Academic journal article International Journal of Business

Cinema Industry: Usefulness of the Real Options Approach for Valuation Purpose

Academic journal article International Journal of Business

Cinema Industry: Usefulness of the Real Options Approach for Valuation Purpose

Article excerpt

ABSTRACT

The discounted cash flow (DCF) valuation method is used by the practitioners. However, the net debt which is deducted from the enterprise value to obtain the equity value is the book value. It should be based on its economic value. Indeed, it enable to take into account its maturity and the bankruptcy risk of the firm especially within sector where it is difficult to establish reliable business plans because of the historical volatility of the revenues and the free cash flows. The reference to the options literature (mainly Black & Scholes (1973), Merton (1973), Hull, Nelken, and White (2004)) enables to propose a new breakdown of enterprise value between equity and net debt economic values. This study proposes to apply the option model in the cinema and broadcasting industry in order to compare statistically the results with the brokers' forecasts based on DCF method.

JEL Classifications: G13, G32

Keywords: real option; growth; DCF

I. USEFULNESS OF REAL OPTIONS IN THE CINEMA AND BROADCASTING INDUSTRY

Traditionally, firms' valuation is based on the discounted cash flow (DCF) approach. In that context, the enterprise value (EV) is the sum of present values of future free cash flows to perpetuity. Then, the equity value is derived from the EV thanks to the deduction of the net financial debt. The book value of the net debt is generally taken into account. Using such an approach assumes the capacity to deal with 3 main issues:

* Availability of a business plan, at least on a 3-year period which can then be mechanically extended. Generally, an additional 5 year period is taken into account in order to have a soft landing of the business plan. This period enables to introduce a linear phasing of the growth rate of the revenues towards the perpetuity growth rate.

* Calculation of an accurate weighted average cost of capital (wacc).

* Matching of the book value of the net financial debt with its economic value. In the case of the cinema and broadcasting industries, the DCF approach does not seem appropriate for the following reasons:

* Difficulty to elaborate a reliable business plan, given the historical volatility of the revenues and therefore of the future cash flows. A central case with sensitivities is always a possibility but the determination of a probability to each scenario is a highly theoretical exercise which is unlikely to be consistent with the reality.

* Subjectivity of the WACC. Indeed, according to the data provider which is chosen (Bloomberg, Factset, Datastream), the beta of the firm (or the betas of the listed peers) can vary significantly. Various sources (Bloomberg, Damodaran, Detroyat) can also provide high discrepancies at the market risk premium level. Moreover, several weightings of the respective costs of resources can be accounted for: it can be a normative debt to EV based either on industry references or on past achievements. It can also be the output of a loop on the model itself. In that case. The enterprise and equity values of the weighting coefficients are the output of the model.

* According to the financial theory, the resources, including the debt, have to be accounted for their economic values. The book value of the debt has no reason to correspond to its economic value for several reasons: on the one hand, assuming a fixed interest rate, the economic value depends on the evolution of the reference rate; on the other hand, its sensitivity depends on the Macaulay duration (S=-D/(l+i)) and therefore on the time to expiration. Without entering into technical details, assuming the EV is lower than the nominal value of the debt; its value is worth zero if it is maturing tomorrow. But, if it is maturing later, its economic value is strictly positive as the market considers the volatility of the revenues enables to expect higher cash flows in the future which will be consistent with an increase in the EV beyond the debt's nominal value. …

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