License Contracts with Embedded Options to Expand and Withdraw: Disc Flex Filter in Japan case 12th

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License Contracts with Embedded Options to Expand
and Withdraw µ Disc Flex Filter in Japan case
12th Managerial conference in 12th Annual
conference on real optionsJuly 10th, 2008 in Rio
de Janeiro
Haruyoshi Ito Keio University Kenji Yamada Coteau
Vert Co. Ltd., Akane Iwasaki Waseda University
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Contents

• Introduction
• License contract case
• Valuation method of the license contract
• The results
• Summary
• Appendix

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1. introductionmotivation for study

• Using simulation method for Real Option Valuation
• Application of ROP to practice
• Notice point when taking into account options to
  both expand and withdraw
• Clarifying the dependency between decision
  criteria and the value of the license contract
• Clarifying the dependency between the operations
  and the option value
• Rational license valuation

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2.1. The license contract

• License to sell and produce µ DISC flex filter
  (CV and NGMS)
• Contract timeJanuary first, 1997
• Duration of the contract32 years(permitted to
  renew contract annually)
• Exchange rate at the contract116 yen/
• Initial license fee34,800 (thousand yen)
• License fee
• fixed
• 1997-1999150 thousand (17,400 thousand yen)
• 2000-2028200 thousand (23,200 thousand yen)
• variable(every year)2 of the sales
• ?
• At first, CV could not break the contract for 32
  years, however, after negotiation, CV was allowed
  to renew contract annually?withdraw option value

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2.2. CVs business planand its sales
Expanding to oversea Time Control biz
Commercialization of ACES biz
Entrance to ACES biz
Entrance to IT security biz
Getting license from NGMS
Enterprising of noise business
Second step
First step
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3. Important notice of license contract valuation

• Clarifying the uncertainty in license business
• Possibility of that the commercialization is not
  successful
• Possibility of few demand for products or service
• Possibility of that the business will not be
  successful in Japan though the business is
  successful in the U.S.. (eg. MA of Seiyu by
  Wal-Mart)
• The probability of the loss after decision making
  (exercise)
• Sales might reduce after decision making
• Unlike financial option, we cannot determine the
  payoff at the point of exercise

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3. Valuation method of the license

• The license value Calculation
• NPV is enterprise value?sub 0 is at the time 0
• I is initial investment, here, 34,800 thousand
  yen of initial
• license fee
• FCFt is Free Cash flow at time t, r is cost of
  capital
• Cost of Capital is calculated by using NGMSs
  monthly stock price from January, 1992 to
  December 1996.
• NGMS has 50 of CVs shares.
• Risk free rate is 6.148 (10 year the U.S.
  national bond as of January 1997)
• CoC is 14.641 by CAPM.
• The value of license contract in deterministic
  case is 157 million yen.

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3.2. Introduction of uncertaintydistribution and
correlation

• Detailed assumption is described in appendix
• Sales and growth rate of sales
• Assuming correlation between the growth rate of
  sales at time t and that of time t1
• Assuming correlation between current business and
  new business
• Probability of entrance to IT security business
  and the success rate of commercialization
• In case of success, the sales improve drastically
• The success rate in foreign market

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3.3. Decision criteria of both options to
withdraw and expand

• Decision criteria and license value should be
  calculated separately
• If we use the value of license under simulation,
  it means we can measure future cash flow properly
• We need to use different calculation method
  respectively

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3.3. Decision Criteria
Future Cash flow of sample path
NPV of sample path
NPV is uniquely determined
Method should be different
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3.3. Decision criteria

• If we use the results of the simulation shown in
  page 10th, it means we can measure future cash
  flow properly ? how to calculate value for
  Decision?

1. Set DC to equate NPV
NPV by path
2. If DC is above 0, it will Exercise
3. If DC is below 0, it will not exercise
How to set?
Decision Criteria
How to evaluate?
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3.3. Decision of withdrawing

• If the value of license by Gordon Model (GM) is
  negative, it will withdraw from the operation.
• GM valuation of License (left hand)

Free cash flow of the second step business (j) at
th
Free Cash flow of current business (i)at t (time
of decision)
Adjusting in order for the value of left hand
equal to right hand
Decision Criteria
License value at t
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3.3. Decision to expand

• Firstly, we set if value of ACES business (second
  step) by GM (left hand) is positive,
  expand?Later, we improve the criteria
• Valuing second step business by using the cash
  flow of the first step business
• In terms of the second step business, if the CV
  cannot commercialize ACES business, CV withdraw
  from second step business.
• After the success, assuming CV do not withdraw
  from ACES.

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4.2. The value of license by taking into account
both options.

• The value improved by 10,863 thousand yen.
• This is the value of the flexibility of the
  management and decision.
• Assuming only withdrawing option, its value is
  10,863 thousand yen and only expanding option,
  its value is 1,296 thousand yen.
• In this case, not withdrawing means expanding

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4.3. License value and correlation coefficient
(?).

• Without option(?)
• Taking into account options(???, see page 14)

The license value(thousand yen)
?without option? 1.When there is no correlation,
maximizing the license value ??? with
options 1.Until ?0.6, the enterprise value
continue to increase 2.There is strong
correlation, the value is decreased ?because
the option value increase though, intrinsic value
decreases
?
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4.3. The value of optionscorresponding to ?

• The value of option to withdraw(?-?)
• ? As correlation coefficient increases, the
  value increases
• The value of option to expand(?-?)
• ? near the point of ?0, the value of the option
  is almost 0

The value of option to expand (?-?) (thousand yen)
The value of option to withdraw (?-?) (thousand
yen)
?
?
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4.3 why does it need to improve decision criteria?
thousand yen
The value of option to expand (?-?)
Option value is negative
Problems of decision criteria If the value by GM
is positive, CV exercise the option to expand
Need to improve Decision criteria
?
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4.4. Value of option to expandCorrelation
Efficient (0.4)

• Adjusting decision criteria (Growing rate
  dependency between operations 0.4)

Exercise depend on decision criteria
Value of the license
No expansion
Option value
Second bizs NPVlt0
100 Expansion
?frequently exercise
Decision Criteria
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4.4 License value depends on decision
criteria(?0.4)
The expanding option value (units thousand yen)
License value (units thousand yen)
redexpansion blueno expansion greendepend
s on DC purple green - blue
NPV of the second step biz -1,800 thousand yen
The value of option to expand is actually
recognized, by improving decision criteria
Decision Criteria (units thousand yen)
Optimal point 27,000
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4.4. Regression of the second biz value and
decision criteria
Decision Criteria
Assuming ?0.4
Estimating the value of the second biz by using DC
Value of the 2nd biz
Significant It is possible to estimate the value
by the CF of current biz
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4.4. Decision Criteria and the value

• NPV negative project also remain future value as
  long as keep project for an option, not
  discontinue at first stage
• If the decision criteria is inappropriate, the
  value of the license is damaged
• If the two business is correlated the value of
  business is higher than there is no relation,
  because the cash flow of current business have
  information to predict the CF of the second step
  business
• Examination of the value when correlation
  coefficient is 0

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4.4. Expansion option valueCorrelation Efficient
(0)

• Adjusting decision criteria (Assuming operations
  are NOT correlated)

Exercise depend on decision criteria
Value of the license
No expansion
Option value0
Second bizs NPVlt0
100 Expansion
?frequently exercise
Decision Criteria
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The value of license depends on decision
criteria(?0)
Value of the expanding option (units thousand
yen)
Value of the license (units thousand yen)
redexpansion blueno expansion greendepend
s on DC purple green - blue
NPV of the second step biz -1,800 thousand yen
The option value is zero because the CF of the
existing biz has no information to estimate the
CF of the second step biz
Decision Criteria (units thousand yen)
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4.4. Regression of the second biz value and
decision criteria
Decision Criteria
Assuming ?0
Estimating the value of the second biz by using DC
Value of the 2nd biz
Not significant It is NOT possible to estimate
the value by the CF of current biz
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5. Summary

• The license value is NOT the simple sum of value
  of option to withdraw and to expand
• They affect each other
• It may lead to loss depends on decision criteria
• It is important to take into account the
  probability of loss after exercise
• Though there is real option, it is possible that
  enterprise value may be damaged
• The option value is higher when correlation
  coefficient is high it is possible to project
  the future CF (importance of predictability)
• If there is no correlation, the value is zero
• It is better to invest in the business which
  correlates with the current one

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Bibliography

• Takamori, Hiroshi and Haruyoshi Ito (2006), Real
  option teikei senryaku seiyu to Wal-Mart no
  teikei ni miru shinkabuyoyakukenn no hakkou to
  kigyoukachi (MA strategy by real options,
  issuing of warrants and enterprise value shown in
  the business tie up between Wal-Mart and Seiyu),
  KinyuKeiyaku Gijutsuagency to Keiei senryaku
  (Finance, Contracts technique, Agency and
  Management Strategy) ,209-230 (Japanese),
• Takamori, Hiroshi (2006), Real Option no kiso-
  toushi no senryakuteki kachi ha dou hyouka
  suruka (Fundamental of Real Options, How to
  evaluate the value of strategy seen in investment
  , Real options to Keiei senryaku (Real Options
  and Management Strategy), 11-40. (Japanese)
• Kato, Atsushi (2007), Real Option to IT business,
  economicst sha. (Japanese)
• Mano, Yuji, Naoya Takezawa and Nobuya Takezawa
  (2006), Sekiyu kagaku kougyou ni okeru sougyou
  chuushi option ni kansuru jireikennkyuu(A case
  study of the value of option to stop in oil
  chemistry business), Real options to Keiei
  senryaku (Real Options and Management
  Strategy),279-300. (Japanese)
• Panayi, Sylvia, and Lenos Trigeorgis (1998),
  Multi-stage real options The cases of
  information technology infrastructure and
  international bank expansion. Quarterly review of
  economics and finance , 38, 675-692.
• Schwartz, Eduardo S. (2001), Patents and RD as
  Real Options, UCLA Working Paper

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Appendix

• History of the license contract
• The three steps business by CV
• Calculation of Free Cash Flow
• Parameters for the calculation of FCF
• Description of uncertainty
• Shapes of distributions by the simulation
• The value of the license corresponding to the
  correlation coefficient

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A.1 history of the license contract

• 1997
• Northrop Grumman Mission and Systems(NGMS) gives
  Coteau Vert Co., Ltd. License to permit produce
  and sale µ disc
• Firstly, CV could not break license contract for
  32 years, however, NGMS allowed CV to renew
  license contract every year ? option to withdraw
• 1999
• CV successfully got into business of µ disc
  (opportunity to expand sales channel)
• 2000
• Entrance to security business(by application of
  µ disc, CV develop the products in order to avoid
  leaking information through electromagnetic wave
  and comprehensive IT security service)
  Opportunity to expand business
• 2003
• Entrance into certification by fingerprint
  business (ACES) (it also requires to use µ disc
  this license is important ) ? Value of option to
  expand
• 2004
• Commercialization of ACES (RD by CV) uncertain
• 2007
• Expanding to foreign market of ACES (expansion of
  the market)
• Commercialization of time control with finger
  print business

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A.2. CVs three steps biz

• First EMC noise dealing business
• IT security business
• Second (ACES)
• by using finger print technique
• ThirdTime Control business(Veri Time)
• by expanding finger print technology
• ?
• Here, we regard that the second step business is
  expanding option on the first step business

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A.3. Calculation of FCF

• Sales(1-rate of margin)Gross margin
• Promotion and administration costs
• RD the other operating costs
• RDSales variable RD costsfixed RD costs
• The other operating costssalesrate of the other
  operating costs
• Operating Profits
• Gross margin-promotion and administration costs
• NOPATOperating profits(1-tax rate)
• FCFNOPATAmortization
• (increment in working capital and investment are
  zero)

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A.4. Parameters of the calculation of FCF

• RDCV invests high amount of money in RD,
  because CV is IT venture enterprise
• For simplicity , assuming rate of variable RD
  costs (variable RD costs/sales) is constant
• Rate of RD costs is estimated
• Amortizationinitial license fee is amortized for
  20 years equally

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A.5. Introduction of uncertainty

• Sales and growth rate of salesTriangle
  distribution(minimum, mode, maximum)
• Growth rate of sales
• The second step business is more uncertain than
  the first step business. (there are many
  competitors in the finger print business.
  Furthermore, the success of commercialization
  depends on CVs RD)

Sales (first fiscal year) (50 million yen, 75
million yen, 100 million yen)) µ discs growth
rate of sales 2001-2004 (-10, 20m 50)
2005-2011 (-5, 10, 15) ACESs growth rate
2004-2011 (-20, 20, 60)
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A.5. Introduction of uncertaintyCorrelation
Coefficient (?)
?Growth rate of sales (g-rate) 2000 2001
2002 2003 2004 2005 2006
? between the g-rate of this year and
a year before ? 30 ? between the g-rate
of the first biz and that of the second ?
40 ?Success rate of commercialization ?
between the success rate of RD of the first step
biz and that of commercialization of the second
step biz ? 40 ?Simulation by changing the
correlation coefficient between the first step
biz and the second step biz
The first
The second
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A.5. Introduction of uncertainty

• Success rate in the new business fields and
  success rate of commercialization are for the
  following

Success rate of the entrance into IT security
business based on EMC noise dealing
business80 growth rate when entrance into IT
sec biz(1,000?1,500?2,000) success rate
of commercialization after the entrance to ACES
assuming the duration RD for commercialization
is 3 years and its success rate is 42 within a
year. Success rate of commercialization within 3
years is 1-(1-42)380. growth rate when
commercializing (400?1,000?1,600) assuming
in the commercializing is failure, withdrawing
from ACES biz Success rate of ACES in foreign
markets50 in this paper, we assume CV will
begin oversea business in 2007 growth rate when
success(100?150?200) growth rate when
failure(-60?20?60) (same as before year)
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A.6. The shapes of distributions
Without options

• Without options
• Only withdrawing option (both options)
• Minimize loss
• Only expanding
• Exercise only when it is probable to make money

Only withdrawing option
Only Expanding option
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A.7. value of option corresponding to correlation
coefficient
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A.7. Value of license and Decision Criteria
(?0.4)
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A.7. Value of license and Decision Criteria (?0)