Real Options and Hidden Leverage

Financial leverage is customarily measured by the ratio of debt to net assets or debt to enterprise value. These measures usually understate effective leverage, because corporate commitments to ongoing and future capital investments create hidden leverage that acts like debt, but does not appear on book balance sheets. Hidden leverage acts like debt in two important ways. First, it increases financial risk. The more hidden leverage, the more volatile are stock market returns. Second, failure to meet hidden‐leverage obligations is costly. Failure may mean loss of investment opportunities or other damage to the company's long‐term prospects and value. In the case of growth companies, the most important source of hidden leverage is options for future investment. Investment opportunities are real call options, where the underlying asset is a real (as distinct from a financial) asset. Suppose an energy company has a good greenfield site and the opportunity to build a petrochemical plant when and if the time is ripe. The future decision will depend on the spread between feedstock and product prices, on energy and transportation costs, and on the resolution of other uncertainties that will determine the plant's future NPV. Though the plant may never be constructed, the option to construct it is valuable now. Most companies also have real put options: opportunities to abandon assets. Abandonment options are generally more abundant in mature or declining industries. Starting with insight that real call options are equivalent to leveraged positions in the underlying asset, the authors use option pricing concepts to calculate the amounts of option leverage. They show why high‐growth companies like Apple are effectively far more leveraged than their GAAP accounting balance sheets would suggest. Such analysis helps explain why companies like Apple also keep so much cash and marketable securities on hand. Growth (call) options typically have negative debt capacity, which displaces explicit borrowing. Abandonment (put) options have positive debt capacity, which allows the company to borrow more than its assets in place would normally support. This can explain the high debt ratios in many LBOs. The authors explore other effects of hidden leverage. For example, standard procedures for estimating the weighted average cost of capital (WACC) will overestimate WACC for growth firms and underestimate it for mature firms with valuable abandonment options.