Value Of Growth Options Research Articles

Corporate ESG investments and Firm's value under the real-option framework: Evidence from two world-leading economies

Under the UN sustainable development goals (SDGs), the United States (US) and China have ambitious environmental, social, and governance (ESG) investment plans. However, dichotomy is found in the literature about how rising ESG practices affect firm value (FV). This study examines the linear and nonlinear effect of ESG practices on FV and how growth-option value (GV) moderates this connection in the real-option framework. We use data on 5220 listed US and Chinese firms from 2018 to 2022 with a generalized method of moments model. The empirical results confirm that ESG practices nonlinearly affect FV, implying that ESG practices turn FV trajectory from positive to negative, and the degree of this effect varies across the sample but is more pronounced at Chinese firms than US firms. We also find that GV negatively moderates the nexus between ESG practices and FV across the sample. Our endogeneity-adjusted results pass robustness tests and have important policy implications.

Competitive advantages and the proximity of investment: evidence from Hong Kong-listed real estate development firms in Mainland China

ABSTRACT This study examines the investment behaviour of Hong Kong-based real estate firms in Mainland China. Using a sample of individual land transactions, we find that firms with higher value of growth options, as perceived in the capital market, are more likely to invest actively and further away from their home base. However, over time, Hong Kong developers tend to decrease their level of activity in Mainland China, indicating that the ‘liability of foreignness’ becomes a significant challenge. Our findings highlight the importance of balancing strategic expansion with the inherent risks of operating in distant emerging markets.

COVID-19 Pandemic, Corporate Investment and the Real Option Value

ABSTRACT The outbreak of COVID-19 has a huge negative impact on the firms’ business activities. This paper investigates the effects of COVID-19 pandemic on corporate investment and firm value from the real option perspective. Based on the real options-based model (ROM) proposed by Zhang (2000), we find that COVID-19 crisis accelerates low-profitability firms to reduce investment and exercise put options timely, thereby increasing the value of put options. This finding mainly exists in areas where the COVID-19 pandemic was worse and firms that did not receive government subsidies related to COVID-19. We also find that the value of put options is more pronounced for non-state-owned enterprises and firms with higher internal control quality. However, we do not find the change of growth option value of high-profitability firms during the COVID-19, which indicates that it is difficult for high-profitability firms to grasp the investment expansion opportunities under the pandemic. Our study sheds light on the applicability of ROM and the importance of real option in firm valuation under the major public emergencies.

Cross-border M&As and Growth Option Value: Technological Diversity, Uncertainty and Correlation

Cross-border M&As and Growth Option Value: Technological Diversity, Uncertainty and Correlation

The value of flexibility in multi‐business firms

AbstractResearch SummaryWhether diversified firms have advantages over their single‐business counterparts is the focus of much research in strategic management. Indeed, there is sparse evidence that corporate advantage exists, on average. We explore one potential driver of corporate advantage—that multi‐business firms have more flexibility than single‐business firms to cope with uncertainty, because they can internally redeploy resources across businesses. Using Compustat data, we show that uncertainty increases the relative advantage of multi‐business firms, a finding robust to controls for endogeneity. Consequently, the paper provides important insight and evidence around when corporate advantage might obtain. Moreover, we find that growth option value is accentuated in the presence of switching flexibility. Finally, multi‐business firms with redeployment experience and businesses with more inversely correlated returns benefit more from uncertainty.Managerial SummaryMulti‐business firms have a flexibility advantage over single‐business firms as they can reallocate firm resources from one business unit to another depending on inducements. What is the impact of this flexibility on firm value? In this paper, we test whether such a flexibility advantage translates into greater economic returns in more volatile markets. We expect that resource redeployment creates value if it amplifies business‐specific positive shocks while alleviating business‐specific downturns. Consistent with this argument, we find empirical evidence that with increasing stock market volatility, multi‐business firms benefit significantly more in terms of firm value than their single‐business counterparts. In particular, in highly volatile stock markets, monthly adjusted returns are 2.3 times higher for multi‐business firms than for single‐business firms.

The effects of the environmental protection tax law on heavily polluting firms in China.

In 2016, China implemented an environmental protection tax (EPTL2016) to promote the transformation and upgrading of heavily polluting industries through tax leverage. Using panel data of China’s listed companies, this study assesses the treatment effects of the EPTL2016 on the transformation and upgrading of heavily polluting firms by incorporating the intermediary role of the financial market. The empirical findings show that the EPTL2016 significantly reduced the innovation investment and productivity of heavily polluting firms but had no significant effect on fixed-asset investment. Additionally, EPTL2016 reduced the supply of bank loans to heavily polluting firms and increased the value of growth options for private enterprises and the efficiency of the supply of long-term loans to heavily polluting firms. Although the environmental policy of EPTL2016 benefits the transformation and upgrading of heavily polluting industries in many aspects, it generally hinders the industrial upgrading because of the reduction of bank loans.

The Short-Run and Long-Run Components of Idiosyncratic Volatility and Stock Returns

To capture the dynamics of idiosyncratic volatility of stock returns over different horizons and investigate the relationship between idiosyncratic volatility and expected stock returns, this paper develops and estimates a parsimonious model of idiosyncratic volatility consisting of a short-run and a long-run component. The conditional short-run and long-run components are found to be positively and negatively related to expected stock returns, respectively. The positive relation between the short-run component and stock returns may be caused by investors requiring compensation for bearing idiosyncratic volatility risk when facing trading frictions and hold underdiversified portfolios. The negative relationship between the long-run component and stock returns may reflect the fact that stocks with high long-run idiosyncratic volatility are less exposed to systematic risk factors and, hence, earn lower returns. Moreover, the low-risk exposure of stocks characterized by high idiosyncratic volatility lends support to real-option-based mechanisms to explain this negative relation. In particular, the systematic risk of a firm with abundant growth options crucially depends upon the risk exposure of these options. The value of growth options could rise significantly because of convexity when the increase in idiosyncratic volatility occurs over long horizons. And growth options’ systematic risk could fall because the relative magnitude of their value in relation to systematic risk factors decreases.This paper was accepted by David Simchi-Levi, finance.

Does Capital Foster Growth Opportunities? A Real Options Perspective on Newly Public Family Firms

Despite significant organizational challenges, risk of failure and dilution of family control, many private family firms decide to go public with founding families retaining family control, thereby accepting a loss of noneconomic wealth. We argue that family firms may go public and accept such an initial loss of noneconomic wealth but use the proceeds to allocate funds in strategic investments that create more growth opportunities in the future, thereby financially compensating for their loss of noneconomic wealth. Building on real options theory, the aim of this study is to gain insights on the effects of new capital on growth option value in newly public firms and to develop an understanding of the family firm as a source of firm heterogeneity in real options theory. The empirical analysis of 590 IPOs in the United States lends support to our theoretical expectations and show that family firms have a distinct effect on growth option value, particularly under conditions of highly uncertain environments.

The Effect of Short-Term Orientation on Technological Diversification

Firms’ differences in their ability to sustain a competitive advantage depend on the sources of failure in recognizing and exploiting valuable growth options through innovation. By investing in a sufficiently diversified portfolio of technologies, firms can create a broad knowledge base for future innovation opportunities. However, in this study, I argue that short-term earning pressure, providing managerial incentives to increase predictability and reduce waiting time for results, can alter how managers allocate resources among research projects leading to a narrower knowledge base. I employ a difference-in-differences specification and find that, relative to the control group, firms in the treatment group suffer a decline in the level of the breadth of their knowledge base scope (in terms of technological diversification) after the introduction of mandatory quarterly reporting in EU.

Uncertainty and flexibility in infrastructure investments: Application of real options analysis to the Ponta Delgada airport expansion

Ponta Delgada airport is the most important air transport infrastructure in the Autonomous Region of the Azores. The increase in airport activity that resulted from the partial liberalization of the air transport sector has increased the pressure on its capacity. This study used Smit (2003) framework to evaluate the Ponta Delgada airport expansion, taking into consideration the future growth opportunities that come from an increase in tourism activity. Minor extensions were made to accommodate multistage investments. It was possible to capture the growth option value, since the decision to invest only occurs if add value to investor. The results show an option value higher than zero, whether the investment is deployed in one or two phases. Our paper aims to contribute to real options analysis field with an empirical application, allowing practitioners and business managers to better understand this framework.

Correlations, Value Factor Returns, and Growth Options

This paper documents that the average equity market correlation is informative about the value of growth options and the correlation dynamics of growth and value stocks and, in turn, forecasts changes in growth options and the returns on the value factor. Consistently, a production-based asset-pricing model shows that correlations are homogeneous among stocks with similar growth characteristics and increasing in the value of growth options. Therefore, the expected average equity correlation serves as a leading procyclical state variable and drives the value premium. Correlations extracted from an equity value index improve the predictability of value-related factors in-sample and out-of-sample.

Multinational investment and the value of growth options: Alignment of incremental strategy to environmental uncertainty

Research SummaryOne of the motivations for multinational firms' investment in foreign affiliates in uncertain environments is the future growth opportunities the investment may bring. We argue that whether firms derive growth option value from their multinational investment is determined by the interaction between market uncertainty and firms' incremental investment strategy. We show evidence that multinational investment creates growth option value for firms operating affiliates in host countries with high market uncertainty. In such uncertain environments, however, incremental investment strategies—limiting the equity stake or the size of investment in affiliates, across all countries or within each country—prove critical to the value of growth options. Creating growth option value therefore requires an alignment of firms' incremental investment strategy to the uncertain country environments they confront. Managerial SummaryManagers have long recognized the importance of taking an incremental approach to strategy making, but evidence on whether and when strategic incrementalism is valuable to firms remains scarce. This study focuses on two ways Japanese multinational firms invest incrementally in the context of foreign expansion—by limiting the equity stake or the size of investment in their foreign affiliates—and analyzes when such incremental strategies create valuable growth options that translate into market value. We find that these strategies, whether implemented across all host countries or within each country, do create significant growth option value, provided that market uncertainty is high. The findings highlight the importance of aligning firms' incremental strategy to the environmental uncertainties they confront, in line with the core notion of “fit” in strategic management.

The Impact of Uncertainty Shocks on the Cross-Section of Returns

Historically, value stocks earn higher average returns than growth stocks; however, the capital asset pricing model (CAPM) cannot explain this pattern, which is called the value premium puzzle. This study shows that uncertainty shocks can explain the puzzle. Intuitively, the value of growth options increases with uncertainty. As a result, growth stocks provide a hedge against uncertainty risk and earn lower risk premiums than value stocks. An investment-based asset pricing model augmented with time-varying uncertainty accounts for both the value premium and the empirical failure of the CAPM. This study also shows that uncertainty shocks differentially affect corporate investment, depending on the book-to-market ratio. Value firms reduce their investment more severely than growth firms when uncertainty increases.

Real options and institutions

This article shows how growth options are affected by two types of external uncertainty: Transactional uncertainty that stems from institutional voids and increases transaction costs, and economic uncertainty that arises from the business environment. We theorize that these two types of uncertainty have opposing effects: A firm’s growth option value (proportional to firm value) is negatively associated with transactional uncertainty, but positively associated with economic uncertainty. In an empirical study, we directly compare firm-level growth option values across 34 countries and indeed find that economic uncertainty and various institutional measures for transactional uncertainty correlate in opposite directions with the value of growth opportunities. Interestingly, in countries with lower transactional uncertainty, the economic uncertainty in the business environment is more strongly related to proportional growth option value. The link between a country’s institutions and firms’ proportional growth options value is also moderated by firm size. The implication of our study is that institutions, such as property rights, business regulations, and contract enforcement are important preconditions for companies to appropriate growth option value under economic uncertainty. Our findings may help public policymakers in devising strategies for institutional development in their country, and corporate executives in assessing institutional factors when managing their company’s growth options.

Hedge Fund Styles and Macroeconomic Uncertainty

We examine the dynamic trading strategies implemented by hedge fund managers using a Kalman filter. We investigate the risk drivers of dynamic trades, examining which macroeconomic variables strongly lead the time variation in fund trades. We show that hedge funds control the intensity of their exposures according to economic uncertainty and that differences between up- and down-market regimes can be observed. Commonly, Hedge funds tend to dislike high-dividend paying stocks. Besides, all hedge fund styles are shown to display pro-cyclical exposures towards directional equity factors as well as credit and liquidity risks. Small growth stocks, however, are revealed to be crisis investments whose allocation increases with unemployment, inflation or volatility. As volatility increases, the value of growth options embedded into growth stocks indeed increases. Growth stocks are shown to hedge market reversals and volatility. The outperformance of growth companies in recessions might also relate to their cost flexibility.

Recognized intangibles and the present value of growth options

We investigate the relation of recognized intangibles, defined as acquired intangibles net of goodwill, and the market’s perception of firm growth options (PVGO). We find that: (a) on average recognized intangibles are positively associated with PVGO after controlling for intangible expenditures immediately expensed, firm specific characteristics, industry membership and systematic risk (b) the said relation is highly non-linear (negatively skewed) and more strongly pronounced in companies with lower accumulation of RD recognized intangibles are not that significant at higher levels of PVGO and whereas firms have committed to in-house technological development, and (c) while adjusted levels of recognized intangibles increase approximately tenfold over the last 35 years their explanatory power to PVGO over the period generally wanes. Our results are informative for the interpretation of recognized intangibles as a summary balance sheet item and therefore useful to users of financial statements forming investment and credit decisions, to policy makers aiming at stimulating firm growth and to standard setters aiming at improving value relevance.

The Impact of Dividend Payment on Market’s Expectation after the Global Crisis

<p>This paper examines if there is any change in investors’ behavior toward dividend payout policy of the US corporations after the breakout of the global financial crisis in 2007-2008. In order to do so, dividend signaling theory is adopted as the main theme where we build econometrical models describing the influence of dividend payment on market’s expectation. Unlike most of the previous studies which use either price-dividend or dividend-earnings type tests to provide empirical evidence for the signaling theory, this paper attempts to perform a new type of test called present value of growth options (PVGO)-dividend type test. It is inspired by the recent development of real options as an investment valuation tool. This paper is in our opinion the very first to examine the implications of the signalling models in the context of the relation between dividend and PVGO using real options technique. Our result shows that in the market flooded with information like the US financial market, dividend no longer plays a significant role in delivering additional valuable information to investors. This outcome is highly inconsistent with dividend signaling theory. </p>

Corporate payout, cash retention, and the supply of credit: Evidence from the 2008–2009 credit crisis

We document significant reductions in corporate payouts-both dividends and (to a larger extent) share repurchases-during the 2008–2009 financial crisis. Payout reductions are more likely in firms with higher leverage, more valuable growth options, and lower cash balances, i.e., those more susceptible to the negative consequences of an external financing shock. Moreover, firms appear to use the proceeds from the reduction in payout to maintain cash levels and to fund investment. These findings are consistent with the view that a shock to the supply of credit (net of demand effects) during the financial crisis increased the marginal benefit of cash retention, leading some firms to turn to payout reductions as a substitute form of financing.

International Diversification and the Nature of Value Creation: A Real Options Perspective

Firms pursue international diversification to create value. According to real options theory, firm value can be associated with assets-in-place or future growth opportunities. The markets that the firm selects play a critical role in determining the nature of firm value created from international expansion. We examine how the location of diversification influences the nature of firm value. Based on real options theory, we argue that for U.S. firms, international diversification into emerging economies will likely increase growth option value given the higher upside potential and associated higher endogenous and exogenous uncertainty. In contrast, expansion into advanced economies will likely be associated with assets-in-place value. Using a sample of 672 firms from the S&P 1,500 over a period of 9 years, we find support for these arguments. We also examine the focus of the firm’s diversification strategies within emerging and advanced economies on value creation. We find that greater within-economy divers...

Corporate Payout, Cash Retention, and the Supply of Credit: Evidence from the 2008-09 Credit Crisis

Using the financial crisis as a natural experiment, we analyze the extent to which firms adjust financial policies on the margin in response to a credit supply shock. We document significant reductions in corporate payouts – both dividends and (to a larger extent) share repurchases - during the 2008-2009 financial crisis. Payout reductions are more likely in firms with higher leverage, more valuable growth options, and lower cash balances – i.e., those more susceptible to the negative consequences of a credit supply shock. Moreover, firms appear to use the proceeds from the reduction in payout to maintain cash levels and to fund investment. These findings are consistent with the view that an exogenous shock to the supply of credit during the financial crisis increased the marginal benefit of cash retention, leading some firms to turn to payout reductions as a substitute form of financing.