In Practice: Valuing Financial Flexibility as an Option

If we assume unlimited and costless access to capital markets, a firm will always be able to fund a good project by raising new capital. If, on the other hand, we assume that there are internal or external constraints on raising new capital, financial flexibility can be valuable. To value this flexibility as an option, assume that a firm has expectations about how much it will need to reinvest in future periods based on its own past history and current conditions in the industry. Assume also that a firm has expectations about how much it can raise from internal funds and its normal access to capital markets in future periods. There is uncertainty about future reinvestment needs; for simplicity, we will assume that the capacity to generate funds is known with certainty to the firm. The advantage (and value) of having excess debt capacity or large cash balances is that the firm can meet any reinvestment needs, in excess of funds available, using its debt capacity. The payoff from these projects, however, comes from the excess returns the firm expects to make on them.

With this framework, we can specify the types of firms that will value financial flexibility the most.

a. Access to capital markets: Firms with limited access to capital markets-private business, emerging market companies, and small market cap companies-should value financial flexibility more that those with wider access to capital.

b. Project quality: The value of financial flexibility accrues not just from the fact that excess debt capacity can be used to fund projects  but from the excess returns that these projects earn. Firms in mature and competitive businesses, where excess returns are close to  zero, should value financial flexibility less than firms with substantial competitive advantages and high excess returns.

c. Uncertainty about future investment needs: Firms that can forecast their reinvestment needs with certainty do not need to maintain excess debt capacity because they can plan to raise capital well in advance. Firms in volatile businesses where investment needs  can  shift dramatically from period to period will value financial flexibilitymore.

The bottom line is that firms that value financial flexibility more should be given more leeway to operate with debt ratios below their theoretical optimal debt ratios (where the cost of capital is minimized). Using the same logic, firms should value financial flexibility more in periods of market crisis than when markets are buoyant and functioning well.