Assignment

Corporate FinanceOUpm006

Tutor: Miss Ayushi Rama

Name of student: NALLAN

KRISTEN

ID Number: 201300314
Course: MBA Specialization Financial Risk
Management cohort 3

Contents
PART 1........................................................................................................................ 1
1.1

Definition of an OPTION contract...........................................................................................1

1.4 Terminologies of option:..................................................................................................................1

1.5 There are 2 types of options:...........................................................................................................1
1.6 Difference between Bullish and Bearish.........................................................................................2
1.7 Factors Affecting Options Prices....................................................................................................2
Call option.................................................................................................................. 3
2. Definition of call option.....................................................................................................................3
A Simple understanding of a call option..............................................................................................3
2.1 From Buyer point of view....................................................................................... 3
2.2 From Seller point of view........................................................................................ 3
2.3 Profit of a Purchased call........................................................................................ 4
2.4 Payoff / Profit of a written (Seller) call option..............................................................6
Put Options.................................................................................................................... 7
3. Definition of Put option.....................................................................................................................7
3.1 Payoff of put........................................................................................................ 7
3.2 Profit of put option..........................................................................................................................8
3.3 Profit of the buyer............................................................................................................................9
4. Put Call parity...............................................................................................................................10
5. Conclusion........................................................................................................................................10
Part 2........................................................................................................................ 11
1.

(a) Ratio Analysis................................................................................................... 11

2.

(b) Analysis of financial and profitability....................................................................13

(i)

Profitability..................................................................................................................................13

(ii)

Leverage...................................................................................................................................15

(iii)

Liquidity...................................................................................................................................16

(iv)

Conclusion................................................................................................................................16

References............................................................................................................................................17

PART 1
Using examples, explain the concepts of '' Options''?
1.1 Definition of an OPTION contract

An OPTION contract is an agreement in which a seller (writer) conveys to a buyer (holder) of a

contract the right, but not the obligation, to buy or sell a specific quantity of something at a
specified price on or before a specified date The option writer has the obligation to fulfill his side
of the contract if the option holder decides to exercise the option.
An option can be categories either as a Call or Put:
1.2 A Call Option gives the investor the right (not the obligation) to buy an underlying asset at
an agreed upon price (the strike price) at a date in the future (the expiration date).
1.3 A Put Option gives the holder the right (but not the obligation) to sell an underlying asset at
an agreeduponprice (the strike price) at a date in the future (the expiration date T).
1.4 Terminologies of option:
1.4 (a) Strike (or exercise) price: the amount paid by the option buyer for the asset if
he/she decides to exercise
1.4 (b) Exercise: the act of paying the strike price to buy the asset
1.4 (c) Expiration: the date by which the option must be exercised or become worthless
1.5 There are 2 types of options:
American option - can be exercised at any time up to the expiration date.
European option- can be exercised only at expiration date

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1.6 Difference between Bullish and Bearish

An investor is said to be Bullish when it expects that stock price will increase over time.
Whereas an investor is said to be Bearish when it expects that stock price will decline.

Calls

Buyers

Sellers

Puts

Bullish:

Bearish:

Have right to buy

stock, when stock
price is to rise

Have right to sell

stock, when stock
price is to fall

Bearish:

Bullish:

Have obligation
to sell stock
when stock price
is to fall

Have obligation
to buy stock
when stock price
is to rise

1.7 Factors Affecting Options Prices

The list of factors:
1
2
3
4
5
6

Current stock price S0

Strike price: K
Time to expiration: T
Volatility of stock price:
Risk-free interest rate: r
Dividends expected during life of option: D

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Call option
2. Definition of call option
A Call option is a contract between two parties to exchange a stock at a strike price by a
predetermined date. One party, the buyer of the call, has the right, but not an obligation, to buy
the stock at the strike price by the future date, while the other party, the seller of the call, has the
obligation to sell the stock to the buyer at the strike price if the buyer exercises the option.
Payoff means the gain or loss that a party will have when making a transaction.
Payoff of purchaser (buyer) = Max [0, spot price at expiration strike price]
Payoff of writer (seller) = - Max [0, strike price spot price at expiration]
A Simple understanding of a call option
Example 1:
2.1 From Buyer point of view
Today a call buyer acquires the right to pay $1,020 in six months for an index, but is not
obligated to do so.
a

Assumed that, after 6 months (at expiration) the spot price is $1,100.

Therefore the buyer will exercise its option as his payoff= Max [0, $1,100 - $1,020]
= $80
b What if the spot price is $900?
If the spot price is $900, the buys will have a payoff =$0, because he will not exercise the
option.
2.2 From Seller point of view
Using the above example a call seller is obligated to sell the index for $1,020 in six months, if
asked to do so.
a

Assumed that the option is executed in six months, where the spot price is $1,100.

Therefore the sellers payoff = - Max [0, $1,100-$1,020]

= ($80)

b What if the spot price is $900?

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If the spot price is $900, the seller will have a payoff =$0, because the buyer will not exercise the
option.

2.3 Profit of a Purchased call

Profit = Payoff future value of option premium.
Example 2
A call option has a strike price of $1,000 and also a premium of $93 attached with a risk-free rate
of 2% in 6 months.
a

Assumed that in 6 months the spot price is $1100.

Payoff of the buyer= Max [0, $1,100-$1,000] =$100

Profit = $100 ($93 x 1.02)
=$5.14
b Assumed that in 6 months the spot price is $900

Payoff of the buyer = Max[0, $900 - $1,000]

= $0
Profit = $0 ($93 x1.02)
= -$94.86
Spot Price in
6 months
800
850
900
950
1000
1050
1100
1150
1200

Call
Payoff
0
0
0
0
0
50
100
150
200

Future value
of premium
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68

Call profit
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$45.68
$4.32
$54.32
$104.32
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This table helps to assess the point (spot price) at which the buyer will make profit.

Price Index
This chart clearly shows that above $1000, the purchaser of the call option is making a
positive payoff.
The below diagram, shows the profit earned when premium is included in the calculation.
The purchaser will recover the premium when spot price is above $1020.

Price Index

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2.4 Payoff / Profit of a written (Seller) call option

A seller (writer) of a call option has an obligation toward the purchaser, if the latter intends to
exercise its position.
Payoff = -max [0 , strike price spot price at expiration]
Profit = payoff + future value of option premium
Example 3
A person entered in a call option in 6 months, at a strike price $1,000 with a premium of $93.81at
a risk-free rate 2%.
a

Assume in six months the spot price is $1100

The payoff of the seller = - max [0, 1100 1,000]
= -$100
Profit / (loss) of the seller = -$100 + ($93.81 x1.02) = ($4.32)

b Assume in six months the spot price is $900

The payoff of the seller = - max [0, $900-$1,000]
= $0
Profit of the seller = $0 + ($93.81 x 1.02)
= $95.68

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Price Index

Put Options
3. Definition of Put option

A Put option is a contract between 2 parties to exchange a stock at a strike price by a

predetermined date. One party, the buyer of put has the right, but not an obligation, to sell the
stock at the strike price by the future date, while the other party, the seller of the put, has the
obligation to buy the stock from the buyer at the strike price if the buyer exercises the option.
The concept of the put option is exactly same as investing in an insurance company. For
example, when one buy a car, it assured (protect) his car with an insurance company against any
accident.
In the Put option, the following shall be considered:
A seller of a put - is in fact the buyer; where as
A Buyer of a put is in fact the seller.

3.1 Payoff of put

Payoff put option of seller = Max [O, strike price - spot price at expiration]
Payoff put option of buyer = -Max [ 0, spot price strike price]

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Example 4
Suppose a seller of put option has a strike price of $1000 for an index in 6 months.
a

Assumed that in 6 months the spot price of the index is $1100.

Therefore the payoff of the seller

= Max [0, $1000-$1100]

=0
Thus, it is not worth to sell the index for $1000 when the latter worth is $1100.
b If the spot price is $900 in 6 months
Therefore the payoff of the seller

= Max [0 , $1000- $900]

= $100

3.2 Profit of put option

When calculating the profit of the seller, it is important to note that the seller has to pay a
premium to the buyer.
Profit the seller = Max [ 0, strike price spot price at expiration] future value of option
premium.
Example 5
A seller of put option has a strike price of $1000 for an index in 6 months with a risk-free rate of
2% and a premium of $74.20.
Therefore the future value of option premium = 1.02 x $74.20 =$75.68
a

Assume that the spot price of the option is $1100

Therefore the payoff of the seller = Max [0, $1000 - $1100]

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=0
Profit of the seller = 0- $75.68
=-$75.68 (loss)

Thus the seller will not exercise its position as it is incurring a Zero payoff and a loss.
b

If the spot price is $900,

Therefore the payoff of the seller = Max [0, $1000- $900]

=$100

Profit of the seller = $100- $75.68

=$24.32

In this situation the seller will exercise the put option.

Spot Price in
6 months

Put
Payoff

Future value
of premium

Put profit
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800
850
900
950
1000
1050
1100
1150
1200

$200
$150
$100
$50
0
0
0
0
0

-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68

$124.32
$74.32
$24.32
-$25.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68

3.3 Profit of the buyer

Profit of put option for buyer = - Max [0, Strike price Spot price] + future value of option
premium
Using the same example as above
a

If spot price is $1100

The payoff will be zero because the seller will not exercise.
However the profit will equals to $75.68 which is the premium paid by the seller to the buyer.

b If sport price is $900

The payoff of the buyer = -max [0, $1000 -$900]
=-$100
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Therefore profit = -$100 + $75.68

=-$24.32

4. Put Call parity

Put-call parity is a principle that defines the relationship between the price
of European put options and European call options of the same class, that is, with the
same underlying asset, strike price and expiration date. Put-call parity states that simultaneously
holding a short European put and long European call of the same class will deliver the same
return as holding one forward contract on the same underlying asset, with the same expiration
and a forward price equal to the option's strike price.
5. Conclusion
Options are sophisticated trading tools that can be dangerous if one don't educate oneself before
using them. Options are forms of derivatives to minimizing risk and maximizing investment.
Option is different to other derivatives tools such as futures and forward contract and swaps. In
all depends on the risk appetite of the investors. If option is rightly exercise in the right time, it is
meaning a hedge against failure or fall in worth investment can be prevented. The hedger's aim is
to prevent price changes in the price of the underlying security from affecting the value of his
portfolio.

Part 2
1

(a) Ratio Analysis

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Ratio
1

Alpha
Return on Capital
employed
3000480
12000+5000

=
Profit before Interesttax
Capital Employed

Pre-tax on return on
equity
Profit before tax
Equity

=15%

Net asset turnover

turnover
= Net assets

2170
12000

2650
6600
=40.15%

29000
20600

50000
19200

=1.4 times
4

Gross profit Margin

Gross profit
Turnover

x 100

3000
29000

Operating profit margin

operating profit
=
x
Turnover
100

Current ratio
current assets
= current liabilities
Closing inventory
holding

=2.6 times
5000
50000

=10.3%
5

50001000
6600+ 6400+6000+1000
=20%

=18%

Delta

=10%

2520
29000

4000
50000

=8.7%

=8%

11000
9200

15600
12400

= 1.20 : 1

= 1.26 : 1

5000
26000

x 365

8400
45000

x 365

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closing inventory
Cost of sales

=70days

=68days

365days
8

Trade receivable
collection period
trade receivable
=
Credit sales

7200
50000

x 365days

x 365days

x
= 60 days

365 days
9

Trade payables payment

period
trade payables
= Credit purchases x 365

7200
26000

=53 days

x 365days

= 101 days

days
10 Leverage
Debts
= Equity + Debts

4800
29000

5200
12000+5200

11 Interest cover
NPBI
= Interest

2520
350

= 7.2 times
12 Dividend cover
NPA Tax
= Dividend per share

1870
500

=3.74 times

x 365days

= 69 days
=
6400+6000+1000
6600+ 6400+6000+1000

x 100
=30%

8500
45000

=67%
=

4000
600+ 750

= 3 times
=

2300
1400

=1.6 times

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2
(i)

(b) Analysis of financial and profitability

Profitability

The ROCE of 20% Delta is more than 15% of the return of Alpha. This means that Delta is
efficiently using its Net Assets (Capital and Non-Current liabilities invested).

ROCE
35%
30%

0.15

25%
20%
15%

20%

10%
5%
0%

Alpha

Delta

The above statement can be supported by the company Net Asset Turnover, where Delta is
generating 2.6 times of its revenue from its net assets compared to Alpha which is only 1.4 times.
This means that $1 invested by Delta generates $2.6 of revenue compare to $1.4 for Alpha.

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Return on Equity
60%
50%
40%

40.15%

30%
20%
10%
0%

0.18

Alpha

Delta

A major element of ROCE is to assess the carrying amount of the non-current assets. In this
given scenario, it can be found that Alpha held its own premises whereas Delta does not held its
own premises. Thus, Delta has to pay a rental fees compared to Alpha. In addition, Delta owned
plant is nearing the end of its useful life as it remains only 25% on its cost and it seems that Delta
is about replacing owned plant with leased plant. In the Alpha side, it has revalue its factory
which means the latter is at current value.
Another ratio that need due consideration is the Gross Profit Margin. It can be noted that Alpha
has slightly a better gross profit margin of 8.7% compare to Delta which is 8%. This might be
that Alpha is able to pass over cost on customer than Delta, or Alpha is purchasing goods at
lower price.

Profit Margin
18.00%
16.00%
14.00%

8%

12.00%
10.00%
8.00%
6.00%

0.09

4.00%
2.00%
0.00%

Alpha

Delta

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The ROCE measures the overall efficiency of management, however, as Gamma Plc is
considering to buy the equity of one of the 2 companies, therefore, it would be useful to consider
the return on equity (ROE)- as this is what Gamma Plc is buying. ROE means how much profit
is available as dividend for each share held. ROE of Alpha is 18% which is worst compared to
Delta with a ROE of 40.15%. It can be noted that revaluation of Alphas factory is making its
ROE worst.

(ii)

Leverage

The leverage ratio of Delta is 67% which mean that 67% of its assets are financed by borrowing
fund compare to Alpha is only 30%.

Leverage
67%
70%
60%
50%
40%

0.3

30%
20%
10%
0%

Alpha

Delta

In addition, the interest cover of Delta is 3 times whereas Alpha is 7.2 times. The interest cover
explained how many times profit available can meet interest payment. Thus, Delta has fewer
profits to cover its interest payment compared to Alpha. This shows that Deltas profit is
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vulnerable to any small change in the operating activity. For example, a small reduction in
revenue will reduce gross profit and eventually interest changes might not be covered.

Interest cover
12
10

8
6
4

7.2

2
0

Alpha

Delta

It is important to note that Alpha enjoys the government grant which is a risk less finance and
same is not available to Delta.

(iii)

Liquidity

Measuring the current ratio, both companies have a relatively low liquid ration of 1.20 and 1.26
for Alpha and Delta respectively. Delta seems to have a better Alpha, but is important to note that
Alpha has $1.2 million in the bank whereas Delta has $2.5 million as bank overdraft.
The working capital cycle of Alpha is 29 days whereas Delta is 52 days. This means it took 29
days of Alpha, for cash to flow in the business compared to Delta.

(iv)

Conclusion

Gamma investment will depend on its risk appetite. Delta is more profitable in terms of higher
revenue compared to Alpha, but, it is among the riskier of the 2 companies as it depends a lot on
external fund. Gamma should assess the long term objective of the 2 companies and their market
shares. Moreover, taking over a business having many debts might increase liquidity problem
therefore Gamma must assess where it will recover its initial investment in a short period and as
well as maximizing its wealth.
It is important to note that accounting information is always published with a delay. Thus,
accounts published after 5 months of the year end might not bear any relation to the companys
present situation.
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Gamma plc has to see the credit rating of the 2 companies and assess their financial risk in the
following terms:

Ability to honour the stipulate payments and

The specific characteristics of the borrowing, notably its guarantees and legal
characteristics.

References
Books

Robert L McDonald (1995) Derivatives Market (2nd Edn), Northwestern university,

Chapter 2.
Pascal et al (2011) Corporate Finance: Theory and Practice (3rd Edn), Chapter 2

Web Site:
1

http://www.accaglobal.com/content/dam/acca/global/PDF-students/acca/f7/specimen/f7specimen-d14.pdf [Accessed on 14 Oct 2015]

2 http://www.mkaranasos.com/FEOptions.pdf [ Accessed on 11 Oct 2015]

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