Aerospace Technologies Advancements 2012 Part 18 pdf

A Real Options Approach to Valuing the Risk Transfer in a Multi-Year Procurement Contract 489 price would have increased to $134 million. This is due to the upside potential of the MYP and SYP. The exchange option is essentially a put option with a stochastic strike price which allows the protection buyer to capture more payoff if the MYP turns out to yield more units. This assumes that the risk of the MYP is symmetric. There is no reason to believe otherwise, since the government can always buy more units than planned, if they are needed. 15. Other real options embedded in an MYP Within this chapter, we only have the scope to focus on a single real option example within the MYP contract. However, there is at least one other real option available to the contractor with a sole source production franchise such as a major aircraft, missile, ship, etc. This is because defense contracts are incomplete leaving the contractor with residual control of cost reduction innovations. While we will not estimate the value of this real option here, we mention it because in some cases it is potentially worth far more than the revenue stabilization discussed here. Regulatory lag is an incentive concept that emerged from explicitly regulated industries such as utilities. These industries’ profits are regulated directly through rate setting, e.g. $/kWhr, or through rate of return settings by a regulatory authority. Between rate settings, the utility is free to innovate and achieve higher profits. Upon the next regulatory oversight review, the regulator discovers the new cost structure and adjusts the new rate accordingly to a lower profit level-presumably slightly above the weighted average cost of capital for the utility. Longer periods between regulatory oversight periods (i.e. higher regulatory lag), mean greater opportunities for higher profits. Similarly, a defense contractor with a sole source series of production contracts for a weapon system has the incentive to achieve greater than expected efficiency innovations even if the savings are passed on to the government in subsequent contracts. It turns out that there is a substantial regulatory lag in defense contracts due to the length of time it takes for cost reports to be submitted to the government. The regulatory lag increases substantially in a MYP contract. These innovations are real options since the contractor is not obligated to make the necessary investment to achieve the cost savings. They can use real options valuation tool to estimate the worth of these options before a program is executed by looking at prior history of achieving cost reduction innovations as well as a forward looking assessment of the opportunities in a specific weapon system. Unlike the revenue stabilization option, there is considerable information asymmetry between the government and contractor with the regulatory lag options. However, the government could look at prior programs and assess the degree of regulatory lag driven innovation that occurred in past programs and roughly estimate the value of this type of incentive on a new program. This valuation can provide important insight into how aggressively contractors will compete to win a large sole source program. 16. Conclusion: the cost implications of the MYP option Options pricing analysis offers a way to systematically estimate value from the MYP contract earned by the Government for which they have not previously been explicitly compensated. This incremental value is the revenue risk transferred to the Government from the contractor upon signing an MYP. The MYP does not eliminate the revenue risk for Aerospace Technologies Advancements 490 the contractor associated with SYP contracts; rather it transfers it to the government and it becomes budget risk. The Congress clearly values its budget flexibility, as evidenced by the statutory criteria to judge the worth of an MYP proposal. MYP cost savings are usually through operational efficiencies earned through process and purchasing improvements funded by the Government’s “economic order quantity” advance funding. The transfer of revenue risk to the Government is a cash flow hedge that provides real value to the contractor just as any financial hedge does for currency, commodity, or interest rate risks or property and casualty insurance does for operational risks. Lockheed and Raytheon, for example, carry interest rate swaps that hedge interest rate risk for notional $1 billion and $600 million respectively 40,41 . General Dynamics reported a currency swap to hedge a Canadian denominated loan with a fair value of $42 million 42 . It also reported embedded options in the terms of its long term labor and commodity contracts. One can argue that just as public companies are expected to incur expenses as they pay for insurance and financial hedges, they should pay the government when it reduces the contractor’s risk. The option methodology helps the government objectively quantify some of the cost in relinquishing its budget flexibility with a relatively simple tool that has widespread use in the financial community. We do not try to value the cost of transferring the risk from the Government’s side because there is not a readily available tracking asset to estimate the volatility of the revenue risk. It is possible to estimate the actuarial loss history of certain procurements by looking at the Selected Acquisition Report over the span of past programs. If such data were available, it might be desirable to use it in lieu of the equity volatility of the contractor. One benefit of using the contractor’s volatility, however, is that it is more closely coupled to the risk the contractor might be willing to hedge. The option value of the MYP has not been explicitly paid to the government in the past. Thus any method that helps rationalize the cost of this risk transfer is a benefit to the government. Furthermore, the contractor will likely see the value of the MYP option if it is evaluated in its own financial terms. Strategically, the MYP option value represents a significant reduction in the contractor’s profits. Given the skill and sophistication that contractors employ to manage their government customers, they will likely argue that the MYP real option has limited value as an earnings hedge. They could contend that financial hedges are only appropriate for risks that are outside of managers’ control, such as interest and exchange rates, and cannot be offset within the business. They might also contend that not only is their portfolio of business well diversified among a broad scope of government elements but that they have enough support on Capitol Hill to ensure that they will sell all the units in the SYP plan. They would be arguing that the program is less risky than their business in total (i.e. their equity volatility). This would be a difficult argument for most businesses. However, initially it is unlikely the contractors will proactively volunteer to pay for it. 40 Lockheed Martin Corporation, Securities and Exchange Commission Form 10-K, Commission file number 1-11437, Fiscal Year December 31, 2006, p.71. 41 Raytheon Company, Securities and Exchange Commission Form 10-K, Commission file number 1-13699, Fiscal Year December 31, 2006, p. 74. 42 General Dynamics Corporation, Securities and Exchange Commission Form 10-K, Commission file number 1-13671, Fiscal Year December 31, 2006, p. 49. A Real Options Approach to Valuing the Risk Transfer in a Multi-Year Procurement Contract 491 However, the fact is that the lower earnings risk from an MYP has tangible value whether or not the contractors wish to pay for it. The option has the same value no matter what the contractors’ risk preference. If there is no risk hedge in an MYP, why do the contractors routinely enter into this type of contract? In fact Lockheed readily acknowledged that the value of the MYP is its long term stability 43 . The options methodology allows the Government to build a logical business case for reducing the profit on cost paid to contractors when switching from an SYP series to an MYP contract. The exchange option model in particular allows the Government to quickly estimate changes in the value of the contract as the details, e.g. the EPA and VIQ clauses, become more complete. 17. References Amram, M., and K. N. Howe (2003), “Real Options Valuations: Taking Out the Rocket Science,” Strategic Finance, Feb. 2003, 10-13. Baldi, F. (2005), “Valuing a Leveraged Buyout: Expansion of the Adjusted Present Value by Means of Real Options Analysis,” J. Private Equity, Fall 2005, 64-81. Barnett, M. L. (2005), “Paying Attention to Real Options,” R&D Management 35, 61-72. Black, F. and M. Scholes (1973), “The Pricing of Options and Corporate Liabilities,” J. Political Economy 81, 637-654. Charnes, J. M., and B. R. Cobb (2004), “Telecommunications Network Evolution Decisions: Using Crystal Ball and Optiquest for Real Options Valuation,” Proc. 2004 Crystal Ball User Conference. Colwell, D., T. Henker, J. Ho, and K. Fong (2003), “Real Options Valuation of Australian Gold Mines and Mining Companies,” J. Alternative Investments, Summer 2003, 23- 38. Copeland, T., and K. M. Howe (2002), “Real Options and Strategic Decisions,” Strategic Finance, April 2002, 8-11. Copeland, T., and P. Tufano (2004), “A Real-World Way to Manage Real Options,” Harvard Business Review, March 2004, 90-99. Cornelius, P., A. Van de Putte, and M. Romani (2005), “Three Decades of Scenario Planning at Shell,” California Management Review 48, 92-109. Duan, C. W., W. T. Lin, and C. F. Lee (2003), “Sequential Capital Budgeting as Real Options: The Case of a New DRAM Chipmaker in Taiwan,” Rev. Pacific Basin Financial Markets and Policies, 6, 1, 87-112. Ekelund, A. (2005), “Valuating Biotech Project Portfolios Using Crystal Ball and Real Options-Case: Natimmune,” Proc. 2005 Crystal Ball User Conference. Ford, D. N., D. M. Lander, and J. Voyer (2002), “A Real Options Approach to Valuing Strategic Flexibility in Uncertain Construction Projects,” Construction Management and Economics 20, 343-351. Fourt, R. (2004), Risk and Optimal Timing in a Real Estate Development Using Real Options Analysis, Proc. 2004 Crystal Ball User Conference. 43 LMT-Q3 2006 Lockheed Martin Earnings Conference Call, Preliminary Transcript, Thompson StreetEvents, Thompson Financial, October 24, 2006, 11:00AM ET Aerospace Technologies Advancements 492 Gaynor, M. and S. Bradner (2001), “Using Real Options to Value Modularity in Standards,” Knowledge, Technology and Policy 14, 2, 41-66. Herath, H., and C. S. Park (2002), “Multi-Stage Capital Investment Opportunities as Compound Real Options,” The Engineering Economist 47, 1-27. IOMA (2001), “Real Options Analysis Creeps into Use at Intel, Genentech, and Texaco,” IOMA’s Report on Financial Analysis, Planning & Reporting 01-12, 5-11. Janney, J. and G. G. Dess (2004), “Can Real-Options Analysis Improve Decision-Making? Promises and Pitfalls,” Academy of Management Executive, 18, 4, 60-75. Kayali, M. M. (2006), “Real Options as a Tool for Making Strategic Investment Decisions,” J. American Academy of Business 8, 282-286. Laxman, P. R. and S. Aggarwal (2003), “Patent Valuation Using Real Options,” IIMB Management Review, Dec. 2003, 44-51. MacMillan, I., A. B. van Putten, R. G. McGrath, and J. D. Thompson (2006), Using Real Options Discipline for Highly Uncertain Technology Investments,” Research- Technology Management, Jan Feb. 2006, 29-37. Maumo, D. A. (2005), “HP Applies Risk Management to Procurement,” Manufacturing and Business Technology, Nov. 2005, 26-27. Nembhard, H. B., L. Shi, and M. Aktan (2003), “A Real Options Design for Product Outsourcing,” The Engineering Economist, 41, 3, 199-217. Oppenheimer, P. H. (2002), “A Critique of Using Real Options Pricing Models in Valuing Real Estate Projects and Contracts,” Briefings in Real Estate Finance 2, 3, 221-233. Paxson, D. (2002) (ed.) “Real R&D Options,” Butterworth Heinemann, 333pp. Remer, S., S. H. Ang, and C. Baden-Fuller (2001), “Dealing with Uncertainty in the Biotechnology Industry: The Use of Real Options Reasoning,” J. Commercial Biotechnology 8, 2, 95-105. Rigby, D. (2001), “Management Tools 2001-Global,” Bain and Co., Boston, Massachusetts, June, 2001. Rigby, D. and B. Bilodeau (2005), “Management Tools and Trends 2005,” Bain and Co., Boston, Massachusetts. Rothwell, G. (2006), “A Real Options Approach to Evaluating New Nuclear Power Plants,” Energy Journal 27, 37-53. Synergy Partners (2003), “Real Options Primer,” Synergy Partners, Greensboro, North Carolina. Teach, E. (2003), “Will Real Options Take Root?” CFO, July 2003, 73-76. van Putten, A. B., and I. C. MacMillan (2004), “Making Real Options Really Work,” Harvard Business Review, Dec. 2004, 134-141. . the contractor upon signing an MYP. The MYP does not eliminate the revenue risk for Aerospace Technologies Advancements 490 the contractor associated with SYP contracts; rather it transfers. Transcript, Thompson StreetEvents, Thompson Financial, October 24, 2006, 11:00AM ET Aerospace Technologies Advancements 492 Gaynor, M. and S. Bradner (2001), “Using Real Options to Value. Evaluating New Nuclear Power Plants,” Energy Journal 27, 37-53. Synergy Partners (2003), “Real Options Primer,” Synergy Partners, Greensboro, North Carolina. Teach, E. (2003), “Will Real Options