Advance Financial Management - Assignment

The first part of the assignment had three problems. In the first problem, the option pay-off diagrams and put-call parity were used to show the effect of volatility and dividends on call options. In the second problem, the Gordon growth model was used to come up with an NPV for the investment. Then, the value of the option associated with the project was estimated using the Black-Scholes model. In the end, the two values were compared to arrive at a decision. In the third problem, two journal articles and a chapter from a book were used to construct an analysis of the Black-Scholes model. The second part of the assignment had two problems. For the first problem, the APV of the project was calculated in three steps. In the first step, the free cash flows of the project to the firm were determined. In the second step, the unlevered cost of equity of the firm and discounted the free cash flows by the cost of equity were calculated to come up with unlevered value of the firm. In the final step, the unlevered firm value was adjusted for financing side effects, such as value of interest tax shield and issuance costs, to arrive at an estimate of adjusted present value. In the final problem of the assignment, the Journal article by Timothy A. Luehrman was reviewed and two additional journal articles were examined to construct a critical analysis of the adjusted present value approach.

Part A Required: i. Call options are frequently used to hedge financial risk. This is because call options usually have onesided payoffs. They have unlimited upside potential and no downside potential (if you exclude the cost of buying the call option). The following diagram depicts the payoff from a typical call option:

As the diagram shows, the buyer of the call option has essentially eliminated his potential losses from a drop in prices. On the other hand, the more the price increases, the more profits can be obtained from the investment. So, if the stock is currently trading at the strike price of 100, the owner will prefer that the expected volatility in price is high. This is because a high volatility will mean that there is a greater chance of the price ending up very high or very low before the option expires. The investor will not incur any loss even if the stock price drops to zero. On the other hand, if the stock price increases drastically, the investor will earn high profits. Therefore, the investor will prefer a high level of volatility in stock price. This rule is true for all kinds of options (both call and put) because of their asymmetrical payoffs higher volatility increases the value of an option. So even if the value of an investment is substantially greater than zero, it might be a good idea to delay an investment opportunity. The decision to delay will have higher merit if the investment has high expected volatility. The high volatility might signify that value of the option to wait (similar to a call option) is greater than the current NPV of the investment. The value of such an option to delay will decrease with the passage of time and the optimal time to invest will be when the value of option becomes less than the NPV of the investment. Dividends affect the price of a stock. The stock price is expected to drop by the amount of the dividend on the ex-dividend date. Since, the price of stock is affected by dividends; it makes sense that the value of the call option will also be affected by it. A decrease in the value of a stock following a dividend

payment also decreases the call option premium. This relationship can be best understood by the putcall parity equation: C = P + S X/(1+Rf) The value of a call option is directly proportional to the value of the underlying stock. When the stock value decreases, the call option value also decreases. Also note that the effect of dividends on value of put option is opposite. To take into account the effect of dividends, the put-call parity can also be rewritten as: C = P + (S-dividends) + X/(1+Rf) So, if a stock is expected to pay dividends before the expiration date of a call option, it makes sense to exercise an in-the-money call option before the ex-dividend date. This would enable the option holder to receive the dividends which would have been lost if the option had been expired at any time after the ex-dividend date. In short, if an investment is expected to pay dividends, it might be beneficial to make the investment early rather than delaying it. However, this is only true for options that are in-themoney. For out-of-money options, it might be better to wait and see if the value of underlying asset increases.

Required: ii. To calculate the option-free net present value of the project, we need the following variables: Cost of Project: 13 million Cash Flows at the end of first year: 2 million Expected Growth rate: 3% Required Rate of Return: 11% Using the Gordon growth model, PV of future project cash flows = 2 million / (11% - 3%) = 25 million NPV of Project = 25 million 13 million = 12 million However, we also have the option to wait and invest after one year. In other words, we have an option to delay our investment. The value of this option can be calculated using the Black Scholes model. The inputs for Black Scholes model are:

S = Present Value of Cash Flows from Investing Now = 25 million X = Cost of Project = 13 million Rf = Risk-free Rate = 4% 2 = Variance of Value = 0.09 t = Project delay time = 1 year Using these inputs in the Black Scholes model, we derive a value of 12.509737 million for the option. This can be considered to be the real options value attached to the project. Note that this value is greater the NPV of the project ( 12 million) if the project is started immediately. The option to delay the project has a time premium of 509,737 ( 12.509737 million - 12 million). This suggests that the company will be better off waiting rather than undertaking the project immediately. However, it may be noted that the option premium is only marginally higher than the NPV of starting the project today. In addition, there may be costs associated with delaying the project that the Black Scholes model does not take into account. For instance, delaying the project could give a competitor an opportunity to launch a similar project which might affect the companys cash flows. Similarly, delaying the project may cause one of the variables in the project, such as the initial cost of the project, to increase unexpectedly and reduce the projects desirability. Before deciding on whether to delay the project or to undertake it immediately, the company needs to take such factors into account.

Required: iii. Black-Scholes is a popular model that is used to value stock options. It was developed by Fischer Black and Merton Scholes who won the Nobel Prize for their effort. It uses six variables the security's price, the option's exercise price, annualized dividend payments, interest, volatility and number of days until expiration, to calculate fair value of an options contract. The Black-Scholes model explains the prices on European options, which cannot be exercised before the expiration date. A crucial feature of the model is that the call option is equivalent to a portfolio constructed from the underlying stock and bonds. The "option-replicating portfolio" consists of a fractional share of the stock combined with borrowing a specific amount at the riskless rate of interest (Scott H, 1998: 15). This equivalence creates price relationships which are maintained by the arbitrage of informed traders. The Black-Scholes option

pricing model is derived by identifying an option-replicating portfolio, then equating the option's premium with the value of that portfolio (Peter, 1996: 17). According to Don Chance (2003: 202-203), the key assumptions of the Black-Scholes model are as follows: The price of the underlying asset follows a lognormal distribution. The risk-free rate is constant and known. The volatility of the underlying asset is constant and known. Markets are frictionless. The underlying asset has no cash flows such as dividends or coupon payments. There is Homogeneity among traders; that is traders agree on the values of the relevant parameters.

In addition to these assumptions, the two assumptions previously mentions are the condition of noarbitrage and the options under consideration being European options. A closer look at these assumptions reveals many of the limitations of the Black-Scholes model. It is obvious that the model cannot be used to value American options. This is because American options can be exercised before the expiration date and Black-Scholes model does not account for such a scenario. Similarly, the condition of no-arbitrage may not exist in all circumstances. This is especially true for markets of under developed countries and in situations where there are limits to arbitrage. Markets are certainly not frictionless. Factors such as taxes, restrictions on short-sale, and transaction costs may distort option prices, as calculated by the Black-Scholes model. Indeed, research conducted by Peter Fortune found that such distortions result in errors that are economically significant, on the order of at least 10 to 15 percent of the actual premium (1998: 23). The volatility of the underlying asset is hard to calculate and it is often not constant over the life of the option (Don, 2003: 203). The assumption of the constant risk-free rate means that the BSM model is not useful for pricing options on Bond prices and interest rates. In those cases, interest rate volatility is a key factor in determining the value of the option (Don, 2003: 203). The homogeneity assumption, that traders share the same probability beliefs and opportunities, flies in the face of common sense. Clearly, traders differ in their judgments of such important things as the volatility of an asset's future returns, and they also differ in their time horizons, some thinking in hours, others in days, and still others in weeks, months, or years (Peter, 1996: 18). According to tests conducted by Peter Fortune, the probability distribution of the change in the logarithm of the S&P 500 does not conform strictly to the normality assumption. Not only is the distribution thicker in the middle than the normal distribution, but

it also shows more large changes (either up or down) than the normal distribution. Furthermore, the distribution seems to have shifted over time - an increase in the kurtosis and a shift in skewness (1996: 21).

Part B Required: i. To obtain the after-tax cash flows from the machinery, we need to calculate the depreciation allowance on the machinery using 25% reducing balance method: Beginning Asset Value Year 1 Year 2 Year 3 1,200,000 900,000 675,000 Depreciation Allowance (25%) 300,000 225,000 168,750 Ending Asset Value 900,000 675,000 506,250

Note that the ending asset value of 506,250 will be used as balancing allowance in year 3 since the machine has no scrap value. Using this information we calculate the free cash flow to the firm (FCFF) as follows: Revenue Less: Depreciation EBIT Less: Taxes (33%) EBIAT Add: Depreciation FCFF Year 1 650,000 300,000 350,000 115,500 234,500 300,000 534,500 Year 2 650,000 225,000 425,000 140,250 284,750 225,000 509,750 Year 3 650,000 675,000 (25,000) (25,000) 675,000 650,000

Adjusted Present Value requires us to discount the cash flows at the unlevered cost of equity. Since the company is diverging into a line of business that is different from its usual line of business, it is reasonable to assume that the risk of the project will be different from the overall risk of the company. Therefore, it is appropriate to use the unlevered beta for the mobile phone industry. So, I will be using the mobile phone industry data to calculate the unlevered beta. The beta can be unlevered using the following formula:

 unlevered = levered / (1+(1-t)D/E) unlevered = 1.12 / (1 + 0.67*40/60) unlevered = 0.77 Unlevered cost of equity = Rf + Unlevered Beta*(Market risk premium) Unlevered cost of equity = 8% + 0.77 * 12% = 17.3% We calculate the unlevered firm value by discounting the FCFF at the unlevered cost of equity: Unlevered firm value = 534,500/1.173 + 509,750/(1.173^2) + 650,000/(1.173^3) Unlevered firm value = 1,228,881 The question does not mention the interest rate on debt issued. Since we only need to calculate the tax shield for the three years of the project, we cannot use the tax shield to perpetuity. Hence, we will need to assume an interest rate on debt to estimate the debt tax shield for three years. It is assumed the interest rate on the debentures issued is 12% per year. Based on this assumption, the present value to interest tax shield is calculated as follows: Total Value of Debentures = 45% * 1,200,000 = 540,000 Interest Tax Shield = T * Rd * Debt Year 1 Interest Tax Shield = 0.33 * 0.12 * 540,000 / 1.12 = 19,093 Year 2 Interest Tax Shield = 0.33 * 0.12 * 540,000 / (1.12^2) = 17,047 Total Tax Shield = 36,140 Note that there is no interest tax shield in year 3 because no tax is paid. We also need to adjust the unlevered firm value for any issuance costs: Issue cost of Equity = 55% * 1,200,000 * 4% = 26,400 Issue cost of Debentures = 45% * 1,200,000 * 2% = 10,800 Total Issuance Costs = 37,200 Adjusted Present Value = Unlevered Firm Value + Debt Interest Tax Shield Issuance Costs Adjusted Present Value = 1,228,881 + 36,140 - 37,200 = 1,227,821 Since the cost of the project is 1.2 million, the project will yield a net benefit of 27,821 to MyCompany plc, as estimated by the Adjusted Present Value approach.

Required: ii. Timothy A. Luehrman hypothesize that Weighted Average Cost of Capital (WACC) has now become obsolete and is more widely accepted across the financial industry only because it has been around for over 20 years. He states that Business schools teach WACC only because its a standard method [of valuing investments] and not because it is the best method. He further predicts that APV, being the better and more accurate measure, is soon going to replace WACC (2002: 95). Mr Timothy wrote his paper in 2002; and 9 years later, WACC continues to be a dominant method used in the financial industry which suggests that Timothy might have overestimated the significance of APV. APV is surely an important tool in valuing investments but it is not without its own limitations. The APV analysis and discounted cash flow (DCF) analysis yield similar but they differ in their approach. Whereas DCF attempt to capture taxes and other financing effects in a WACC or adjusted discount rate, APV follows a different approach. In APV method, we first calculate the unlevered value of the firm by dividing the cash flows by the unlevered cost of equity. The idea is to capture the firm value regardless of its financing side effects. This unlevered firm value is then adjusted for the effects of financing, most notably the interest tax shield savings from paying interest on debt and higher expected bankruptcy costs from additional borrowing. The value is also adjusted for other costs such as issuance costs of new debt or equity, hedging expenses and subsidies. The reason APV might be preferred over traditional methods like DCF (or WACC) is that APV requires fewer restrictive assumptions and may produce results in situation where WACC does not work (Timothy, (2002: 96). Since APV breaks down various cash flows into its constituent parts, APV can tell managers not only how much an investment is worth but also where the cash flow is coming from (Timothy, (2002: 96). Because of its flexibility, a skilled analyst can configure the model in a way that makes more sense in each particular case. Whereas WACC can produce a value in one single discounting operation, it does not accurately handle the financial side effects. It does take into account the effect of taxes on the value on investments but only for simple capital structures (JSTOR, 1980: 99). WACC loses its accuracy especially in cases where the taxes paid are less that the interest tax shield savings because such savings may not be realized (JSTOR, 1980: 99). In such cases, APV adjusts its estimate for the interest tax shield but WACC keeps discounting the cash flows at the same, tax adjusted, discount rate. APV compartmentalized all the cash flows into its separate components which makes APV very transparent:

you get to see all the components of value in the analysis; none are buried in the discount rate [as in the case of WACC] (Timothy, (2002: 103). Laurence Booth, however, hypothesize that APV model is frequently unreliable and should only be used in conjunction with more conventional valuation frameworks (2002: 97). Booth argues that we need to know the optimal amount of debt to determine the value of the debt tax shield in the APV method. However, before knowing the NPV (APV), we cannot know how much debt is optimal (2002: 102). This problem is avoided in WACC since it is based on the firms target debt to equity ratio. Moreover, APV gives the same answer as WACC if the same optimal amount of debt is used (Laurence, 2002:102). In other words, as long as there is a constant optimal debt ratio, APV valuations turn into WACC valuations. Keeping this in mind, Booth concludes that the APV model only has applicability in transactions that involve a structured financing, like leveraged buyouts (LBOs), project financing, and real estate financing (2002: 104).

References for A-iii: Don, C. (2003) Analysis of Derivatives for CFA Program, New York: AIMR, p.187-242. Peter, F. (1996) Anomalies in option pricing: the Black-Scholes model revisited, New England Economic Review, 31(July), p.17-24. Scott H, F. (1998) The striking price: Using Black-Scholes , Barron's, 78(1), p.MW15. References for B-ii: Laurence, B. (2002) FINDING VALUE WHERE NONE EXISTS: PITFALLS IN USING ADJUSTED PRESENT VALUE, Journal of Applied Corporate Finance, 15(1), p.95-104. JSTOR (1980) The Refunding of Discounted Debt: An Adjusted Present Value Analysis, [online] Available at: http://www.jstor.org/pss/3664913 [Accessed: 15 December 2011]. Timothy A., L. (1997) Using APV: A Better Tool for Valuing Operations, Harvard Business Review, 75(MayJune), p.145-154.