Acquisition Strategy and Real Options

Acquisition Strategy and Real Options 45© 2009 IUP. All Rights Reserved.

Acquisition Strategy and Real Options

This paper presents strategic level real options that acquiring companies have in the corporate acquisitionsprocess. The real options presented are different from those residing within the acquisition candidate companiesas stand-alones. The paper further presents acquisition synergies as real options and as sequential real optionsto acquisition timing, and the rather special case of acquiring businesses with divestible non-core assets. Modelsfor the valuation of the aforementioned real options are discussed with special focus on input variable values.The paper illustrates the non-core business acquisition issue with a case of acquisition and partial divestmentof Partek by Kone.

* Research Fellow, Institute for Advanced Management Systems Research, Joukahaisenkatu 3-5 A, 4th Floor,20520 Turku, Finland. E-mail: [email protected]

** Researcher, Institute for Advanced Management Systems Research, Joukahaisenkatu 3-5 A, 4th Floor,20520 Turku, Finland. E-mail: [email protected]

Mikael Collan* and Jani Kinnunen**

IntroductionCorporate acquisitions are a common and a popular form of corporate development.With an overall yearly value of hundreds of billions of dollars and numbering in tens ofthousands (Cartwright and Schoenberg, 2006), acquisitions are also the most importantform of Foreign Direct Investment (FDI) (Schjelderup, 2001; and Brackman et al., 2006),with about 75% of the FDI being in the form of acquisitions (UNCTAD, 2000). Even ifacquisitions are very common, research results on their effect on company profitabilityand performance are mixed, and there is no clear wisdom on wealth transfers between theacquiring and target company shareholders (Bruner, 2004b; Moeller et al., 2005; andCartwright and Schoenberg, 2006). It seems that when done under the right circumstancesand executed well, acquisitions can be highly profitable and win-win for shareholders ofboth the acquiring and the target companies. However, in some cases, the results ofacquisitions turn out to be negative for one or both the parties. For reaching a win-winresult from corporate acquisitions, valuation issues play a major role.

For valuation of companies (e.g., acquisition targets), we believe in the total valueconcept. In the total value concept, the value of a company not only includes thecash-flow generating active assets, i.e., the economic capital, but also the strategic capital,including the intellectual and human capital that includes the plans and the know-howof turning the plans into economically viable operations. This concept is presented wellin Boer (2002), for example (Figure 1). The concept acknowledges the value of real optionsas a part of the value of a company.

This means that when a company is a target for acquisition, its stand-alone valueshould include the strategic capital that the company has as a separate entity, includingthe real options that exist for the target company without the acquiring company.

The IUP Journal of Business Strategy, Vol. VI, Nos. 3 & 4, 200946

When we reflect this with the notion that possible synergies caused by, or created in,the acquisition can be understood as added real options and as increase in the (value of)strategic capital that the involvement of the acquiring company adds to the equation, wecan see that synergies are not the same thing as the strategic capital that already existsin the target company. In other words, if the synergies were real options and other strategiccapital already existing for the stand-alone company, then they would, and should, alreadybe included in the value (acquisition price) of the company, i.e., they would not besynergies at all, and acquisitions made at fair prices could never be wealth-creating [NetPresent Value (NPV) positive].

As we view it, if synergies are the additional new real options (the possibility to createsynergies) brought to the table by the acquiring company, then acquisitions can be NPVpositive even if fair price (with premium) is paid for the target company, and win-win.This means that when acquisition synergies are priced, they should be valued as the realoptions that the acquiring company brings to the acquisition process, plus the added valueof strategic capital. Viewing synergies as options is in line with reality, as synergy benefitsare not given (i.e., they do not autogenerate), but most often require investments, andtheir size is uncertain.

In this paper, we are interested in the real options that the acquiring company has atthe strategic level, including the possible synergies as real options (as discussed above), andthe inverse to synergies as options, splitting the business as an option. Other strategicacquisition-related real options of interest to this research are the postponement (timing),staging and abandonment of the acquisition (partly or fully). We will also look at therather special situation of ex-ante analysis of a strategy to acquire targets with non-coreassets that are, from the get-go on the track, to be divested after the acquisition; we will

Figure 1: Total Value of a Company Includes the Valuesof the Economic Capital and the Strategic Capital

Source: Boer, 2002

Human Capital+ Transformation Processes

Financial and PhysicalCapital + ValueProcesses

Economic Capital Strategic Capital

Acquisition Strategy and Real Options 47

also discuss the possibility to time the divestment of the non-core business part of theacquired company.

In the next section of this paper, we will look at some selected previous literature onreal options in general and those within the domain of corporate acquisitions. Then, wewill look at acquisition process level real options of interest to us as a whole, followed byanalysis of each one of them separately. We will continue with a case presentation of thenon-core business acquisition issue, with a case of acquisition and partial divestment ofthe acquired company. We close the paper with a summary and conclusions.

Literature on Real Options in Corporate AcquisitionsThe idea of real options is an old one, but the term ‘real options’ was introduced in Myers(1977), four years after Black and Scholes (1973) presented their famous option pricingformula for European financial options. Since the coining of the term, using optionvaluation models to frame analogous real investment problems has been growing, and realoptions are a subject of increasing attention among academics and practitioners.

Real options literature can be divided roughly into two categories—general theory andapplication. Some topics on the general theory side have been (with selected references),e.g., entry and exit decisions (McDonald and Siegel, 1986; Majd and Pindyck, 1987; Dixit,1989; Berger et al., 1996; Alvarez, 1999; and Pennings and Lint, 2000), growth options(Kogut, 1991; and Garner et al., 2002), and the valuation of interrelated projects(Trigeorgis, 1993; and Childs et al., 1998). Real option valuation has been applied notablyto some specific types of industries and situations (with selected references), e.g., topetroleum (Ekern, 1985; Paddock et al., 1988; and Smit, 1996), mining (Cortazar andCasassus, 1998; and Moel and Tuffano, 1999), natural resources in general (Brennan andSchwartz, 1985; and Cortazar et al., 1998), R&D (Newton and Pearson, 1994; Grenadierand Weiss, 1995; Smit and Nau, 1995; Faulkner, 1996; Lint and Pennings, 1998; andChilds and Triantis, 2000), information technology (Benaroch and Kauffman, 1999;Balasubramanian et al., 2000; and Campbell, 2002), and corporate strategy (Bowman andHurry, 1993; Das and Elango, 1995; and Kulatilaka and Marks, 1998). Real options havealso been found to be useful when framing problems found within the realm of corporateacquisitions and mergers. Below, we present a selection of literature on applying realoptions in corporate acquisitions in more detail.

According to Myers (1977), growth opportunities can be viewed as real options whosevalue depends on future investment by a firm. This suggests that the value of a firm canbe decomposed into the value of assets in place and the value of growth options. We findthat this is in line with the total value model presented earlier and also with our positionon synergies being real options available to the acquiring company (and are not includedin the stand-alone valuation of companies). Kester (1984) takes a similar approach statingthat the difference between the total value of a firm’s equity and the capitalized value ofits current earnings stream estimates the value of its growth options.


McDonald and Siegel (1986) consider the option to postpone investment, i.e., timing,which is also relevant to corporate acquisitions. They build a simple rule for timing ofinvestment (acquisition) with the practical intention to minimize the lost NPV ofsuboptimal investment timing. By simulation of parameter values, they analyze the valuelost during waiting versus the gains of waiting. They conclude that timing considerationsare quantitatively important for a wide variety of parameters, i.e., suboptimal timing canlead to substantial (10-20%) loss of value. Their finding is in line with the known NPVcaveat of ex-ante single number (non-fuzzy) future cash flow expectation. The timing rulepresented in their paper can be applied for acquisition timing.

Smith and Triantis (1995) discuss strategic acquisitions that create real options whichare able to increase upside potential, while truncating downside risk. They argue thatsynergies have an effect on the growth options that an acquirer has on an acquired firm.They state that in the long run, the success of an acquisition program is determined bythe options acquired, created, or developed, and the actions taken for the optimal exerciseof these options. They identify three classes of real options important in acquisitions:growth options, flexibility options, and divestiture options. Their findings are in line withour perception that synergies are the real options that are available to the acquirer inexcess of the stand-alone value of a target company, even if the point of view is different.While we see the synergies as real options on top of the stand-alone value (with realoptions), they see synergies as positively affecting the post-acquisition total value ofcompanies—two sides of the same coin.

Option value in acquisition and timing of acquisition entry are discussed in Miller andFolta (2002). The authors start by discussing the opportunity cost of moving from havingthe option to invest (acquire) to investing (acquiring); they call this the incrementalvalue of moving from an option position to a sunk investment. The opportunity cost ofdelaying entry is the dividends forgone during the time the option is held and dividendsare paid; the authors observe that in the absence of dividends, the best strategy is alwaysto wait until the end of the option maturity before exercise. This means that dividends(the opportunity cost of delaying entry) are the primary reason for early exercise, and thisis reflected also by the literature. ‘Dividend’ may be the competitive advantage gained bymoving early (early exercise), or as we interpret it from the point of view of synergies, thePresent Value (PV) of synergies lost by waiting (synergies are realized later). Their paperpresents the discussion with a formula and solves the optimal time of exercise. Threemajor areas that affect the value of waiting are discussed. They are threat of preemption,whether the option is simple or compound, and whether the option is shared orproprietary. The paper discusses different preemption situations and their effects on thevalue, and hence, the optimal timing of exercise, also under different market conditions(e.g., monopoly). The possibility to signal exercise to force the competition exercise (andforfeit option value) is also discussed.

Dapena and Fidalgo (2003) study tender offers and acquisitions with a real option pointof view (looking at acquisitions of a controlling/majority stake of a firm as a sequential,


rather than one-time purchase), looking at the control premium value as a real option.The paper concentrates on two options found in the acquisition—the option to wait (toacquire), and the option to grow (through growth possibilities opened up by acquisition;embedded options). The authors discuss the learning process (during waiting) and thevalue of corporate control (especially important with embedded options) that can begained by making an investment to a company to become a minority or a majorityshareholder (while a large minority holding will give a position on the board and accessto information, a majority share will give control rights). The paper illustrates three waysof making a tender offer. The model presented studies the differences between obtaininga controlling stake immediately and obtaining a minority stake, and then contemplating(learning about the company) and having the possibility of acquiring the rest that isneeded for the controlling stake later. The paper presents a model for optimal acquisitiontiming that assumes full irreversibility of the acquisition. It also presents a numericalexample of the model that calculates the value of the control premium.

The impact of real options on practice in Mergers and Acquisitions (M&As) isdiscussed in Bruner (2004a). He emphasizes the importance of real options for M&Apractitioners. The book presents important reasons to master real options thinking:pervasiveness of real options, Real Option (RO) influence on company value for both theacquiring and the target company, the possibility to actively create or passively destroy thevalue of ROs, and the fact that real option analysis captures value that Discounted CashFlow (DCF) methods do not take into consideration.

Smit et al. (2005) research the distribution of value gains in acquisitions with areal options game model that examines the bidding process, the likelihood of a biddingcontest (war), and the expected value distribution for the acquirer. The model presentedis a two-player (two bidder) game, and three variants are considered: preemptive bidding,accommodating bidding, and deliberation. The paper considers the cost of a duediligence—a purchase of a real option on the target’s value (that is revealed). Similarbidders can learn from this signal about the revealed value of the target and benefit. Thisis especially true if the opening bidder is a bidder who has performed due diligence on thetarget (which is the case of the presented model). An important point illustrated in thepaper is that similarity or dissimilarity of bidders has an effect on the probability of abidding contest and the outcome of the acquisition price.

Warner et al. (2006) investigate in their empirical paper how, in an industry whereformal standards are important (for example IT), companies that develop technology areacquired to enter or stay present in the industry. As a future standard can be one amonga number of possible technologies, the relevant technology companies are all potential‘hosts’ of the coming standard. This means that any company with a relevant technologycould receive a boost from having its technology selected as the standard technology. Theauthors explore the hypothesis that when an acquiring firm lacks technical knowledge, itis more likely to make an acquisition before a formal standard has been established. Thisis supported by the presented data. They further expect that targets possessing relevanttechnical patents are more likely to be acquired before the establishment of a formal


standard, rather than after, due to the possibility of assessing the technology via viewingthe patents (technological due diligence); this is also supported by data. Thirdly, the paperexpects the firms that already have an alliance with, or especially firms that are partiallyowned by, a potential acquirer firm, to be more likely to be acquired before a formalstandard is established—the cases where equity ownership was the form of an alliance, thehypothesis was supported (with a high level of significance). When the alliance was notof an equity form, no significant support was found.

The logic behind these hypotheses is that a company with more knowledge of thetechnology of the target (less uncertainty) is in a better position to acquire a companywith technology. Also, if the acquirer is large, it may have a possibility to influence thestandardization process (as has been discussed in the introduction of the paper).The sample in the study is from the US, from 1995-2000, and the data is from 163Information and Communication Technologies (ICT) sector companies (acquisitions),mostly having to do with network technologies. The possibilities of the larger acquiringfirm are what we would in this research call synergies. An issue that the paper implicitlypresents (which is not, however, written down) is the idea of ‘staged acquisition’, i.e., firststage—an alliance or a partial ownership, and second stage—acquisition of the rest of acompany. By investing in an alliance or in a direct equity ownership, the company buysan option to strike with an acquisition at a later time. This can be compared with directacquisition, where the whole company is acquired at once.

Alvarez and Stenbacka (2006) discuss the different types of real options available incorporate M&As, including the option to divest parts of the acquired company. Theyconsider the divestment option as an embedded sequential option. The paper discussessynergies as a result of reorganization of the target firm by the acquirer, which is in linewith our perception of what synergies are. The paper refers to Mulherin and Boone’s(2000) observation that both successful acquisitions, as well as divestures, will havepositive effects on the acting firm. Alvarez and Stenbacka (2006) present a compound realoptions model that considers the different phases of acquisition: divestment, synergy,consolidation and takeover. The model is useful for calculating optimal timing and priceof acquisitions.

We acknowledge that in addition to the literature presented above, there are a numberof articles not presented here that research real options in the context of corporateacquisitions. In the following section, we will present the different types of strategic levelreal options connected to acquisitions, which are of interest to this research.

Different Types of Strategic Level Real Options Connectedto AcquisitionsThis research is limited to discussing the strategic level real options in the acquisitionsprocess and does not present new models for valuation of real options. However, we notethat there are a number of general option valuation approaches available to choose from,e.g., the methods based on the Black-Scholes (1973) option valuation formula, binomial


methods based on the work by Cox et al. (1979), and numerical methods includingmethods based on parameter value simulation, e.g., Monte Carlo (Boyle, 1977). There arealso methods available for using fuzzy numbers as inputs into real option valuation byusing the Black-Scholes method (Collan et al., 2003), the binomial method (Muzzioli andTorricelli, 2000), and also some methods for the valuation of real investments that arebased on novel fuzzy real option valuation constructs (Carlsson and Majlender, 2005), orconstructs that to a very large extent resemble real options valuation (Collan, 2004). Tothe best of our knowledge, methods based on the binomial lattice and on the Black-Scholes formula are used most often for valuation of real options.

Figure 2 depicts the different strategic acquisition process level real options of interestto this paper. Firstly, we will look at the option to postpone the acquisition and the issuesconnected to acquisition timing. We will also discuss the possibility to stage theacquisition, or, as is discussed in the literature, to first engage in cooperation with a targetfirm, or to buy a minority share of the target. The rest of the real options under analysisare all contingent on the acquisition decision (exercise of the option to acquire) and arehence a part of an options sequence.

Figure 2: Acquisition Related Strategic Level Real Options Availablefor the Acquiring Company, Which Are of Interest to This Paper

Option to postpone divestment

Synergies as optionsOption to split the companyOption to divest

PossibleSyngeries

The acquisition opens the possibility to split the acquired company into parts, whichin turn opens the possibility to divest a part, or parts of the company; this divestmentcan be postponed (timing). The acquisition also makes it possible for the acquirer to investin generating the synergies.

Even if this research is not about option valuation methods, we include a discussionof the inputs needed in valuation of each of the presented strategic level options. We willdo this by presenting, for each one of the presented options, suggestions on the source forvalues to the six inputs needed in the Black-Scholes framework, with the enhancementsby Merton (1973): time to expiry (t), present value of investment expected cost (X),present value of expected cash-flows (S), standard deviation (), discount rate (rd), andcost of keeping the option alive (). We have selected the Black and Scholes inputs, asthe needed inputs to binomial lattice methods can be derived from them. In addition to

Acquisition Target Company(Total Value Valuation)

Option to postpone acquisitionOption to stage acquisition


the above-listed parameters, a tailor-made analysis on a specific acquisition case wouldmost likely require a number of additional inputs/parameters.

We start by presenting the options to postpone and to stage acquisition, followed bydiscussing synergies as real options, and by the option to split the existing business intoparts. We close with the option to abandon (non-core) parts of a company.

Options to Postpone and to Stage Acquisition ( in Figure 2)The possibility to postpone an acquisition is born when the possibility to acquire a targetcompany becomes available. We can say that for a ‘rational’ company, this would mean atthe minimum after a screening and a short analysis of the target, and definitively after acomprehensive due diligence. Both of these are investments and constitute the price ofthe option to acquire, which comes with the option to postpone. A similar situation ispresented, e.g., in Smit et al. (2005).

The decision to postpone an acquisition is most often driven by a cost-benefit assessmentof value lost during the time of waiting and the positive effect of waiting. In this analysis, thefactors that contribute to the total value of the target company should be taken intoconsideration, i.e., the stand-alone value of the target, plus the potential acquisition synergies.The options that are sequential to the acquisition may also gain or lose value if the acquisitionis postponed. For a complete analysis, these changes in value should also be considered.

The situation, with loss of value caused by the postponement of competitive positionand synergy effects, can be analyzed by pointing to the analogy between loss of value andloss of dividends; this is discussed, e.g., in Miller and Folta (2002). We must, however,observe that lost synergies may not be constant over time, which may requiresimplification, by using, e.g., averages. If the acquisition case is such that the acquirer iscontemplating further strategic actions with the target company, e.g., splitting thecompany and selling non-core parts, then the effect of postponement to the value of thesefollow-up or sequential options should also be taken into consideration.

Learning may be an important reason to defer an acquisition or to execute theacquisition in stages. The value of learning may be especially important in cases where theacquisition opens further options—the value of the opened options is often notobservable immediately. By becoming a minority stakeholder in the target company, theacquirer can commit less than full resources to the acquisition and have the possibilityto learn about the value of the target and the options that are embedded in the target.Staged acquisition is discussed, e.g., in Dapena and Fidalgo (2003). Table 1 discusses someinputs for the analysis of postponement of an acquisition.

Interestingly, our discussions with senior managers involved in acquisitions haverevealed that in the case of nonpublic companies, the analysis on the option to postponeis often simplified by the fact that the acquisition cost often remains constant over time.In other words, the seller will sell at a certain price that does not change during the time


t = Time Option Available Option to acquire and postpone, or stage acquisition, is acquired byidentifying and screening, or due diligence of the potential target. The timethe options are available may be limited by the existence of competingbidders.

S = PV of Revenues The revenues of the option to postpone are connected to the gains thatare realized by waiting, e.g., a lower acquisition price or a lower level ofrisk that can be obtained through learning (that will have a correspondingvalue). Also, possible increase in the value of possible sequential optionsshould be attributed to the revenues of waiting.

X = PV of Costs The costs of postponing are the revenues lost during waiting, includingthe value that is lost in the form of synergy benefits starting to materializelater and negative changes in the value of possible sequential optionsduring postponement. If acquisition cost is known to increase, it shouldbe taken into consideration.

= Standard Deviation If the target is a publicly traded company, then the standard deviation ofthe stock of the target can be used. The analysis of lost synergies’ valueshould be done separately, in addition to option valuation. In the caseof nonpublic companies, where stock movement is not market-based(but negotiation-based), it may not be sensible to use option valuationmodels in analyzing the cost vs. benefit of waiting.

= Cost to Keep Option As the cost term (X) includes the cost caused by waiting, the costs ofAlive keeping the option to postpone acquisition alive are, e.g., the costs of

monitoring and learning. We can also consider, in the case of stagedacquisition, the costs of a minority share purchase (which may bereversible, even at a profit) of a target company a cost of keeping theoption to postpone alive.

rd = Selected Discount Rate The option calculation discount rate for the time an acquisition ispostponed should be the risk-free rate (nothing is ventured). However,the discount rate used to derive the PVs for revenues and costs shouldbe selected, based on the risk of the revenues and the cost.

Table 1: Analysis of Postponement of Acquisition

the possible acquisition is on the table. In such cases, the problem of analyzingpostponement becomes simpler.

Synergies as Real Options ( in Figure 2)We view synergies as the potential value, i.e., real options that are created in anacquisition, on top of the stand-alone value of the target company. The potential addedvalue can be realized in the acquired company by the acquirer by exercising the realoptions. This differs from Smith and Nau (1995), who discuss synergies as a factor affectinggrowth options within a firm in the way that we propose synergies to be added value overand above the growth options that already exist in the target firm. To put in another way,we do not consider ‘the option to be acquired’ as something that is in the hands of thetarget, but something that is in the control of the acquirer. Hence, we see the added valuecaused by the acquisition as separate from the growth options within the stand-alonetarget company.


Obviously, we are trapped in a semantic discussion about which real options alreadyexist within the target and which do not exist; this issue can probably never be fullyresolved. However, existing real options that cannot be exercised by the target, neitherin the present, nor in the near to medium-term future, and that which become exercisablebecause of the acquisition, we consider as belonging to our definition of synergy. That is,if such possibilities are already identified by the target and valued as ‘low value, far outof the money’, and if there is a change in the perception due to, e.g., the resources of theacquirer, then the dramatic shift in RO value (be it growth options or something else) willbe attributed as synergies. This also means that the synergies can be seen as such existingreal options that the acquirer can turn to cash flows, i.e., RO that can be turned fromstrategic to operational capital, and the additional new RO that is generated through theacquisition. To put an end to the philosophical discussion on synergies, we observe thatthe real options world is one of incomplete markets which cause the possibility of findingsynergies. The synergies (as real options) are sequential options on the option to acquire,i.e., they will not be available before the acquisition option is executed.

The sources of synergies are numerous, but they can be roughly divided into threemajor categories: revenue (increasing) synergies, cost (reduction) synergies, andbalance sheet synergies. These categories can all be divided into more precise sources ofsynergies, which are presented in more detail for specific domains, e.g., in Lewis and Webb(2007) (bank mergers), and in Weber and Dholakia (2000) (marketing synergies).

As can be understood from the above, synergies are not made of a single value source,but are the sum of the added value from a number of sources. This is why the valuationof synergies may prove to be very difficult. When we consider synergies as real options,we must accept that for the different kinds of synergies to be analyzed, we may have toperform a separate analysis for each of them, because the risks related to each one of themmay be different (and the most often used RO valuation models assume only one risklevel). Above, we mentioned the three rough categories of synergies, but it may benecessary to go even further and evaluate single sources of synergy separately (within thebroad categories). Looking at the most important sources of synergy separately may beactually very good for a better overall understanding of the synergies.

Table 2 discusses some inputs for the analysis of synergies (as real options).

Option to Split the Existing Business into Parts ( in Figure 2)We present the option to split an existing business into parts because in cases where thetarget company is composed of parts which are partly non-core for the acquirer, the lattermay want to divest these. In such situations, the option to split the existing business intoparts is valuable—this possibility, however, may not always be available. Also, thepossibility to split is a prerequisite for a divestment; if a non-core business cannot be splitto a business, it can be quit as a business—split or quit. The issue is nothing more thanthat of business restructuring viewed as an option.


t = Time Option Available In general, synergies are value generating possibilities that come from theacquisition. Availability is thus connected to the availability of theacquisition option. Synergy-generating action can be started even yearsafter the acquisition. However, in corporate acquisitions, the practice islikely to set some upper limit—e.g., a company board, most likely, hasset a limit of, say, two to five years, when synergies should be achieved,and the options to create synergies after that are not seen relevant for theanalysis of acquisition. Some types of synergies may take a very long timeto materialize, e.g., synergies from R&D, but in concert with above, theinvestments in R&D that are made during the ‘synergy’ time, can beconsidered.

S = PV of Revenues Expected present value of the synergies that can be transformed to cashflow by the acquiring firm. This can be, e.g., the cost savings reached,enhanced sales, or the ability to reduce working capital. Also, estimatednon-cash-flow gains from synergies.

X = PV of Costs Costs of transforming (exercising) the potential synergies to cash flowsinclude costs that are needed in making the acquired company workbetter (to produce the synergies). This can include, e.g., costs of integratingthe target company to the acquiring company, investments, and costs ofchanges needed for cost reduction, sales increases, efficiency gains, etc.

= Standard Deviation Standard deviation of the underlying asset, in this case the synergies, istraditionally assumed to be the same for the revenues and for the costs.In practice, however, this is seldom the case. What actually takes placeis that the costs to realize synergies are usually quite predictable and areoften paid upfront, but the revenues are variable, or more precisely said,the actual size of the expected revenues is uncertain. Furthermore, thestandard deviation is most likely to be different for each one of thedifferent synergies because the processes that cause the synergy to takeplace are different (e.g., different markets for costs and revenues).

= Cost to Keep Option The cost of keeping the option alive needs to be considered case by case.Alive Whether there are costs to keep an option alive depends on whether there

are actions or threats that can kill the synergy generation option, andwhether that can be avoided by some (costly) actions. For example, R&Dsynergies may not be available if the target’s key R&D people leavethe combined firm, or cross-selling synergy options can be destroyed ifthe target’s customers change their supplier. While the former may requirehigher salary costs, the latter may require enhanced marketing effortstowards the target’s customers.

rd = Selected Discount Rate The discount rate, rd, is often based again on corporate practice. Themost common practice is to use the Weighted Average Cost of Capital(WACC) with possible adjustments, or simply use the risk free rate. Thelatter approach may suit the very first analysis of the target, but WACCor some other risk-adjusted discount rate is suggested.

Table 2: Analysis of Synergies as Options

In a simple situation, a target is already divided into separate businesses with separateleaderships; however, this is most often not the case. In cases where the target has partsthat are not of interest to the acquirer, and the acquirer wishes to separate the target intotwo (or more) parts, an analysis is to be done about the uncertain costs and revenues.


Sometimes, business restructuring can be rational because of societal factors, e.g., taxreasons that make smaller units more profitable.

Some assets are easier to split than others, e.g., inventories between two businesses arerather easily separable, whereas commonly used information systems will have to beduplicated, or a new system may have to be installed for the parts to be able to operateseparately. Splitting management and personnel are probably the most risky operations aspersons are non-divisible assets. We do not consider abandoning a part of business assplitting; this we discuss in the next section when we talk about abandonment. Table 3discusses some inputs for the analysis of splitting a business into parts.

t = Time Option Available Options to rearrange the business are available to the owner of the business;the time that specific reasons for corporate restructuring demand may belimited (e.g., tax benefits may be available only for certain periods). If thereorganization is made with abandonment in mind, the existence of a buyer/willingness of a buyer to buy may also be time-dependent.

S = PV of Revenues Revenues of the option to split (rearrange) a business come from the addedvalue of the new corporate constellation vs. the old one. In cases where thesplit is done to divest a non-core part of a company, the revenues shouldinclude the value received over the value of the split unit for the acquirer;some revenues may come from liquidating superfluous assets.

X = PV of Costs Costs of rearranging the business; costs arising from establishing unitsthat are operationally independent.

= Standard Deviation Market factors are usually not in the background of decisions to split,especially in cases where the reason to rearrange the business is drivenby core-business thinking. The standard deviation for these operationsshould be estimated from the outcomes for the costs and the benefitsarising from them.

= Cost to Keep Option There is no relevant cost to keep the option alive, as the option isAlive proprietary to the owner of the business.

rd = Selected Discount Rate The discount rate used for discounting of the revenues and costsshould in this case be something other than the WACC or the risk freeinterest rate. This is due to the fact that rearranging a corporate structuremay be very risky; what is being done is dismantling the way things havebeen in the whole company. We suggest that for the discounting, aseparately assessed rate be used.

Table 3: Analysis of Splitting an Existing Business into Parts

The option to split an existing business to parts may be a prelude to a divestment;however, it can also be an action done to enhance efficiency in the company. If the partsare more profitable separately than as a whole, then such moves are justifiable.

Option to Abandon Non-Core Part(s) of a Company and the Timing( and in Figure 2)The abandonment option is a right to sell or stop the operations of the (acquired)business, fully or partly. When a company is acquired, the acquiring company receives an


option to abandon; however, the actions of the acquiring company affect its availability,e.g., total integration of the target with the acquiring company will destroy the option toabandon. In such cases, the option to split will have to be exercised first to restore theoption to abandon.

The option to abandon gives the acquiring company protection against an unsuccessfulacquisition and a possibility to get rid of unwanted assets. Using the abandonment optionmay depend on a number of reasons, but the reason that is of most interest to us isthe want to concentrate on core business and to abandon non-core assets. Alternativeways to abandon a business (or a part of a business) include, e.g., Initial Public Offering(IPO), Management Buy-Out (MBO), Leveraged Buy-Out (LBO), direct sale, and assetliquidation and shutdown. Each type of abandonment requires different actions andcarries different revenues and costs.

If the abandonment possibility (of non-core assets) has already been considered beforean acquisition, it makes possible the ex-ante analysis of the availability of (the differenttypes of) options to abandon, which will be an important benefit in decreasing the risksinvolved in the abandonment. Table 4 discusses some inputs for the analysis ofabandoning (parts of) a business.

t = Time Option Available Different types of abandonment options (different types of sale/liquidation)may be available at different times and for different periods; theiravailability should be assessed separately for each situation.

S = PV of Revenues Revenue from abandonment is the proceeds of the sale of an abandonedpart of business (IPO, MBO, LBO, asset liquidation), or otherproceeds from the abandonment, e.g., the cost savings reached throughdiscontinuation of operations.

X = PV of Costs The costs arise from the different actions that have to be made; in orderto realize the abandonment, these vary according to the type ofabandonment that is at hand. All types of abandonment carry costs,and these are not always easy to identify beforehand. Costs may beconsiderable, e.g., in the case of IPO.

= Standard Deviation As the revenue received from abandonment is usually a one-time cash-flow, standard deviation may be an irrelevant factor. At least, using thestandard calculation methods may not be applicable; using fuzzy standarddeviation derived from the supports of the expected cost and revenuecash-flows may, however, be usable, see, e.g., Carlsson and Fuller (1999).

= Cost to Keep Option Costs to keep the abandonment option alive may arise, e.g., from keepingAlive a separate management and support systems for the to-be abandoned part

of the business. When the option to abandon is ‘passive’, the costs maybe zero.

rd = Selected Discount Rate The discount rate should be selected according to the risks involved, caseby case.

Table 4: Analysis of Abandoning (Part of) a Business

As discussed above, with option value of timing the acquisition, similar timingpossibilities exist for the timing of the abandonment of (non-core) parts of the business


( in Figure 2). Delaying abandonment may be beneficial if the question is about a saleof, e.g., a non-core business part of a company, the market conditions making the expectedsales price fluctuate over time (Smith et al., 1995). The optimal type of abandonment maybe different under different market conditions, e.g., IPOs are likely to be successful duringhigh general market valuations and the likelihood of LBOs is affected by the liquidity inthe markets. Price received through MBOs or asset liquidations may also depend onmarket factors.

In the next section, we will present an interesting case of the acquisition of Partek Inc.by Kone Inc., and the different dealings that were connected to the acquisition. This caseis a good example of how high level strategic real options available to the acquiringcompany can be exercised.

Case: Acquisition of Partek Inc. by Kone Inc.The 2002 acquisition of Partek Inc. (Partek) by Kone Inc. (Kone) is a good example ofacquisition of a company with non-core business parts and assets, which can be analyzedwith real options. Kone made a profit by recognizing the option to split Partek and thesequential options to abandon. On the other hand, the sellers, i.e., the old owners(including the Finnish Government) of Partek, can be criticized for neglecting thedevelopment of, or not having given the proper attention to, the available strategy levelreal options. Kone had business intuition, while Partek’s owners did not have theresolution to act. A story of the deal is available in Optio Kauppalehti (2003), and is shortlydiscussed in Alvarez and Stenbacka (2006).

Before the deal, Kone already had a long history of growing through acquisitionsin a relatively mature and consolidating engineering industry (elevators andescalators), and it was actively looking for acquisition targets to restructure theindustry. Partek, a conglomerate of engineering businesses with a stock price lowerthan the company’s substance value, had previously rejected bids on parts of itsbusinesses, e.g., on Valtra, a tractor manufacturing unit, in 2001. In 2002, Kone starteda hostile takeover of the whole Partek and ended up paying €1,450 mn for thecompany, acquiring a total personnel of 12,447 and sales of €2,740 mn, which is aboutthe same size as Kone itself (Talouselämä).

The parts of Partek that Kone perceived as core business were valued at €960-1,040 mnand integrated into a separate division within Kone, renamed in 2004 as Kone Cargotec.This includes Partek’s elevators, escalators, container and load handling businesses, i.e.,Hiab (valued at €440-490 mn) and Kalmar Industries (valued at €520-550 mn). From this,we can approximate that the core business part had a paper worth of €960-1,140 mn.

The divested parts included the already-mentioned Valtra, Partek’s forestry machinesbusiness, and Nordkalk (lime extraction-based business unit). Valtra, with a totalpersonnel of 2400 and sales of €762 mn, had earlier been valued at €250-300 mn byPartek’s investment bank. Kone received some €600 mn for the divestiture through abidding contest in 2003. Partek’s forestry machines business, with a personnel of 1008


and sales of €240 mn, had been valued at €150-200 mn. Kone received €120 mn in a dealclosed the same year. Both these divestments represent exercise of options to abandonnon-core businesses. Nordkalk, valued at €250-300 mn and sold for €270 mn, hadalready been negotiated to be sold by Partek. The other parts that were acquired andwere to be divested were Addtek (valued at €60 mn), Faroe (valued at €70 mn), and realestate (valued at €30 mn). We can see that the overall value of the non-core part wasaround €1,150 mn (Optio, 2003; Talouselämä). In the end of 2004, Kone Cargotecacquired MacGregor Inc., focusing on marine cargo handling and maintenance services,with a total personnel of 935 and sales of €370 mn.

In November 2004, Kone released a demerger plan to split the company into two parts.The demerger was to be executed by transferring all Kone’s assets and liabilities to two newcorporations. The new structure was such that the new Kone Corporation would getshares, assets, and liabilities of the lift, escalator and automated doors businesses, whileCargotec Corporation would get the shares, assets, and liabilities of the container andcargo handling business, i.e., Kalmar, Hiab, and the newly acquired McGregor. The statedpurpose of the demerger was to form “two internally synergetic corporations [that] willmake them more effective, provide them with growth potential and improve shareholders’ability to evaluate them as investments” (Kone, 2004) (with enclosed demerger plan).The demerger was executed on June 1, 2005. In 2007, Kone Corporation’s total numberof employees was 32,544 and sales were €4,080 mn (Kone Corporation, 2007).The corresponding figures for Cargotec in 2007 were €11,184 and 3,020 mn respectively(Cargotec, 2007). Figure 3 illustrates these dealings graphically.http://www.iutripura.edu.in/

Figure 3: Kone’s Acquisition of Partek and the Exercise of the Strategic Level RealOptions that Followed the Acquisition, 2002-2005

Value Inflow: €2,110-2,190 mnValue Outflow: €1,450 mn

2002 2003 2004 2005

Kone acquires Partek in2002Core business part ofPartek integrated to Koneas Kone Cargotec +€1,100 mn in cash

Kone Corp.(Lifts,

Escalators,Sliding Doors)

Partek:Acquisition

Price€1,450 mn

Cargotec(Hiab,

Kalmar,McGregor)

Kone demerges into KoneCorporation and Cargotec

Kone uses the possibilityto separate the companyinto two unitsKone divests non-coreparts of Partek

Paroc€70 mn

Addtek€60 mn

ForestryMachines€120 mn

Real Est.€30 mn

Valtra€600 mn

Nordkalk€270 mn

Kalmar€520-550

mn

Hiab€440-490

mn

Kone

McGregor(separate deal)


As a commentary of the dealings described above, we can observe that the strongconcentrated ownership of Kone, that had previous experiences in acquisitions, madeit possible to make quick and decisive moves on a strategic level—a momentum thatthe partly state-owned Partek did not have. In hindsight, it is clear that the benefitfrom these dealings to the original Kone shareholders was massive, with a value inflowof over €2,100 mn, vis-a-vis the acquisition costs of Partek (€1,450 mn). For theinternationalization and acquisition history of Kone, see Oksanen and Rilla (2006) andwww.kone.com (Kone’s homepage).

ConclusionThis paper has focused on strategy level real options in corporate acquisitions that areavailable for the acquiring companies. It has discussed the total value concept for valuingcompanies, in this case the acquisition targets, and shortly reviewed selected literature onreal options applied to corporate acquisitions. It has presented five strategic level realoptions in acquisitions, focusing on the process level options available to the acquirer, i.e.,the high level possibilities that the acquirer has to rearrange the target company. Further,the paper shortly presented each of the real options in more detail, with a discussion aboutthe available option value calculation methods and the input variable values. It has beennoted that of the presented strategic level options, synergies and the possibility to splita business are issues that have seldom been discussed within the options framework, andthese interestingly seem to be mirror images of one another—this is a novel approach.A case presentation was made to illustrate the different strategic level real options in reallife, about how Kone acquired Partek and consequently abandoned non-core parts ofPartek’s business, ending up demerging into two more specialized companies, Kone Corp.and Cargotec.

Real options is a growing field of research and there also seems to be a growing interestin modeling and analyzing real options connected to corporate mergers and acquisitions.The research has, so far, mostly concentrated on the single real options connected toM&A and it is believed that this is among the first to present a holistic view on thestrategic process level real options available in corporate acquisitions.

Obtaining data for calculating real option values may be tricky due to a number ofissues, of which one of the most important is the availability of data on the acquisitiontargets. This is especially true for cases where the target is a nonpublic company withlimited or no requirements for publicizing financial information. Even if the availabilityand quality of data for real option valuation (and numerical analysis in general) is a veryimportant issue, from the point of view of the credibility of analysis results, it is a fieldthat is most often not touched in the literature regarding real options. The importanceof discussing the sources of data and methods for the generation of input variable valuesin the numerical analysis of acquisition real options has been felt here.

This paper has also very shortly discussed the different models commonly available foranalyzing real options; in addition to the commonly used models, there are novel methods


that use fuzzy number inputs in numeric calculation. These methods have the advantageof being able to incorporate estimation inaccuracy present in the input variable values;also, the results from the available fuzzy methods are fuzzy numbers, i.e., the results includeinformation about the distribution of the possible results.

The presented acquisition case shows that the type of holistic analysis of corporateacquisitions that is presented in this paper is relevant from the point of view of acquisitionpractice, and can be used to support strategic planning of acquisitions. What the case alsoshows is that the existence of strategic level real options alone does not create value; forthe value of the available real options to be realized, the owner of the real options (e.g.,the acquiring company) must have the confidence and momentum to drive large changesthrough the organization that will constitute the successful exercise of process level realoptions.

All in all, it seems that when planning corporate acquisitions, it may be very relevantto think about and analyze the strategic acquisition process level real options available.This is because understanding the options and the value that they may bring to theacquisition can enhance the potential benefit from corporate acquisitions. Smart andresolute managers can optimize value by timing acquisitions and divestment, and createvalue by selecting acquisition targets that bring synergies, as has been defined in this paper.

Acknowledgment: The authors are presently working in a corporate strategy development project jointly

financed by a consortium of Finnish industry companies and the Finnish Technology Agency, Tekes.

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