PwC Transactions Blog

The Belgian tax law enables companies to deduct a fictitious interest calculated on the basis of their shareholder’s equity, the so called notional interest deduction (NID). This measure reduces the cost disadvantage of equity in the capital structure of Belgian businesses and effectively lowers the corporate income tax rate.

The applicable NID rate is determined every year, based on the average return on the secondary market of a Belgian government bond with a remaining maturity of 10 years (OLO10).

Business plan practitioners may be confronted with the question which NID rate to use, especially in long term forecasts? The current NID rate is known, but what within 5 or 30 years? Making an accurate estimate for every year during the thirty years to come is practically impossible, so a thirty year average might be an easy-to-use alternative.

One might consider taking a closer look at the historic evolution of OLO10 (see graph).

The data (period 1991-2010) indicate an average for OLO10 of 5,5% with a standard deviation of 1,7%. The notional interest rate is capped by Royal Decree at 6,5%, using this cap would most likely result in a too optimistic projection. Using 3% would conversely result in a too gloomy outlook.

In order to refine this bracket of 3 to 6,5% various approaches can taken. A conservative approach is to argue that 3,8% (average minus 1 times standard deviation) is appropriate. Another option is the use longer-term bond rates (reflecting for instance the horizon of the business plan), which will however result in higher, more aggressive NID rates.

There is obviously no right or wrong answer to this question. Unless the Belgian government would lower the cap of 6,5% to … 3% !

When confronted with a situation where the “standard” NPV is inappropriate (see article – Part I), one should first identify all the value drivers and the key elements of the business plan for which uncertainty is high. It should then identify all the options for which it has either to mitigate these uncertainties or to react upon their resolution: the option to postpone the investment, to downsize production capacity, to close down capacity, to exit, to increase capacity, to transform itself into another business, etc.

The difficulty in this process is to find the relevant options, the ones bringing value to the project – the ones for which undertaking a real option valuation approach will be worthwhile.

The fact that management can stop a research project whenever the results of a test are negative, that uncertainty about the success of a research programme is high and that the NPV of such a programme is close to zero clearly indicates that a real option valuation approach should be used. The three conditions discussed in the previous article are met. Starting research on a chemical formula today is effectively an option that gives the right to make pre-clinical trials in a few years. These pre-clinical trials are nothing else but a further option giving the right, if they are successful, to make clinical trials. The clinical trials in turn provide yet another option to invest in a production process if they turn out to be positive. Today, valuing research programmes as a portfolio of compounded options is the best way to estimate the real value of an R&D programme.

In the same way, the portfolios of Venture Capital funds providing “seed capital” should be looked at as portfolios of real options. Investing a “small” amount of money in a start-up provides such funds with an opportunity to know more about the business, the management and to invest in a second and third stage if the project turns out to evolve as foreseen or better than foreseen.

The methods used to value real options are based on the groundbreaking work of Black and Scholes, who developed a formula to value financial options on stocks paying no dividends in the 1970’s. Since then, their work has been further developed by other academics and researchers to encompass the valuation of many kinds of different options. Black, Scholes and Merton originally showed that the value of a financial option on a share was dependent upon six parameters: the life of the option, the exercise price, the share price, the volatility of the return of the stock, the risk free rate and the dividend yield.

Real options are similar to financial options. The difference is that the asset underlying the option is not a quoted security but a “fixed” asset. The six key parameters affecting the value of a real option become therefore: the life of the option, the investment to be made (the purchase price of the asset), the present value of the future cash flows generated by the asset, the volatility of the return of the project, the risk free rate and the cost of keeping the option alive.

These six parameters can then be used in the Black & Scholes formula to compute an estimate of value when the option cannot be exercised before its expiry (maturity) or when the cost of keeping the option alive is null. When none of these two conditions is met, other methods such as binomial trees or Monte Carlo analysis for instance, should be used.

The complexity of the computation should not refrain investment analysts from using this approach, as it is probably the only one that will capture correctly the value of management flexibility. And it is not uncommon to see estimates of option values reaching 30% of the present value of the projected future cash flows, in cases in which a “standard” NPV analysis would indicate a zero value.

As we are living in a world changing at an ever-faster pace, uncertainty is increasing and will increase further in almost all business sectors. The investment decision process will therefore require a more frequent use of the real option methodology, starting right at the moment when the company defines its strategy. Firms understanding this and applying the real option concept will therefore build a new kind of competitive advantage.