Managerial flexibility in strategic decisions embedded a real option because a good strategic activity creates value for a firm. For example, through mergers and acquisitions or spin-off activities, managers can adjust the scale or scope of their firms based on future market expectations. The embedded managerial option value (later denotes as MOV) can be elevated by good strategic decisions and good timing. However, even under ideal conditions, a high MOV does not necessarily improve a firm’s credit. According to Merton’s (1974) framework, a firm’s credit risk is determined by its asset value distribution and default threshold.
A positive MOV increases the mean X of a firm’s asset value distribution, but has different impacts on the volatility of the X distribution based on types of strategic activities. Few studies have examined these specific areas, and therefore, this study investigates the relationships between MOV, timing (cyclicality), and the firm’s credit risk. This study asks the following research questions: First, is MOV affected by the business cycle? Second, is a firm’s credit risk affected by cyclicality? Third, does MOV influence a firm’s credit risk? And finally, do focused type and diversified type strategic activities have different effects on a firm’s credit risk?
hen examining strategic timing, Nelson (1959) suggested that stock market valuation is a key driver for merger expansion. Maksimovic and Philips (2001) suggested that M&A activities take place in waves during periods of economic expansion. These studies imply that a close relationship exists between merger activities and business cycles. To calculate the MOV for examining this relationship, this study employs the intrinsic valuation approach suggested by Liao and Chen (2005). This approach estimates a firm’s value by its future free cash flows.
A firm’s free cash flow is directly related to its operating performance, and operating performance in turn is affected by both management policies and industrial cycles. As such, a firm’s free cash flows are closely linked to changes in the industrial economy. This study uses the growth rate of a firm’s sales, industrial shipments, and GDP as proxies for corporate, industrial, and macroeconomic cycles respectively. This study also examines the effects of managerial timing on the value created by strategic activities.
Previous studies address the relationship between cyclicality and a firm’s credit risk. Kooperman and Lucas (2003) used 1933–1997 U.S. data on real GDP, credit spreads, and business failure rates to investigate this issue. They found a negative relationship between GDP and credit spread, and between GDP and a firms’ failure rate. Couderc and Renault (2003) suggested that changes in default intensity cannot be solely attributed to financial variables such as equity returns, equity return volatility, or interest rates, but also include the business cycle and the specific behavior of credit markets. Moreover, Hackbarth et al. (2006) and Carling et al. (2007) incorporate the cyclical effect on credit risk modeling. This study re-examines the relationship between business cycle and the credit risk. To implement the investigation, a firm’s default probability is first estimated using Liao, Chen and Lu (2006)’s approach as the proxy of a firm’s credit risk, and then this study investigates whether or not this is affected by cycles.
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Managerial Option Value, Cyclicality and Credit Risk
