Financial Management - I

Case Analysis
Of
The Galaxy Dividend Income Growth
Fund’s Option Investment Strategies

Submitted to
A Kanagaraj

Submitted by
Shyam Somani
(B18051)

Shyam Somani (B18051)

 Case Background

The case talks about an asset management company, Galaxy Dividend Income Growth Fund,
which manages assets of approx. $1.25 billion. The net asset value of the company was $10.68
per share at the end of year 2013. The company has its offering in managing active and passive
mutual funds, retirement accounts for institutions and also managed the fund of high net worth
individuals. The company followed the strategy to employ at least 75% assets towards equities
which gives quick short returns and have potential to grow capital. While the remaining 25%
of the assets are invested in equities with the long term prospects.

The company has the legacy of giving quarterly dividend of $0.10 per share to its investors
even in rough years as well. But the financial crisis of 2008 had a huge impact on the earnings
of the company. As a result, the dividend payment policy has posed the question of
sustainability as it started taking its pie from the capital. Moreover, the share price of company
has been constantly decreasing and had reached record low of $9.4 in the history of the
organization. Therefore, in light of all these challenges the management have to come up with
new trading strategy to revitalize the company.

In this regard, a proposal of options trading was suggested and the same needs to be understood
as the initiative is new of the organization. Therefore, the board of director asked for a pilot
study on options trading for Facebook and JP Morgan Chase and Co. as a proof of concept.

Shyam Somani (B18051)

 Critical Financial Problems

1. Capital erosion due to dividend payment

The company has been following its policy of giving out quarterly dividends of $0.10 per share
to its investors even at the cost of its capital. The total layout of dividends per year for the
company stands at whooping $46.8 million. Dividend payment were approved by board of
directors even against the advice of other board members.

Although paying dividend from the capital is not taxable for shareholders but it essentially is
the return of the capital of investors’ money. Payment of dividends at the cost of capital is not
encouraged as it indicates firstly, the company is struggling to maintain the free cash flow and
secondly it affects the long terming investing and business options due to shirking capital base.

2. Continuous deterioration of share price

Post 2008, the fund had been trading at small premium to NAV between 2009 and 2011 but
situation worsened after this period. The fund began to trade at consistently at discount to NAV
since 2011 which ultimately breached the mark of 12% in the year 2013. The share price of the
fund at the end of year 2013 was $9.40 as against the company’s NAV of $10.68 per share.

Fund should have tackled the deteriorating trading price on time because for investors, past
record of a fund plays a prominent role in deciding to investing in it or continuing with a
scheme. It reflects whether the fund manager is reliable in implement a particular strategy.

3. Fluctuating stream of revenue.

The returns of the fund saw fluctuation year on year. The reason for it can be attributed to
market condition and portfolio selection by managers. The said problem arises due to lack of
balanced portfolio. A balanced fund offers two advantages, it offers manager the best of both
worlds, and on the one side it offers relative safety of debt and on other the wealth creation
potential of equity.

4. Stagnated Dividend Policy

The fund directors have been inconsiderate of the fact the market environment is not conducive
to high yields, and thus this is not the opportune time to engage in generous dividend payout
like the previous trend. Basic financial prudence, would lead a person to understand that it
makes little sense in paying a dividend of $0.4/year/share during such times when the capital

Shyam Somani (B18051)

market environment is not very conducive to revenue generation. This hints at the problem of
a non-dynamic or static dividend policy, which needs to be revised by the directors.

5. Lack of other income avenues

Company did not identify the other source of income to tackle the 2008 crisis. The environment
then required revaluation of income strategy. Company should have evaluated the opportunity
to offering other financial instruments to maintain the sustainability of the dividend flow along
with the generating the new stream of revenue.

Shyam Somani (B18051)

 Case Analysis

The main problem of all the critical issues mentioned above, the lack of financial instrument
of emerges to be a major one. Ideally, the company should have thought of exploring the
optioning when it share price began to deteriorate. However, the company has thought of
experimenting with options trading. Options trading can potentially address following critical
concerns of the company. Firstly, it can help company to develop an avenue of income which
can provide the stream of revenue to tackle the issue of dividends payout. This will help
company to save its self from capital erosion which in turn bolster the confidence of investors.
The other major issue of deteriorating share price can also be handle as a result of above
mentioned advantages. In wake of all these pros and directive of the senior management a pilot
study need to be conducted as proof of concept.

The study of options trading can be carried by understanding the key parameters (as mentioned
below) which affects its value. The value of the Call and Put options are calculated using the
Black Scholes method for both Facebook and JP Morgan chase and Co.

 Volatility of stock
 Time to expiration
 Time value of options
 Stock and Exercise price

In order to carry out analysis using Black Scholes method, the interest rate in USA is considered
as 3.5% and the volatility (standard deviation) of intraday return of stocks has been considered.
The same is calculated using the historical share values available.

1. Analysing Option of JPMC

Referring the exhibit 2 given in the case, it is clear from the graph of daily stock price returns
that the JPMC stocks have very few peaks and that are also within the range of .02%. This
shows the JMPC stock are very stable and hence have less volatility. Moreover, the standard
deviation of daily stock return of JPMC as calculated from historical data came to be 16.8%.

On analysing P/E ratio, it is evident that the market value of the company is growing over the
period of time which again signals towards the stability of the organization. Along with P/E
Ratio, earnings and dividends per share are also growing which also strength the fact that the
company is not only stable but has a growth protective.

Shyam Somani (B18051)

Referring the exhibit 1 attached with the report, the value of call option as compared to call
price is constantly increasing with time of expiry. For instance, the call option having exercise
price of $50 has its value of $7.76 compared to call price of $7.70 for expiry on 18-Jan. This
can give potential payoff of $.04 per share and $4 for a contract (100 shares per contract).
While the same option for 2 years of expiry in the year Jan 2016 will yield $2.12 per share
which in effect may result in earning of $212 per contract.

January 18, 2014 January 15, 2016

Stock Exercise
Price Price Call Call Call Call
Earning Earning
Price Value Price Value
$57.74 $50.00 $7.70 $7.76 $0.06 $10.60 $12.72 $2.12
Table 1 Effect of Time of Expiration on option value

Considering the substantial increase the value of option with maturity time, company should
invest in the options which are having the long maturity date. The reason for this can be
attributed to the time it provides opportunity to buy and sell the option during long period.

Another trend which can be spotted from the valuation of the options is that as the option value
began to decrease with increasing in exercise price. Table 2 shows effective payoff for the
options having maturity in Jan 2016. Therefore, the options having lower exercise price will
bear higher value and hence company should focus on the long term maturity options with low
exercise price to buy call option.

Stock Exercise January 15, 2016

S No
Price Price Call Price Call Value Payoff
1 $57.74 $40.00 $18.15 $20.94 $2.79
2 $57.74 $50.00 $10.60 $12.72 $2.12
3 $57.74 $55.00 $7.80 $9.34 $1.54
4 $57.74 $57.50 $6.75 $7.89 $1.14
5 $57.74 $60.00 $5.65 $6.61 $0.96
6 $57.74 $65.00 $3.95 $4.51 $0.56
Table 2 Showing decrease in payoff per share with increasing in exercise price

Similarly analysing put options, it is evident that the value for the option is increasing with
increase in exercise price as shown in exhibit 1 of the report. Also the value of put option is
increasing with maturity time as shown in the exhibit 1 of the report. This trend is similar to
that of call option. Hence basing on this insights, company should invest in the long term put
options with high exercise price.

Shyam Somani (B18051)

2. Analysing Option of Facebook

Referring the exhibit 3 given in the case, it is clear that the stocks of FB has shown erratic
behaviour in 2013. The graph of daily stock return has many peaks and the peak value of
29.61% on July 25, 2013 is a testimony to it. This shows the FB stock are very unstable and
hence volatile. Moreover, the standard deviation of daily stock return of FB as calculated from
historical data came to be 32.8%.

On analysing P/E ratio, it is evident the company requires time to stabilize owing to recent IPO.
Along with P/E Ratio, the erratic nature of earnings per share also corroborate to the fact that
the company is in its initial phase has the potential to grow.

Further on analysing the value of option, it follows the same trend as that of call and put option
of the JPMC. However, if we compare the value of options of JPMC and FB, we can clearly
notice from the exhibit 1 that the FB options have more value. The reason of this finding can
be answered from the high volatile nature of the FB which essentially provides the opportunity
to investor to earn high returns from it.

On analysing the call and put options of FB, one can notice that option trading provides the
opportunity to earn high payoff especially for the long term maturity. Therefore, the fund can
invest in this option to bank on the opportunity of earning huge returns from the volatility of
FB but at the same time investor needs to be careful of the potential risk the volatility brings
along with it.

Shyam Somani (B18051)

 Recommendations

Based on the analysis, it is recommended to go ahead with options trading as it can try to solve
the impending issues of the company. From the analysis, one aspect which clearly stands out
is that it offers the huge return for the long term maturity options with low exercise price in
case of call option and high exercise in case of put option. Therefore, company can without
any apprehension can invest in these options. This will allow company to generate new source
of income and sustainably continue with the dividend policy. Moreover, the option trading of
volatile stocks can be an opportunity to earn high returns but caution needs to be exercised with
respect to the risk it brings along. However, this risk can be hedged by investing in stable stock
like JPMC

It is also recommended to board of directors to relook the dividend policy of the company.
Continuation of such high level of dividend policy will tough environment will stress the
capital of the firm. These new initiative will boost the confidence of the investors which in turn
improve the share price of the company.

Shyam Somani (B18051)