Cephalon, Inc. Taking Risk Management Theory Seriously
48 Pages Posted: 30 Nov 2000
Date Written: April 2000
We study a firm that justifies its novel use of equity derivatives as a cash-flow hedging strategy. Our purpose is to understand the challenge of translating risk management theory into managerial action. Cephalon Inc., a biotech firm, bought a large block of call options on its own stock. If the FDA approved the firm's new drug, the firm would have large cash needs, which the options were designed to meet. We analyze this stated rationale for the firm's choice, applying the cash flow hedging concepts articulated by Froot, Scharfstein and Stein (1993). In applying the theory to practice, there are lessons for both managers and theorists. Managers consider deadweight costs of financing and of risk management, whereas theory tends to ignore the latter costs. While theory is driven by costs of external financing, managers must measure these costs to arrive at decisions and this measurement problem is severe. Cephalon's risk management decisions seem motivated as much by fluctuations in the availability and cost of external financing and by accounting considerations as by fluctuations in operating cash flows or desired investment. Finally, even a field-based examination of this strategy cannot reject the conclusion that the transaction was motivated by goals other than risk management.
There is an accompanying case study that can used in the classroom if the instructor wants to present the students with the facts without the interpretation given in the paper. This case study is entitled Cephalon, Inc and is available from HBS Publishing (9-298-116). The paper listed here is essentially an expanded teaching note for the case. In the classroom, the teaching modules are (1) What is the risk that Cephalon faces and why is it material to the firm? (2) What are the alternatives facing the firm? (3) How do the proposed option transaction work? (4) Is it apparently a "fair" deal? and finally (5) What would you recommend Cephalon do? Why? The paper deals with these issues in some detail. In the classroom, issue (4) can be used to teach about the valuation of equity derivatives with jumps. While we construct an elaborate model in the paper, instructors can have students value the options with simpler binomial tree structures with a jump corresponding to the FDA decision.
JEL Classification: G31, G32, G39
Suggested Citation: Suggested Citation