Phased Investment Planning: Applying Real Options Valuation to a Small Manufacturing Firm

Abstract

All in Smoke Ltd (AIS Ltd), 100% export oriented unit (EOU) and in the manufacturing business of tobacco and cigarette, is a wholly-owned subsidiary of its listed parent firm. The parent firm, a sizable player in the same industry with a number of well-known brands in its portfolio, has recently decided to float the Initial Public Offering (IPO) of its subsidiary to raise equity. This paper deals with the valuation of AIS Ltd and highlights several issues in financial and business valuation using Real Options Analysis (ROA) and Illiquidity discounts. The paper attempts to present an analysis on forecasting uncertain cash flows, uneven investment for expansion, and hidden managerial flexibility. Valuing a small private firm is a very challenging exercise to understand most of the pertinent financial principles, such as asset pricing. Valuation of such firms particularly involves an in-depth consideration of issues like the level, timing, and variability of expected cash flows, opportunity cost of capital, growth rate calculation, and related considerations. Hence the need to understand such value determinants and plug them to appropriate places is of utmost importance. In this procedure we study the industry as well the economy dynamics which act as the best estimator of the future growth trajectory of the firm. Appropriate illiquidity discounts are used to reflect the peculiarities of the firm. Overall this paper provides a holistic approach to valuation with a critical insight into real life situation.