	Very good $1.20 $1.10 $1.00Medium $1.05 $.95 Very bad $.90	Two years from now5,000 Also assume the following: •The mine, which will exhaust its supply of silver ore in two years, is assumed to have no salvage value. •There is no option to shut down the mine prematurely.
		•The current price of silver is $4 per troy ounce.
		•Today’s forward price for silver settled one year from now is $4.20 per troy ounce.
12.3.	Assume that the risk-free rate is 5 percent peryear, compounded annually. Compute the project’spresent value (a) with the option to scale downand (b) without the option to scale down. Computethe difference between these two values, which isthe value of the option. Vacant land has been zoned for either one 10,000-square-foot five-unit condominium or two single-family homes, each with 3,000 square feet.	•Today’s forward price for silver settled two years from now is $4.50 per troy ounce. •The cost of extraction, ore purification, and selling is $2 per troy ounce now and at any point over the next two years. •The risk-free return is 5 percent per year. What is the value of the silver mine? 12.5.Widget production and sales take place over a one- year cycle. For simplicity, assume that all costs

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Chapter 12

Allocating Capital and Corporate Strategy

457

(revenues) are paid (received) at the end of the12.7.Compute the risk-neutral probabilities attached to

one-year cycle.the two states—high demand and low demand—in

Afactory with a life of three years (from today)Example 12.2. Show that applying these probabilities

has a capacity to produce 1 million widgets eachto value the mine provides the same answer for

year (which are to be sold at the end of each yearvaluing the outcomes in scenarios 1 and 2 as given

of production). Widgets produced within the lastin Example 12.2.

year have just been sold.12.8.Although there is no empirical evidence to strongly

Each year, production costs can either rise orsupport this hypothesis, some financial journalists

decline by 50 percent from the previous year’shave claimed that American managers are

cost. Over the coming year, widgets will beshortsighted and overly risk averse, preferring to

produced at a cost of $2 per widget. Unliketake on relatively safe projects that pay off quickly

production costs, which vary from year to year, theinstead of taking on longer-term projects with less

revenue from selling widgets is stable. Assumecertain payoffs. Assume the journalists are correct.

that in the coming year and in all future years thea.Explain why managers who use a single discount

widget selling price is $4 per widget.rate for valuing projects are likely to have a

The performance of a portfolio of stocks in thesystematic bias against longer-term projects if the

widget industry depends entirely on expectedsystematic risk of the cash flows of many long-

future production costs. When widget productionterm investment projects declines over time.

costs increase by 50 percent from date tto dateb.Discuss how the presence of strategic

t1, the return on the industry portfolio over theinvestment options affects the decisions to

same interval of time is assumed to be 30adopt long-term over short-term investments.

percent. If the production costs decline by 50

12.9.Example 12.9 illustrates how an increase in

percent, the industry portfolio return is assumed to

leverage can affect Micro Technologies’

be 40 percent over that time period.

price/earnings ratio. If the interest rate on the new

Assume that the factory producing the widgets

debt was 2 percent rather than 6 percent, would

is to be closed down and sold for its salvage value

the firm’s price/earnings ratio increase or

whenever the cost of extraction per widget

decrease?

exceeds the selling price of a widget. This closure

12.10.Porter and Spence (1982) pointed out that firms

occurs at the beginning of the production year.

may want to overinvest in production capacity to

Value the factory, assuming that its salvage

show a commitment to maintain their market share

value is zero and that the risk-free return is 12

to competitors. In their model, excess plant

percent per year.

capacity would not be a positive net present value12.6.Assume that the futures closing prices on the New

project if the cash flow calculations take the

York Mercantile Exchange at the end of August

competitors’actions as given. However, since

2002 specify that futures prices per barrel for light

competitors are less likely to enter a market when

sweet crude oil delivered monthly from mid-

the incumbent firm has excess capacity, the added

October 2002 through mid-December 2004 are,

capacity may be worthwhile even if it is never

respectively, $21.56, $21.08, $20.63, $20.23,

used. Comment on whether this strategic

$19.88, $19.55, $19.26, $19.00, $18.76, $18.58,

consideration should be taken into account when

$18.41, $18.25, $18.09, $17.93, $17.83, $17.77,

analyzing an investment project.

$17.71, $17.66, $17.61, $17.56, $17.52, $17.48,

12.11.Solve the unlevered price/earnings ratio, A/X,by

$17.46, $17.46, $17.46, $17.47, and $17.48.

rearranging equation (12.1).

Compute the August 27, 2002, value of an oil well

12.12.In Example 12.11, assuming that the stock per

that produces 1000 barrels of light sweet crude oil

share and the firm’s operations do not change as a

per month for the months October 2002 through

consequence of the leveraged recapitalization

December 2004, after which the well will be dry.

a.Identify the dividend yield both before and

Assume that there are no options to increase or

after the leveraged recapitalization.

decrease production and that the cost of producing

b.Identify rafter the leveraged recapitalization.

each barrel of oil and shipping it to market isE

c.Identify gafter the leveraged recapitalization.

$2.00 per barrel. Also assume that the risk-free

return is 5 percent per year, compounded annually.

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458Part IIIValuing Real Assets

References and Additional Readings

Aguilar, Francis, and Dong-Seong Cho. “Gold Star Co.

Ltd.” Case 9-385-264. Harvard Business School, 1985.Amram, Martha, and Nalin Kulatilaka. Real Options:

Managing Strategic Investment in an Uncertain World.

Cambridge: Harvard Business School Press, 1998.

Brennan, Michael, and Eduardo Schwartz. “Evaluating

Natural Resource Investments.” Journal of Business

58 (April 1985), pp. 135–57.

———. “ANew Approach to Evaluating Natural

Resource Investments.” Midland Corporate Finance

Journal3 (Spring 1985). (Aless technical version of

the previous entry.)

——— and Lenos Trigeorgis (eds.). Project Flexibility,

Agency, and Product Market Competition: New

Developments in the Theory and Application of Real

Options Analysis.Oxford: Oxford University Press,

1999.

Copeland, Tom, and Vladimir Antikarov. Real Options: A

Practitioner’s Guide. Boston: Texere Monitor

Group, 2001.

Dixit, Avinash, and Robert Pindyck. Investment under

Uncertainty.Princeton, NJ: Princeton University

Press, 1994.

Ekern, S. “An Option Pricing Approach to Evaluating

Petroleum Projects.” Energy Economics10 (1985),

pp. 91–99.

Fine, Charles H., and Robert M. Freund. “Optimal

Investment in Product-Flexible Manufacturing

Capacity.” Management Science36 (April 1990),

pp.449–66.

Hayes, Robert, and William Abernathy. “Managing Our

Way to Economic Decline.” Harvard Business

Review58 (July–Aug. 1980), pp. 67–77.

Ingersoll, Jonathan E., and Stephen A. Ross. “Waiting to

Invest: Investment and Uncertainty.” Journal of

Business65 (Jan. 1992), pp. 1–29.

Jacoby, Henry D., and David G. Laughton. “Project

Evaluation: APractical Asset Pricing Method.”

Energy Journal13 (1992), pp. 19–47.

Kogut, Bruce, and Nalin Kulatilaka. “Operating

Flexibility, Global Manufacturing, and the Option

Value of a Multinational Network.” Management

Science40, no. 1. (1993), pp. 123–39.

Kulatilaka, Nalin, and Alan J. Marcus. “General

Formulation of Corporate Real Options.” Research in

Finance7 (1988), pp. 183–99.

Lerner, Eugene, and Alfred Rappaport. “Limit DCF in

Capital Budgeting.” Harvard Business Review46

(Sept.–Oct. 1968), pp. 133–39.

Lohrenz, Joh, and R. N. Dickens. “Option Theory for

Evaluation of Oil and Gas Assets: The Upsides and

Downsides.” Proceedings of the Society of Petroleum

Engineers,1993, pp. 179–88.

Majd, Saman, and Robert S. Pindyck. “Time to Build,

Option Value, and Investment Decisions.” Journal of

Financial Economics18 (Mar. 1987), pp. 7–27.

Margrabe, William. “The Value of an Option to Exchange

One Asset for Another.” Journal of Finance33, no. 1

(1978), pp. 177–86.

McDonald, Robert, and Daniel Siegel. “Investment and

the Valuation of Firms When There Is an Option to

Shut Down.” International Economic Review26,

no.2 (1985), pp. 331–49.

———. “The Value of Waiting to Invest.” Quarterly

Journal of Economics101, no. 4 (1986), pp. 707–27.Milgrom, Paul, and John Roberts. Economics,

Organization and Management.Englewood Cliffs,

NJ: Prentice-Hall, 1992.

Myers, Stewart C. “Determinants of Corporate

Borrowing.” Journal of Financial Economics5 (Nov.

1977), pp. 147–75.

———. “Finance Theory and Financial Strategy.”

Interfaces14 (Jan.–Feb. 1984), pp. 126–37.

Paddock, James L.; Daniel R. Siegel; and James L. Smith.

“Option Valuation of Claims on Real Assets: The

Case of Offshore Petroleum Leases.” Quarterly

Journal of Economics103 (Aug. 1988), pp.479–508.Pakes, Ariel. “Patents as Options: Some Estimates of the

Value of Holding European Patent Stocks.”

Econometrica54 (July 1986), pp. 755–84.

Porter, Michael, and Michael Spence. “The Capacity

Expansion Process in a Growing Oligopoly: The

Case of Corn Wet Milling.” In John McCall, ed., The

Economics of Information and Uncertainty.Chicago:

University of Chicago Press, 1982.

Quigg, Laura. “Empirical Testing of Real Option-Pricing

Models.” Journal of Finance48 (June 1993),

pp.621–39.

Rappaport, Alfred. “Forging a Common Framework.”

Harvard Business Review70 (May–June, 1992),

pp.84–91.

Schwartz, Eduardo, and Mark Moon. “Rational Pricing of

Internet Companies.” Financial Analysts Journal56,

no. 3 (May/June 2000), pp. 62–75.

Schwartz, Eduardo, and Lenos Trigeorgis (eds.). Real

Options and Investment Under Uncertainty.

Cambridge: MITPress, 2001.

Shapiro, Alan. “Corporate Strategy and the Capital

Budgeting Decision.” Midland Corporate Finance

Journal3, no. 1 (Spring 1985), pp. 22–36.

Stibolt, R. D., and John Lehman. “The Value of a Seismic

Option.” Proceedings of the Society of Petroleum

Engineers,1993, pp. 25–32.

Grinblatt932Titman: Financial	III. Valuing Real Assets	12. Allocating Capital and	© The McGraw932Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 12

Allocating Capital and Corporate Strategy

459

Titman, Sheridan, “Urban Land Prices under Uncertainty.”Trigeorgis, Lenos. Real Options.Cambridge,

American Economic Review75, no. 3 (June 1985),Massachusetts: MITPress, 1996.

pp. 505–14.

Triantis, Alexander J., and James E. Hodder. “Valuing

Flexibility as a Complex Option.” Journal of

Finance45 (June 1990), pp. 549–65.

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Strategy, Second Edition		Real Asset Valuation

CHAPTER	Corporate Taxes and the
13	Impact of Financing on Real Asset Valuation

Learning Objectives

After reading this chapter, you should be able to:

1.Understand the effect of leverage on the cost of equity and the beta of the firm

when there is a corporate tax deduction for interest payments.

2.Apply the adjusted present value method (APV) to value real assets.

3.Understand the weighted average cost of capital (WACC) and the effect of leverage

on the WACC when there is a corporate tax deduction for interest payments.

4.Understand how debt affects the payoffs of projects to equity holders.

In 1995, Los Angeles, the second largest metropolitan area in the United States and

a major world media market, found itself without a professional football team. The

Raiders of the American Football Conference and the Rams of the National Football

Conference departed after the 1994 season for the seemingly less attractive markets

of Oakland and St. Louis, respectively. Not only were the markets and media

exposure in these cities inferior to those of Los Angeles, but there was the

complication for the Raiders of competing against the successful and popular San

Francisco 49ers, the dominant football franchise since the mid-1980s. Since pure

economics, based on market size and media exposure, makes these decisions

seemingly irrational, some other inducements were responsible for these moves.

Up to this point in the text, we have assumed that firms can create value only on

the asset (left-hand) side of their balance sheets. In reality, however, firms also cre-

ate value on the liability (right-hand) side because the design of the financing of invest-

ment projects can create value for the firm. The best example of this is that debt inter-

est payments are tax deductible, implying that debt financing is somewhat cheaper than

equity financing if additional debt does not add substantial financial distress costs.

Another example would be subsidized loans, such as those received by the Raiders and

Rams to entice them to move. This chapter takes as given the mix of debt and equity

financing for a project and asks how to value investments, taking into account the way

in which they are financed.¹

¹Part IVaddresses the implications of this observation on the optimal financial structure of a firm.460

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Chapter 13

Corporate Taxes and the Impact of Financing on Real Asset Valuation

461

Two valuation methods, both extensions of the methods discussed in Chapter 11,

can be used to account for the additional cash flows that arise from the project’s debt

financing. The first method, the adjusted present value (APV) method, introduced in

Myers (1974), calculates present values that account for the debt interest tax shield and

other loan subsidies by:

1.Forecasting a project’s unlevered cash flows.

2.Valuing the cash flows in step 1, assuming that the project is financed entirely

with equity. Any method of computing present values (PVs) discussed in the

last three chapters can be used for this step.

3.Adding to the value obtained in step 2 the value generated as a result of the

tax shield and other subsidies from the project’s debt financing.

The second method, known as the weighted average cost of capital (WACC)

method, is an adaptation of the risk-adjusted discount rate method, designed to account

for the cost of debt and equity financing from the firm’s perspective. It generates pres-

ent values by:

1.Estimating a project’s expected unlevered cash flows.

2.Valuing the expected cash flows in step 1 by discounting them at a single

risk-adjusted discount rate that varies with the degree of debt financing that

can be attributed to the project.

The WACC approach thus combines steps 2 and 3 of the APVmethod into one step

by adjusting the discount rate.

The result below summarizes these points formally.

Result	13.1	Analysts use two popular methods to evaluate capital investment projects: the APVmethod
		and the WACC method. Both methods use as their starting points the unlevered cash flows
		generated by the project, assuming that the project is financed entirely by equity. The APV
		method calculates the net present value (NPV) of the all-equity-financed project and adds
		the value of the tax (and any other) benefits of debt. The WACC method accounts for any
		benefits of debt by adjusting the discount rate.

Although corporations use the WACC method more than the APVmethod, most

academics believe the APVmethod is the better approach for evaluating most capital

investments and that the APVapproach will grow in popularity over time. The advan-

tage of the APVmethod is that it calculates separately the value created by the proj-

ect and the value created by the financing. For this reason, it is often referred to as val-

uation by components. It also fits in nicely with the alternative approaches discussed

in Chapter 12, such as the real options approach and the ratio comparison approach.

Moreover, the APVmethod is much easier to use when debt levels or tax rates change

over time.

The WACC method may be conceptually easier to understand because it discounts

only one set of cash flows, while the APVmethod discounts separately the cash flows

of the project and the cash flows of the tax savings or other debt subsidies. In addi-

tion, the WACC method is used more widely, so that analysts presenting a WACC-

based valuation will be able to communicate their analysis to others more easily. It is

important to understand both approaches—the APVmethod because it is a superior,

more flexible approach, and the WACC method because it is more widely used and

understood.

The location decisions of the Raiders and Rams, discussed in the chapter’s open-

ing vignette, were driven by huge enticements, including packages of subsidized loans,

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462Part IIIValuing Real Assets

rents, and free stadium renovations offered by Oakland and St. Louis. The renovations

included expensive corporate skyboxes, from which 100 percent of the revenue would

go to the team. In the case of the Raiders, $85 million in improvements were targeted

for the Oakland Coliseum, which was to add 175 luxury suites and locker rooms.²In

deciding to relocate, the owners of these teams must have weighed these additional

transfers of wealth against the traditional considerations of population size and media

coverage, which favored the Los Angeles location.

Afinancial analyst needs to value the subsidies offered by St. Louis and Oakland

and determine whether the present value of the subsidies exceeds the net additional value

of a Los Angeles location in the absence of these subsidies. While we are unfamiliar

with the methods used by the owners of the Rams and Raiders to weigh these factors,

the APVmethod provides the best way to account for these subsidies. The APVmethod

accounts for all subsidies by discounting their cash flows at the discount rate that is

appropriate for the risk of the cash flows, irrespective of where they come from.For

example, the APVmethod would treat the cash flows from the subsidized rents in a sim-

ilar manner to the incremental cash flows that are generated by subsidized loans. By

contrast, the WACC method draws a distinction between subsidies that are related to the

project’s financing and those that are not related to financing. Thus, with the WACC

method, the loan subsidies offered to the football teams would affect the discount rate

applied to the remaining cash flows, but would not affect the size of what is discounted.

To simplify the analysis, this chapter ignores personal taxes.³It is also important

to emphasize that this chapter considers as given the amount of new debt financing the

firm will add when taking the project, which we call the project’s debt capacity.⁴