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The market interest rate is the rate of exchange between present and future resources. Any
transaction that a participant might make by borrowing or lending at the market interest
rate of interest will produce a result that lies on the Financial Exchange Line.
CF(1) = CF(0) (1 + I)
Present Value
Present Value is defined as the amount of money you must invest or lend at the present
time so as to end up with a paticular amount of money in the future. Present value is also
an accurate representation of what the market does when it sets a price on a financial
asset.
The present value of all present and future resources (cash flows) is known as present
wealth. It is a useful benchmark or standard to judge whether an individual will be better
or worse off when undertaking a proposed financial decision.
One cannot change present wealth merely bey transacting at the market rate. Borrowing
and lending at this rates simply moves you up and down the exchange line--so it impacts
only time allocation. (Only investing in real assets can increase present wealth. This
produuces a parallel shift in the financial exchange line.)
The amount of parallel shift in the exchange line can be calculated using the present value
equation.
PV = CF(0) + CF(1)
(1 + i)
The number produced by this expression is exactly equal to the change in present wealth.
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PV = CF(2)
(1 + I(2))^2
Compound Interest
Continuous Compounding
CF(0) x (e^it)
Finding IRR in these situations is more complicated, but still is found by setting NPV = 0,
and solving for discount rate. Usually found with good calculator, or by trial and error.
Math Summary:
PV = CF(t)
(1+ i(t))^t
From t=1 to T. Reduces to 1+i when the discount rate is the same across all periods.
Helpful when calculating far off periods. Find interest rate, and period. Multiply times
actual amount.
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Perpetuity
PV = CF
i
PV = CF
(i - g)
Where g is the constant per period growth rate of the cash flow.
The relationship between spot rates (those which begin at the present, and run to some
future point), forward rates (rates that begin at some point in the future), and and YTM
(yield to maturity--the IRR of a bond’s promised cash flows, total yield given term
structure and rates), can be seen as follows:
Spot Rates:
Forward Rates:
YTM:
Summarizing:
Example:
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2f(3)= 9%
Bond YTM
Yield’s can be different even if discount rates are the same due to the coupon effect on the
yield to maturity--that is, cash flow amounts that occur in different spot rate periods ipact
the yield. YTM’s reflect not only rates, but amounts invested.
Financial markets allow you to guard against the risk of an interest rate change giving your
investment a negative NPV (whereas formerly, it was positive). One tactice would be to
sell an interest rate futures contract in the aproximate amounts and timings of the cash
inflows of the project.
Example:
i(1) = 10%
i(2) = 11%
(1 + 1f(2)) = (1.11)^2/(1.10)
1f(2) = 12.0009%
Suppose the 1f(2) rate changes to 15%. Then, by plugging this into the equation above,
i(2) becomes 12.4722%. By doing an NPV, we get
=- $.40
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The positive NPV became negative due to the change in interest rates. You could hedge by
selling a $1000 futures contract at a forward interest rate of 12.009%. (if the forward rate
increases, the price of your security will decline, but, since you have a contract to sell at a
higher price, the value of your contract will increase. The increase offsets the NPV of your
investment.
= $1000/1.12009 = $892.79
If forward rates gor to 15, then price of the cash flow is 1000/1.15=869.57. You sold at a
higher price, so your investment value increases by 892-869=21.11, offsetting the NPV
decrease.
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Corporate Equity:
1) A residual claim
2) Limited Liability
3) No contract as in bondholders, but have rights to all leftover resources
Key Points :
Regardless of who pays the initial outlay (retained earnings from forgone dividends or
issueing new shares), the NPV of the investment stays the same regardless.
If an investment is undertaken by borrowing, the NPV does not change as in the case of an
all equity company.
1) The P/E ratio is nothing more nor less than the ratio between the present value of all the
company’s future dividends (its market price), and its expected earnings during the first
period.
2) A company’s P/E ratio is a very complex number in terms of information that can
influence it. It is affected by the pattern of dividends that a company pays, its payout ratio,
the riskiness of the company as evidenced by the discount rate of its equity, and the stream
of earnings that the company is expected to be able to generate across the future.
3) For certain companies with very simple cash flow patterns (such as constant or constant
growth perpetuities) we can derive a specific relationship between P/E ratios and equity
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discount rates. But for most companies, the relationship is much too complex to make
numerical estimation worthwhile.
4) If we are careful, we could use the P/E ratios for example, to:
a) Infer that expected future growth rates for dividends and earnings will be above average
of other companies within the same industry.
b) Other
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Financial cash flows are the cash amounts that are expected to occur at the times for
which the expectations are recorded. They are not to be confused with accounting
numbers.
FCF-’Free Cash Flow’: The amounts of cash that can be taken by capital suppliers from
the company as a result of the investment while leaving all of the plans of the company
intact.
Conclusions to Module 3
1) Investment NPV is correctly calculated by discounting to the present all of the changes
that will occur in the cash flows of the corporation as a whole, were it to accept the
project. The net of the amounts is called the free cash flow.
2) These corporate cash flows can be conveniently depicted at one level of generality by
listing all of the outside groups with whom the corporation transacts.
3) Free cash flow is defined as the net amounts of cash that the company could pay to its
capital suppliers from the proceeds of the project at each time point, and not upset the
expectations associated with the project. This essentially means that free cash flow is the
amounts that are expected to be left over or ‘residual’ after all commitments and contracts
other than those to capital suppliers have been satsified according to the market’s
expectations.
4) Cash flows are not the same as the numbers that appear in financial statements of
corporations. Included in items such as Revenues and Expenses are non-cash items that
cause accounting numbers to differ from cash flows (changes in debtors or accounts
receiveable, and creditors or accounts payable , and depreciation, are examples.). There
are also certain cash flows that are not included in accounting figures at the times when
they occur (such as outlays for depreicable assets, and collections of receivables and
payment of payables.) If accounting data are to be used as the basis for cash flow
estimates, all necessary adjustments must be made to result in cash flow estiamtes at each
time point of the investment.
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Overall Rate=
Debt Market Rate x Debt Required Rate + Equity Market Value x Equity Required Rate
Total Market Value Total Market Value
Debt Cost is debt’s required rate multiplied by the complement of the project’s corporate
income tax rate. (In other words, the after tax effective cost of debt given the interest tax
shields.)
WACC is used when the proportions of debt and equity can be determined.
WACC-NPV
NPV(0) = FCF(t) *
(1 + rv*)^t
Where:
D (rd*) + E (re)
V V
Where:
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FCF(t) * = Unleveraged (ungeared) free cash flow: the amount of free cash flow that the
company is expected to generate at time t due to the project not including interest tax
shields.
rd* = Cost of debt as a rate to the investment; equal to rd x (1-T(c)),
rd = Required return on the debt of the investment
re = Required return on equity of the investment
D = Market value of debt
E = Market value of the equity
V = Market value of the investment
APV- When amounts of debt that projects will use are known--but not proportions.
Method:
Where:
from t=0 to n,
FCF*(t) = Unleveraged (ungeared) free cash flow: the amount of free cash flow that the
company is expected to generate at time t due to the project not including interest tax
shields.
ru = All-equity or unleveraged (ungeared) required return on investment; the rate that
would be required on the investment were it to be financed purely with equity.
rd = The required return on the debt of the investmen
ITS = Interest tax shield cash flow: the reduction in corporate income taxes at time t
caused by interest deductibility of the debt issued for the investment. Equal to interest cash
flow x coporate tax rate.
Summary:
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When estimating cash flows, its important to work the procedures in the correct order, so
one procedure isn’t interrupted for another.
Note: Straight line depreciation involves equal amounts for each year. Salvage value is
registered in year asset is liquidated.
Sales Revenue
Other Revenue
Subtotal
Direct Expense
Labor
Other
Management
Marketing
Subtotal
Depreciation
Subtotal
Total Expense
Profit Before Tax (Total Revenue Less Total Expense)
Less Taxes
Total Income
Accounts Receivable
Accounts Payable
Cash and Inventories
Note:
a) Add these together, but they should be noted as negative changes to net working
capital.
b) Don’t forget total liquidation value at final period. This is a positive entry.
Sales Revenue
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(Generally, all of the above are subtracted from sales revenues, except possible liquidation
pluses in the final period.)
Summary
1) Include all changes that will occur in the cash flows of the corporation were it to accept
the project, at the time points when those cash flow changes are expected to take place.
Those cash flows comprise all transactions that the corporation would undertake with
suppliers of labor and management skills, with suppliers of materials and assets, and with
government. Operational opportunity costs are legitimately included in a projects cash
flows, but cash flows to and from capital suppliers are not.
2) When the cash flows are being estiamted for an NPV or an IRR analysis, it is not
necessary to estimate the interest tax shields for the project: the cash flows are ‘all-equity’
flows. When an APV analysis is to be done, interest tax shields must also be estimated,
based upon the debt issued to finance the project.
Important Notes:
1) Cash inflow timing is often different from that reflected in accounting records
2) Cash outflows for apital outlays etc. follow a pattern different from accounting records.
3) The accounting expenses for overhead, depreciation, and interest generally differed
from cash flows, but had cash flow implications.
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There are several alternatives to the NPV advocated by the business world. It can be
demonstrated that NPV is superior to all.
NPV Alternatives
Problems:
1) Ignores all cash flows beyond the minimal acceptable payback period.
2) It does not discount cash flows during the minimum acceptable period--so inconsistent
with investor opportunity costs.
where rv* is the weighted average cost of capital and n is the number of periods in the
project’s total lifetime. Accurate only for fairly constant cash flows.
Dividing expected accounting profits by net book value (depreciated value). These
numbers are added together, divided by number of periods, and compared to standard.
Problems:
IRR can be used to compare projects with the incremental cash flow analysis. Follow the
steps below to use this method:
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1) If you have a lot of projects to pick from, think of them as being in a pot, and pick any
two from the pot.
2) Find the one that has the highest net positive cash flow total (the simple sum of all its
FCF*’s, which can be thought of as an NPV calculated with a discount rate of 0. Call the
project with the highest net positive cash low total “the defender”, call the other one the
challenger.
3) At each time point, subtract the cash flows of the challenger from those of the defender,
and call the resulting stream the ‘incremental cash flows’.
5) If the IRR of the incremental cash flows is greater than the appropriate hurdle rate,
keep the defender, and throw out the challenger. If the IRR of the incremental cash flows
is less than the appropriate hurdle rate, keep the challenger, and throw out the defender.
6) Omitting the thrown out projects and keep the survivor--keep goin until there’s only
one left. That’s the winner.
7) Calculate the IRR of the winner. If it exceeds the hurdle rate, accept the winner, if
lower, all in the pot get rejected.
Inflows
CBR= (1 + rj)^t
Outflows
( 1 + rj)^t
PI= FCF*t
(1 + rv)^t
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-FCF*(0)
PI>1 OK
< 1 Reject
The PI is used only when the present cash flow FCF*(0) is a net outlay.
Because it is a ratio, has same problem as CBR--displays “wealth increase per dollar of
initial outlay” instead of net total wealth increase.
Capital Rationing.
All calculations up to now assume that there is enough money available to pursue all
projects. How to decide on investment projects when capital is limited?
Renewable Investments
Some company investments have different renewal cycles. How to compare ‘apples to
apples’?
This procedure converts actual cash flows associated with each investment to a constant
annuity cash outlay.
Inflation
Be sure you are consistent when using “real” & “nominal” rates.
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The securities market line (SML) describes the relationship between risk and return.
Risk is best measured by the standard deviation of rates of return on the entire portfolio of
assets.
Example:
The mean,(average expected return), is found by multiplying the individual rates of return
by the probabilities, and summing. In this case, the mean is .12125 or 12.125%.
Found by squaring the difference between the mean, and individual returns, muliplying
times the probability of the individual return, and summing:
_________________
SD= (ir - bar x)^2 * Pn from 1 to n
SD=
(.085 - .12125)^2 * .35 = .00045992
(.11 - .12125)^2 * .1 = .00001266
(.135 - .12125)^2 * .3 = .00005672
(.16 -.12125)^2 * .25 = .00037539
Problem: The SD of return has not proven to be a valid indicator of performance. It has
little empirical validity.
The positive relationship between risk and return is only true for entire portfolio, not
individual assets within it. (Reason: part of the SD for individual assets is “diversified
away”).
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Can not use the weighted average standard deviation of return of individual assets--must
use “joint probability distribution”
Examples:
Asset B Returns
7% 12%
.65 .35
Probability is higher for one asset returning low, while another is returning high.
Average SD was wrong because it ignored interaction of returns. Can deal directly with
this issue by handling the interrelatedness of asset returns via the correlation coefficient.
Main lesson: Portfolio risk is not the same as average individual security risk.
Actual Measure:
Typical Measure:
The market only compensates for undiversifiable risks, therefore, correct measure of risk
is that which exists after diversification. How much compensation?
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Summary:
1) The total risk of an individual asset or security can be separated into two types of risk,
that which can be diversified away, and that which cannot.
2) The risk that cannot be diversified away is related to an underlying ‘market factor’ that
is common to all assets and securities, and is thus a common correlation limiting the
amount of risk reduction through diversification that is possible by including a security in
the portfolio.
3) This undiversifiable or systematic risk can be measured by the coefficient (SD times
correlation with the market) of the security in question.
4) If the financial market sets securities’ returns based upon their risks when held in well
diversified portfolios, systematic risk will be the appropriate measure of risk for individual
assets and securities, and the SML as depicted in Fig. 7.6 and formula 7.1 will dictate the
set of risk adjusted returns available in the market.
5) These SML-based returns are the opportunity costs of capital suppliers of companies,
and thus can form the basis for evaluating internal company investments. These
investments must offer retuns in excess of capital supplier’ opportunity costs in order to be
acceptible.
The Capital Asset Pricing Model, or security market line, the system which generates
required rates of return based upon the riskiness of assets
.
WACC should not generally be used as an investment criteria. It will only give a correct
answer when the investments risk is the same as the average risk of the entire company.
(For example the WACC is in fact an average of the risk adjusted rates of return of the
company’s various asset risks--it includes mix of both high and low risks.)
Finding Beta:
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The ungeared beta is found by the above formula. This is the beta that would exist if the
company had no debt outstanding.
Now the beta of the equity of the project can be found by the formula given above:
u =e E/V + d D/V: The idea here is to plug in the ungear beta numbre for the project,
the proportions of debt and equity, and the given beta of the debt to solve for beat of the
equity.
5) At step 4, we have the required return for equity, but if project is also financed with
debt, so we need to find the WACC for the project (rv*)
6) Find E(rd) by plugging in the beta for the debt in the SML equation from step four.
(Equation is same, just use debt beta instead of equity beta.)
7) Apply the effect of interest tax shields to debt’s required return to find the true cost of
debt (rd*).
8) Now we know (rv*) ,(rd*), and thr proportions of debt and equity for the project, so
we can now calculate the WACC for the project.
Certainty Equivalents
How much money would I agree to accept in the futurefor certain in exchange for a risky
cash flow?
Where
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Var.(rm) = the variance (the squared SD) of the market return, and
Cov. (CF,rm) = x the variance of the market return
What we are doing here is subtracting out from a risky cash flow an adjustment for
systematic risk.
Remember: you are to receive this cash flow in the future (t1), so don’t forget to discount
one period.
Summary:
2) Capital suppliers require higher returns for bearing higher risks, but the risk they bear is
only that which is undiversifiable.
3) The market prices securities as if they were held in well diversified portfolios.
4) The pricing process of financial markets is captured in the SML equation which is a
function of beta.
5) The SML relationship can be used to estimate the appropriate risk-adjusted discount
rates for company investment projects.
6) The WACC can be used for an investment project only if the project is similar to the
company WACC.
7) If the investment differs from the company, a project specifc WACC can be found by
using a beta of another company consistent with the risk and activities of the project under
consideration.
8) If there is no beta available to be observed for the investment, the beta must be
artificially constructed. This process uses a bench mark beta adjusted for various gearing
ratios.
10) Analyses are more complicated for cash flows who’s risk are not constant across time.
Change in risk across time must be accounted for.
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2) When the effect of company financial decisions upon shareholder’s portfolios can be
undone by offsetting actions of shareholders, the company financial decision is irrelevant.
3) A company’s dividend change is the substitutability of capital gains (i.e. share value
increases) when the dividend is reduced, for cash when the dividend is paid.
4) One argument for dividends is the “bird in the hand” argument. Capital gains are
uncertain, current dividends are not. However, uncertainty has a price, and its price is
factored into the price of the shares.
5) Shareholders may prefer one dividend policy over another due to transaction costs. (i.e.
those who prefer cash incur costs in selling shares.)
6) Dividends are taxable, so some shareholders may prefer capital gains over dividends. (in
the UK, this is sometimes alleviated by various tax policies)
8) One optimal dividend policy is would be to find all investments with positive NPV’s,
retain enough cash to undertake the investments, only raise new equity capital when
internally generated funds are insufficient, and pay any remaingin cash out as dividends.
(the passive residual dividend policy).
9) Given different clienteles seeking to add shares into their portfolio of companies with
particular dividend philosphies, and many different companies serving different interests,
there is nothing to be gained by changing dividend policy.
10) Companies are restricted as to what information they can release to the market.
Dividends play a role in signalling messages to investors.
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Argument #1: Debt is more expensive than equity in a company’s capital structure
because debt carries required interest payments whereas equity does not.”
False: Equity requires shareholder returns, no less a cost of capital than interest payments.
Argument #2: Equity’s returns must be higher than debts’ because equity’s claims are
residual, so their risk is higher. Because risk higher, returns are higher, so equity is more
expensive than debt.”
False: This argument ignores important interactions within the set of a company’s required
capital returns
Debt renders more risky its capital claims--therefore, it could be said that the gains that are
had from issueing low interest debt might well be offset by increases in in the risk and
attendant returns required by shareholders.
3) Since debt is first in line, debt amplifies the variability of return. The terms “gearing” or
“leverage” is a description of this amplification of variability idea. See example below:
Ungeared Company
Geared Company
This type of risk is called financial risk to distinguish from business operating risk.
M&M argue that it would make no difference to shareholder wealth whether the
companies borrowed money or not. Financial markets would ensure that this is so.
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What happens to the wealth of shareholders when the companies capital structure is
altered by borrowing?
Summary:
Market prices must adjust to cause all equivalent future cash flows sold in whatever form
as single securities or as portfolios of holdings to sell for the same price.
Because interest payments are generally deductible in some fashion, and directly benefit
shareholders, it would seem obvious that companies would make use of this benefit, and
tend to be financed by debt.
For one thing, companies can take many types of write offs--including depreciation. So,
companies could in effect show no income (due to heavy depreciation write offs), and
therefore pay no taxes. So why then borow?
Also, the amount of income a company will earn is uncertain, however, the amount of
interest payments is fixed, making borrowing undesirable.
Agency problems deal with issues such as conflicts of interest among principals or
angents. For instance, lenders wish to ensure that borrowers don’t do things that make
their returns more risky. (Like borrowing in order to undertake one investment, and
instead doing another.)
How to resolve: Lender Covenants, other arrangments such as complex debt contracts.
A positive covenant is the convertibility provision which some debt claims carry.
(Meaning, under certain conditions, bonds can be exchanged for shares.)
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Default
Debentures: debt collateralized by the overal assets and cash flow of the company.
1) Use cash flow simulations to obtain worst case view where the existence of borrowing
might lead to financial distress.
3) If simulations indicate that borrowing tax benefits simply replace other tax benefits,
then little reason to borrow.
4) If the company’s value is largely in tangible assets, more borrowing is sustainable than if
the same value is dependent upon intangibles (like future profitability of investments not
yet undertaken, or skill skill of managers to find new opportunities). Industry gearing
ratios are useful to see the amounts of borrowing which other similar companies have been
able to sustain.
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6) There are reasons why companies would choose to avoid new equity issuances (loss of
ownership and control) and such considerations outweigh negative aspects of borrowing.
7) When a tentative conclusion is reached, see if the result is inconsistent with the capital
structures of other companies in the same line of business.
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A company’s ‘working capital’ is its short term investments in cash, marketable securities,
receivables (debtors), and short term financings. Because of the short term nature of these
assets and financings, an entirely different set of financial mangement techniques is used in
dealing with them.
Assets
Financings
Use maturity matching using the rule of thumb, “finance short term assets with short term
liabilities and long term assets with long term liabilities”
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In idealized sawtooth waveform representing use of cash down to some minimal amount,
and then replenishing with bulk amount, use this formula:
where:
r is the optimal amount of cash replenishment
D is the total amount spent by the firm
i is interest foregone due to liquidity of asset
T is transaction costs
$R = [(3 x $T x s^2)/4i]^1/3
s^2 is the variance of the changes in the cash balances from the probability distribution
described earlier.
s^2 = $c^2 x t
$U = $M + 3($R - $M)
Management of Receivables
Accounts Receivable
Expected Profit = Number of good customers x Profit per customer + Number of Bad
Customers x Loss per customer
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Expected Profit = Number of good customers x Profit per customer + Number of bad
customres x Loss per customer - Costs of credit analyses
Example:
$1,206.30
In aggregregate, short term financing is best considered a function of two phenomena, the
company’s line of business, and maturity matching with short term assets.
Question: Should you pay early, and take a vendor discount? Or pay on time with no
discount?
.02 x 365
1-.02 20
i = ( 1 + 365/20 )^365/20 -1 = 44.58%
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Not a good deal. Better to borrow if you have to, and take the discount.
Cash Budgeting
Short term financial management is best pursued within the context of a company’s cash
budgeting. Cash budgeting is the setting forth of the company’s expectations for its
inflows and outflows of cash over some future time period, usually near term.
2) The optimal setting of policies for such decisions, so that each of these small decisions
is almost automatically determined by the company’s well considered policy.
Liquidity Ratios
Current Ratio
Cach and assets expected to turn into cash during the current year--liabilities to be paid
during the current year.
Backing inventory out of assets is a more rigorous test of company’s ability to pay
obligations.
Profitability Ratios
Profit Margin
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Debt Ratio
Note: Total debt would include deferred taxation, current liabilities, loans, investment
grants
Efficiency Ratios
Inventory Turnover
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Firms deal with exchange rates between currencies of different countries when buying or
selling to different countries. Exchange rates fluctuate over time, firms must deal with this
risk.
Other concerns involve determining the location, security, and currency in which to
borrow. Finannly, government controls and subsidies.
Exchange rates bear the relationship to each other that they do due to purchase power
parity and the law of one price.
Interest rates preserve wealth across time, exchange rates preserve wealth across borders.
The following is an example of spot and forward rates between pounds and dollars:
Dollar/Pound Pound/Dollar
Spot 1.5960 .6266
180 Day Forward 1.5780 .6337
1) A UK firm wants to sell product in July 87 in the US, and not receive payment in dollars
until Jan 88.
2) To avoid uncertainty, the firm can buy sterling forward at .6337 per dollar buy entering
into a forward exchange contract.
3) If amount is 100k, the firm would receive 63,370 sterling six months hence.
a) borrowing dollars today at the six months interest rate in the US, and exchange these
dollars for sterling at the existing exchange rate,
b) calculate exactly how many dollars it can borrow so as to pay off the dollar loan with
the dollars expected from collecting receivables six months hence,
c) Formula is:
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Cash proceeds are exactly the same as the forward interest rate. This is a necessity due to
interest rate parity. Interest rate parity in forward exchange markets is similar to
purchasing power parity in spot markets.
Bottom line is that interest rate differentials between countries are caused by inflation
differentials between countries.
1) Buying a forward exchange option: Has benefits, but also costs associated with it.
2) Investing in Foreign Real Assets
Real assets in foreign locations tend to increase in value as inflation increases, monetary
assets do not.
Don’t overlook other investment risks, such as takeover by foreign governments. Agency
theory helps correct for this--by building automatic and irreversible counter-incentives.
Assume all parties will act in their own best interests, so structure the deal accordingly.
Companies need not expose themselves to serious risks due to exchange fluctuations,
they should hedge. Also, be careful to ake into account inflation and exchange rate biases
in reporting from foreign subsidiaries.
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Option Characteristics
Options are properly termed “contingent claims” because their value depends upon the
value outcome of some underlying asset.
Call Option
Allows you to purchase (‘call’) another security or asset at a fixed price at a fixed time.
Summary:
1) You own a call option for 100 shares at $1.25/share between now and the end of the
year..
2) $1.25 is the strike price.
3) Shares are the underlying assets.
4) The last time you can exercise is the expiration date.
Suppose the stock is trading now at $1.50 per share. You can now exercise the call.
1) You pocket $25 (difference between 100 x $1.25 & 100 x 1.50) less price of option.
2) When an option can be exercised profitably, it is said to be in the money, when it
cannot, it is out of the money.
Note: Remember-Options are optional. Futures contracts are not. The pruchaser of a
futures contract is forced to complete the transaction, even if its detrimental.
Exercise Time
Options Valuation
The market value of the option is always somewhat higher than the market value of the
asset itself. (The ‘premium’ of the option.) Even when the market value is zero, the option
is higher than zero. Though immediate excersize nets you nothing, event excersize could
net you something.
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So = $1.50
The payoff is Cu 2.40 -1.25 = 1.15 at a strike price of 1.25 when the security price is up,
and 0 when its down. Your chances are Cd 60% of hitting, and 40% missing it. So what is
your option worth?
The law of one price says that two portfolios with the same financial performance are
priced the same. So, we find the value of the call option by constructing a portfolio with
the same performance. This portfolio must have payoffs equal to Cu and Cd with the same
liklihoods as those of the option.
Also:
rf = the risk free interest rate (either borrowing or lending) for the period of the option;
assume this is 10%.
Y = the number of underlying shares to puchase (or negative to sell short)
Z = the amount lending (if positive) or borrowing (if negative) at the risk free rate
So-
Cu = YuSo + Z(1+rf)
Cd = YdSo + Z(1+rf)
Then:
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This means that if you purhase .7666 of a share of the underlying asset, and at the same
time, borrow .62727, you will have the same future cash flow expectations.
Then Yso + Z = .766(1.5) -.62727 = .5227 this is the market value of the option.
1) The binomial model deals only with two possible security values. A realistic model must
allow for many possible prices.
2) Instead of putting in multiple prices, the model can be made to deal with multiple
periods.
This model is conceptually simple, but numerical complexity would render it inefficient.
Black & Scholes reformulated the binomial model and made it continuous.
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eMBA – Finance 2003-06
Consider the equity of a firm with debt in its capital stucture. This equity is actually a call
option: if interest and principal are paid to creditors, shareholders own the underlying
assets of the firm; if interest and principal are defaulted, creditors will end up with the
assets.
1) The ratio of underlying asset value to excersize price. (So/X). For the option held as
equity by shareholders, the underlying asset value is the total value of the company’s
assets, and the strike price is the interest and principal promises to creditors.
2) If the ratio is high (in the money), implies low debt. If low, a highly geared company.
Agency
Agency solutions:
Bondholders can issue call provisions on the bond to solve agency problems.
Convertible bonds: bonds can be converted into shares to take advantage of equity
increase over debt should equity take on riskier investment than agreed upon. Convertible
bond problems can be solved using binomial option valulation equations.
In any case, the value of the convertible bond will be the same regardless of high or low
risk investment--and their will be no incentive to take one over the other.
m = So(u-d)
Cu-Cd
m is the hedge ratio, it tells you how many call options to write for every one share held.
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eMBA – Finance 2003-06
Then:
So-mCo=X
Call option Co = X/So-m
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