Measuring Growth Opportunities
University of Edinburgh Business School
Ian R. C. Hirst
Edward A.E. Jones
Heriot-Watt University, Edinburgh
Applied Financial Economics
Although the impact of growth opportunities on company value has been recognised since Miller and Modigliani (1961), relatively little empirical work has been undertaken to value growth opportunities. In this paper we test the validity of the KBM model (Kester (1984) and Brealey and Myers (1981)) on a sample of 278 large UK companies for 1987-1995. Applying standard assumptions, we find the value of growth opportunities to account for a larger proportion of market values than assets-in-place. However, tests of the KBM model cast doubt on the credibility of these results and the validity of the model. The KBM model is highly sensitive to the inclusion of inflation in the risk free interest rate, and with a real interest rate (which on theoretical grounds is preferable), the model ceases to provide credible results. The model also fails to provide results consistent with expectations derived from option pricing theory regarding the relationship between the value of growth opportunities and the value of assets-in-place. These limitations of the KBM model indicate a need for a reappraisal of the method of measuring the value of growth opportunities.
JEL Classification: G30, G12Accepted Paper Series
Date posted: October 23, 2000
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