Valuing Contingent Consideration Using Option Pricing

Dwight Grant

doi:10.5791/BVR-D-11-00016.1

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Article Contents

Abstract
Introduction
Two Types of Contingent Consideration with Different Risks
Basic Valuation
Valuing Contingent Considerations as Real Options
Required Rates of Return on Options
Valuation Challenges and Solutions
Challenges in Adopting the Real Options Approach
Conclusion
Appendix

Editorial Type:

Article Category: Research Article

Online Publication Date: 01 Dec 2011

Valuing Contingent Consideration Using Option Pricing

PhD

Page Range: 121 – 131

DOI: 10.5791/BVR-D-11-00016.1

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Abstract

When SFAS 141R went into effect in 2009, it introduced the requirement that buyers report the fair value of contingent consideration at the acquisition date and, in the case of asset or liability classified contingent consideration, at each reporting date. Valuing contingent consideration can be difficult. This article explores those difficulties and proposes an approach that we have found effective.

Figure 1

First-Year Cash Flow above the Contingent Consideration Threshold (millions)

Figure 2

Required Rates of Return on Call Options for Different Strike Prices: Stock Price = $20, Holding Period = 1 Year, Risk-Free Rate = 2%, Volatility = 30%

Contributor Notes

Dwight Grant is managing director in the Financial Analytics & Derivatives practice at PwC, based in San Francisco. He received a BA in economics from the University of Western Ontario and an MBA and PhD in finance from the Wharton School at the University of Pennsylvania.