1

SUMMER 2016

FINANCIAL MANAGEMENT II
REVISION CLASS
August 12, 2016
LECTURER: FRAY ELLIS
 2

THE SEVEN AREAS OF STUDY

A-Complications_ F-Corporate_Risk_
Capital_Budgeting Management

AREAS
B- E-
Leverage_Capital_ International_Business
Structure _Finance

C- D-
Dividend_Policy Working_Capital_Management
 3

Some Complications in Capital

Budgeting Analysis
 4

Independent Versus Mutually Exclusive

Investment Projects
• An independent investment project is one
that stands alone and can be undertaken without
influencing the acceptance or rejection of any
other project.

• A mutually exclusive project prevents

another project from being accepted.
 5

Evaluating Mutually Exclusive

Investment Opportunities
• There are times when a firm must choose the
best project or set of projects from the set of
positive NPV investment opportunities. These
are considered mutually exclusive opportunities
as the firm cannot undertake all positive NPV
projects.
 6

Evaluating Mutually Exclusive

Investment Opportunities (cont.)

• Following are two situations where firm is faced

with mutually exclusive projects:

1.Substitutes – Where firm is trying to pick

between alternatives that perform the same
function. For example, a new machinery for the
new project. While there might be many good
machines, the firm needs only one.
 7

Evaluating Mutually Exclusive

Investment Opportunities (cont.)

2. Firm Constraints – Firm may face constraints

such as limited managerial time or limited
financial capital that may limit its ability to
invest in all the positive NPV opportunities.
 8

Choosing Between Mutually Exclusive

Investments
1. If mutually exclusive investments have equal
lives, we will calculate the NPVs and choose the
one with the higher NPV.
2. If mutually exclusive investments do not have
equal lives, we must calculate the Equivalent
Annual Cost (EAC), the cost per year. We will
then select the one that has a lower EAC.
 9

Choosing Between Mutually Exclusive

Investments (cont.)
Computation of EAC requires two
steps:
1. Compute NPV
2. Compute EAC as:
 10

Calculating the Equivalent Annual Cost (EAC)

Suppose your bottling plant is in need of a new bottle capper. You are
considering two different capping machines that will perform equally well,
but have different expected lives. The more expensive one costs $30,000 to
buy, requires the payment of $3,000 per year for maintenance and
operation expenses, and will last for 5 years. The cheaper model costs only
$22,000, requires operating and maintenance costs of $4,000 per year, and
lasts for only 3 years. Regardless of which machine you select, you intend
to replace it at the end of its life with an identical machine with identical
costs and operating performance characteristics. Because there is not a
market for used cappers, there will be no salvage value associated with
either machine. Let’s also assume that the discount rate on both of these
machines is 8 percent.
 11

Checkpoint 11.2
 12
Checkpoint 11.2
 13

Tools for Analyzing the Risk of Project

Cash Flows

• It is reasonable to assume that the

actual cash flows an investment
produces will never equal the
expected cash flows used to estimate
the investment’s NPV as there are
many possible cash flow outcomes for
any project.
 14

Tools for Analyzing the Risk of Project

Cash Flows (cont.)

• Tools such as Sensitivity analysis,

Scenario analysis, and Simulation
analysis provide better understanding of
the uncertainty of future cash flows and,
consequently, the reliability of the NPV
estimate.
 15

Key Concepts - Expected Values and

Value Drivers
• Expected Values
▫ The expected value of a future cash flow
is given by the probability weighted
average of all the possible cash flows that
might occur.

▫ The cash flows used to calculate a

project’s NPV are expected values.
 16

Key Concepts - Expected Values and

Value Drivers (cont.)
▫ What is the expected cash value if there are
two possible cash flows, $100 and $400 and
the probabilities of these cash flows are 25%
and 75%.

▫ Expected cash value = .25 ( 100) + .75 (400)

= $325
 17

Value Drivers
• Value drivers are the basic determinants of an
investment’s cash flows and consequently its
performance.

• Value drivers may consist of determinants of

project revenues (e.g., market share, market size,
and price) and costs (e.g., variable and cash fixed
costs)
 18

Value Drivers (cont.)

• Identification of value drivers allow the financial
manager to:
▫ Allocate more time and money toward refining
their forecasts of these key variables.
▫ Monitor the key value drivers regularly so that
prompt corrective action can be taken in the event
that the project is not proceeding as expected.
 19

Sensitivity Analysis
• Sensitivity analysis occurs when a financial
manager evaluates the effect of each value driver
on the investment’s NPV.

• It helps identify the variable that has the most

impact on NPV.
 20

Scenario Analysis
• Sensitivity analysis involves changing one value
driver at a time and analyzing its effect on the
investment NPV.

• Scenario analysis considers the effect of

multiple changes in value drivers on the NPV.
For example, the scenarios could be Expected or
base-case, Worst-case and Best-case.
 21

Simulation Analysis
• Scenario analysis provides the analyst with a
discrete number of estimates of project NPVs for
a limited number of cases or scenarios.
• Simulation analysis generates thousands of
estimates of NPV that are built upon thousands
of values for each of the investment’s value
drivers. These different values arise out of each
value driver’s individual probability distribution.
 22

Simulation Analysis (cont.)

• Simulation process involves the following steps:
1. Estimate the probability distributions for each of
the investment’s key value drivers.
2. Randomly select one value for each of the value
drivers from their respective probability
distributions.
3. Combine the values selected for each of the values
drivers to estimate project cash flows for each year
of the project’s life and calculate the project’s NPV.
 23

Simulation Analysis (cont.)

4. Store or save the calculated value of the NPV
and repeat Steps 2 and 3. Computer softwares
can easily repeat steps 2 and 3 thousands of
times.
5. Use the stored values of the project NPV to
construct a histogram or probability
distribution of NPV.
 24

Break-Even Analysis
• Break-even analysis determines the minimum
level of output or sales that the firm must
achieve in order to avoid losing money i.e. to
break even.
• In most cases, break-even sales is defined as the
level of sales for which net operating income
equals zero.
 25

Accounting Break-Even Analysis

• Accounting break-even analysis involves
determining the level of sales necessary to cover
total fixed costs (both cash fixed costs and
depreciation).

• To compute the accounting break-even point, we

need to decompose the costs into two
components: fixed costs and variable costs.
 26

Accounting Break-Even Analysis (cont.)

• Fixed costs are costs that do not vary directly
with sales revenue. For example, insurance
premiums, administrative salaries.
• As the number of units sold increases, fixed cost
per unit decreases, as fixed costs are spread over
larger quantities of output.
• Fixed costs are also known as indirect costs.
 27

Accounting Break-Even Analysis (cont.)

• Variable costs are costs that vary directly with
the level of sales. Hence, they are also referred to
as direct costs. For example, hourly wages,
cost of materials used, sales commission.

• Variable costs per unit remain the same

regardless of the level of output.
 28

Accounting Break-Even Analysis (cont.)

• The accounting break-even point
is the level of sales that is necessary to
cover both variable and total fixed costs,
such that the net operating income is
equal to zero.
 29

Checkpoint 13.4
 30

Calculating the Cash Break-Even Point

• The cash break-even point computes the
level of sales where cash fixed costs (ignoring
depreciation) are covered and as a result, cash
flow is equal to zero.
 31

NPV Break-Even Analysis

• The NPV break-even analysis
identifies the level of sales necessary
to produce a zero level of NPV.

• NPV break-even focuses on cash

flows, not accounting profits.
 32

Operating Leverage and the Volatility

of Project Cash Flows

• The composition of fixed and variable

costs vary by firm. For example, a
manufacturing firm is likely to have a
higher fixed cost component
compared to service firm.
 33

Operating Leverage and the Volatility of

Project Cash Flows (cont.)

• Most businesses may have some flexibility in

their cost structure and maybe able to alter the
composition of fixed and variable costs, at least
marginally.

• The mix of fixed and variable costs will impact

the breakeven output and also the operating
leverage.
 34

Operating Leverage and the Volatility

of Project Cash Flows (cont.)
• Operating leverage results from the use of
fixed costs in the operations of the firm and
measures the sensitivity of changes in operating
income to changes in sales.

• Degree of operating leverage (DOL)

measures the firm’s operating leverage for a
particular level of sales.
 35

Operating Leverage and the Volatility

of Project Cash Flows (cont.)

• DOL indicates by what percentage the NOI will

change for a given percentage change in sales.
 36

Operating Leverage and the Volatility

of Project Cash Flows (cont.)
• We can make the following observations
about operating leverage:
▫ Operating leverage results from
substitution of fixed operating costs for
variable operating costs.

▫ The effect of operating leverage is to

increase the effect of changes in sales on
operating income.
 37

Operating Leverage and the Volatility

of Project Cash Flows (cont.)
▫ The degree of operating leverage is an
indication of the firm’s use of operating
leverage. The DOL is not a constant but
decreases as the level of sales increases
beyond the breakeven point.

▫ Operating leverage is a double-edged

sword, magnifying both profits and losses.
 38

Real Options in Capital Budgeting

 39

Real Options in Capital Budgeting

• Opportunities to alter the project’s cash flow
stream after the project has begun are referred
to as real options. The most common sources
of flexibility or real options that can add value to
an investment opportunity include:
1. Timing Option – the option to delay a
project until expected cash flows are
more favorable.
 40

Real Options in Capital Budgeting

(cont.)
2. Expansion options – the option to increase the
scale and scope of an investment in response to
realized demand; and

3. Contract, Shut-down, and Abandonment option

– the option to slow down production, halt
production temporarily, or stop production
permanently (abandonment).
 41

SECTION B
 42

Financial Leverage &

Capital Structure
 43

A Glance at Capital Structure Choices

in Practice
• The primary objective of capital
structure management is to maximize
the value of the shareholders’ equity.

• The resulting financing mix that

maximizes shareholder value is called
the optimal capital structure.
 44

Defining the Firm’s Capital Structure

• A firm’s capital structure consists of
owner’s equity and its interest bearing debt,
including short-term bank loans.

• The combination of firm’s capital structure

plus the firm’s non-interest bearing
liabilities such as accounts payable is called
the firm’s financial structure.
 45

Financial Leverage
• The term financial leverage is often used to
describe a firm’s capital structure. Leverage
allows the firm to increase the potential return
to its shareholders.

• For example, if the firm is earning 17% on its

investments and paying only 8% on borrowed
money, the 9% differential goes to the firm’s
owners. This is known as favorable financial
leverage.
 46

Financial Leverage (cont.)

• However, if the firm earns only 6% on its
investments and must pay 8% then the 2%
differential must come out of the owner’s share
and they suffer unfavorable financial
leverage.

• So leverage is beneficial if the rate of return

exceeds the borrowing cost.
 47
The CAPM and Modigliani
and Miller's capital
structure theory
MANAGEMENT ACCOUNTING (UK), February, 1999 by Ogilvie, John

The Capital Asset Pricing Model (CAPM) and

Modigliani and Miller's (MM) theory of capital
structure are two of the most technically
challenging subjects within the Strategic
Financial Management syllabus. When the two
are combined, they provide an approach to
calculating discount rates for use in investment
appraisal.
 48

Capital Structure Theory

• We begin with capital structure
irrelevance theory that is based on
unrealistic assumptions and then
relax these assumptions to examine
how they influence a firm’s incentive
to use debt and equity financing.
 49

A First Look at the Modigliani and Miller

Capital Structure Theorem
• Modigliani and Miller showed that, under
idealistic conditions, it does not matter
whether a firm uses no debt, a little debt or
a lot of debt in its capital structure. The
theory relies on two basic assumptions:
1. The cash flows that a firm generates are
not affected by how the firm is financed.
2. Financial markets are perfect.
 50

A First Look at the Modigliani and Miller

Capital Structure Theorem (cont.)

• Assumption 2 of perfect market

implies that the packaging of cash
flows, that is whether they are
distributed to investors as
dividends or interest payments, is
not important.
 51

I have a simple explanation [for the first

Modigliani-Miller proposition]. It's after the
ball game, and the pizza man comes up to Yogi
Berra and he says, 'Yogi, how do you want me
to cut this pizza, into quarters?' Yogi says, 'No,
cut it into eight pieces, I'm feeling hungry
tonight.' Now when I tell that story the usual
reaction is, 'And you mean to say that they
gave you a [Nobel] prize for that?'"
--Merton H. Miller, from his testimony in Glendale Federal
Bank's lawsuit against the U.S. government, December 1997
 52

Yogi Berra and the M&M Capital

Structure Theory
• The number of pieces that a pizza is cut into
doesn’t affect the total amount that is eaten.

• The size of the pizza pie (the value of the firm,

which is determined by the cash flows to both
creditors and owners) does not depend on the
size of the slices (the portions of firm’s cash flow
that is distributed to creditors or stockholders
and consequently how much of the firm is
financed with debt and equity).
 53

Capital Structure, the Cost of

Equity, and the Weighted Average
Cost of Capital
• When there are no taxes, the
firm’s weighted average cost of
capital is also unaffected by its
capital structure.
 54

Capital Structure, the Cost of Equity,

and the Weighted Average Cost of
Capital (cont.)
• Assume, we are valuing a firm whose cash
flows are a level perpetuity. The value of
the firms is then represented by the
following equation.
 55

Capital Structure, the Cost of Equity, and the

Weighted Average Cost of Capital (cont.)
• Since firm value and firm cash flows are
unaffected by the capital structure, the
firm’s weighted average cost of capital is
also unaffected.
 56

Capital Structure, the Cost of Equity, and the

Weighted Average Cost of Capital (cont.)

• The cost of equity will increase with the

debt to equity ratio (D/E).

• However, because there is less weight on

the more expensive equity, the firm’s WACC
(equation 15-5) does not change and is
always equal to the cost of capital of an
unlevered firm.
 57

Capital Structure, the Cost of Equity, and

the Weighted Average Cost of Capital (co)
• JNK can borrow money at 9% and its cost
of capital if it uses no financial leverage is
11%. It has a debt-to-equity ratio of 1.0, the
cost of debt is 8%, and weighted average
cost of capital is 10%. What is the cost of
equity for JNK?
Capital Structure, the Cost of Equity, and 58

the Weighted Average Cost of Capital

(cont.)

• Cost of equity = .11 + (.11-.08) × 1.0

= .14 or 14%
 59

Why Capital Structure Matters in

Reality?
• In reality, financial managers care a great
deal about how their firms are financed.
Indeed, there can be negative consequences
for firms that select an inappropriate
capital structure, which means that, in
reality, at least one of the two M&M
assumptions is violated.
 60

Violation of Assumption 2
• Transaction costs can be important and because
of these costs, the rate at which investors can
borrow may differ from the rate at which firms
can borrow.
• When this is the case, firm values may depend on
how they are financed because individuals cannot
substitute their individual borrowings for
corporate borrowings to achieve a desired level of
financial leverage.
 61

Violation of Assumption 1
• There are three reasons why capital structure
affects the total cash flows available to its debt
and equity holders:
1. Interest is a tax-deductible expense, while
dividends are not. Thus, after taxes, firms have
more money to distribute to their debt and
equity holders if they use more debt financing.
 62

Violation of Assumption 1 (cont.)

2. Debt financing creates a fixed legal

obligation. If the firm defaults on its
payments, the creditors can force the firm
into bankruptcy and the firm will incur the
added cost that this process entails.

3. The threat of bankruptcy can influence the

behavior of a firm’s executives as well as its
employees and customers.
 63

Corporate Taxes and Capital Structure

Since interest payments are tax

deductible, the after-tax cash
flows will be higher if the firm’s
capital structure includes more
debt.
 64

Bankruptcy and
Financial Distress Costs
• A firm cannot keep on increasing debt because
if the firm’s debt obligations exceed it’s ability
to generate cash, it will be forced into
bankruptcy and incur financial distress costs.

• Furthermore, debt financing also severely limits

financial manager’s flexibility to raise
additional funds.
 65

The Tradeoff Theory and the Optimal

Capital Structure

• Thus two factors can have material impact on

the role of capital structure in determining
firm value and firms must tradeoff the pluses
and minuses of both these factors:

▫ Interest expense is tax deductible.

▫ Debt makes it more likely that firms will
experience financial distress costs.
 66

Capital Structure Decisions and Agency

Costs

• It is argued that debt financing can

help reduce agency costs.

• For example, debt financing by

creating fixed dollar obligations will
reduce the firm’s discretionary
control over cash and thus reduce
wasteful spending.
 67

Making Financing Choices When

Managers are Better Informed than
Shareholders
• When firms issue new shares, it is
perceived that the firm’s stock is
overpriced and accordingly share
price generally falls. This provides
an added incentive for firms to
prefer debt.
 68
Making Financing Choices When
Managers are Better Informed than
Shareholders (cont.)

• Stewart Myers suggested that because of the

information issues that arise when firms issue
equity, firms tend to adhere to the following
pecking order when they raise capital:
▫ Internal sources of financing
▫ Marketable securities
▫ Debt
▫ Hybrid securities
▫ Equity
 69

Managerial Implications
1. Higher levels of debt can benefit
the firm due to tax savings and
potential to reduce agency costs.

2. Higher levels of debt increase the

probability of financial distress
costs and offset tax and agency
cost benefits of debt.
 70

Why Do Capital Structures Differ

Across Industries?
• Firms in some industries (such as utilities)
tend to generate relatively more taxable income
and can benefit more from tax savings on debt.

• Financial distress can be fatal for some

companies (like computer and software firms
like Apple) as consumers will be very reluctant
to buy the product if there is a possibility of
bankruptcy. Thus such firms will tend to have
lower levels of debt.
 71
Evaluating the Effect of Financial
Leverage on Firm’s Earnings per Share

• Firms that use more debt

financing will experience greater
swings in their earnings per share
in response to changes in firm
revenues and operating earnings.
This is referred to as the
financial leverage effect.
 72

Financial Leverage and the Volatility

of EPS (cont.)

• We observe that when EBIT is high, a

more levered firm will realize higher
EPS. However, if EBIT falls, a firm
that uses more financial leverage will
suffer a large drop in earnings per
share (EPS) than a firm that relies less
on financial leverage.
 73

Capital Structure Management

EBIT-EPS Analysis - Used to help

determine whether it would be better to
finance a project with debt or equity.

EPS = (EBIT - I)(1 - t) - P

S
I = interest expense, P = preferred dividends,
S = number of shares of common stock
outstanding.
 74

• XYZ has debt with both a face and a market

value of $3,000. This debt has a coupon rate of
7% and pays interest annually. The expected
earnings before interest and taxes is $1,200, the
tax rate is 34%, and the unlevered cost of capital
is 12%. What is the firm’s cost of equity?
 75

Solution
• Valunlev = [EBIT *(1-T)/Ru = [1200*(1-.34)]/.12
= 6600
Vallev = Valunlev + (T*D) =6600+.34*3000 = 7620
Val - Val
lev Val
debt = = 7620 -3000 =4620
Eq

RE = R + (R – R )*Debt/Equity *(1-T)
Unlev Unlev debt

= .12 +[(.12-.07)*(3000/4620)*(1-.34)]
= .12+0.2143
= 14.14%
 76

SECTION C
 77

Dividend Policy
 78

Introduction
• When a firm generates cash from operations,
what can the firm do with the cash?

1. Use the cash to fund new investments,

2. Use the cash to pay off some of its debt, and/or
3. Distribute the cash back to the firm’s
shareholders either as a cash dividend or as
stock repurchases.
 79

Introduction (cont.)
• This chapter provides answers to three questions
regarding a firm’s dividend policy:
1. What are the pros and cons of the methods the
firm can use to distribute cash?
2. Why should the firm’s shareholders care about
the firm’s dividend policy given that they can
generate cash when they need it by selling some
of their shares?
3. What cash distribution policies do most firms
use in practice?
 80

How Do Firms Distribute Cash to their

Shareholders?
• Cash distributions can take two basic forms:

1. Cash dividend

2. Share repurchase
 81

How Do Firms Distribute Cash to their

Shareholders? (cont.)
• With cash dividend, cash is paid directly to the
shareholders.

• With a share repurchase, a company uses

cash to buy back its own shares from the market
place, thereby reducing the number of
outstanding shares.
 82

How Do Firms Distribute Cash to their

Shareholders? (cont.)
• The impact on the balance sheet will be as
follows:

▫ On the Assets side, cash will be reduced due to

cash dividend or share repurchase.

▫ On the Equity side, there will be a corresponding

decrease.
 83

Cash Dividends
• A firm’s dividend policy determines how
much cash it will distribute to its shareholders
and when these distributions will be made.

• Dividends are generally described in terms of

dividend payout ratio, which indicates the
amount of dividends paid relative to the
company’s earnings.
 84

Dividend Payment Procedures

• Generally, companies pay dividends
on a quarterly basis.
• There are several dates that are
important with regard to dividend
payment.
 85

Dividend Payment Procedures

(a) Announcement date: It is the date on which dividend is
formally declared by the board of directors.
(b) Date of record: Investors who own stock on this date receive
the dividend. However, this date was pushed forward two
days to ex-dividend date.
(c) Ex-dividend date: The ex-dividend date is usually set for
stocks two business days before the record date. If you
purchase a stock on its ex-dividend date or after, you will not
receive the next dividend payment. Instead, the seller gets the
dividend. If you purchase before the ex-dividend date, you
get the dividend.
(d) Payment date: This is the date on which dividend checks are
mailed to the investors.
 86

The Ex-Dividend Date

 87

Dividend Payment Procedures

Date Explanation Calendar Date
Announcement Date Dividend is declared. March 15
Ex-Dividend Date Shares begin trading May 17
ex-dividend.
Record Date Dividend will be paid to May 19
shareholders who own the
stock on this date.

Payment Date Dividends are distributed to May 27

the shareholders of record
on the record date.

Mar 15 May 17 May 19 May 27

Declare Ex-div. Record Payment

dividend date date date
 88

Stock Repurchases (Stock Buyback)

• Stock repurchase is when a firm uses its cash
to repurchase some of its own stock.

• This results in a reduction in the firm’s cash

balance as well as the number of shares of stock
outstanding. Firms use one of three methods to
purchase the shares: Open market repurchase,
tender offer, and direct purchase.
 89

How do Firms Repurchase Their

Shares?
• Open Market Repurchase
▫ Here the firm acquires the stock on the
market, often buying a relatively small
number of shares everyday. This will put
upward pressure on share prices. This is
the most widely used method for stock
repurchase.
 90

How do Firms Repurchase Their

Shares? (cont.)
• Tender Offer
▫ A company uses this method when it wants
to buy a relatively large number of shares
very quickly.
▫ The company makes a formal offer to buy a
specified number of shares at a stated price.
▫ The price is set above the market price to
attract sellers.
 91

How do Firms Repurchase Their

Shares? (cont.)
• Direct Purchase from a large investor

▫ Here the firm purchases the stock from

one or more major stockholders on a
negotiated basis. This method is not
used frequently.
 92

Non-Cash Distributions: Stock

Dividends and Stock Splits
• A stock dividend is a pro-rata distribution of
additional shares of stock to the firm’s current
stockholders. These distributions are generally
defined in terms of a fraction paid per share.

▫ For example, a firm might pay a stock dividend

of .20 shares of stock per share or 2 shares for
every 10 held.
 93

Non-Cash Distributions: Stock

Dividends and Stock Splits (cont.)
• Stock split is essentially a very large stock
dividend. For example, a 2-for-1 split would
entail receiving two new shares for every old
share currently held.

• With a 2-for-1 split, the number of shares will

double and the share price will drop in half.
 94

Rationale for a Stock Dividend or Stock

Split
• One rationale for splits and stock dividends is
that there is an optimal price range for the firm’s
stock. Also, beyond a certain price range, there
might be lower demand for shares from
investors.
• If the price exceeds that optimal range, it can be
brought back to the optimal range by doing a
stock split or paying stock dividend.
 95

Stock Dividend Example

An investor has 120 shares. Does the value

of the investor’s shares change?
• Shares outstanding: 1,000,000.
• Net income = $6,000,000.
• P/E = 10.
• 25% stock dividend.
 96

Before the 25% stock dividend:

• EPS = 6,000,000/1,000,000 = $6.
• P/E = P/6 = 10, so P = $60 per share.
• Value = $60 x 120 shares = $7,200.

After the 25% stock dividend:

• # shares = 1,000,000 x 1.25 = 1,250,000.
• EPS = 6,000,000/1,250,000 = $4.80.
• P/E = P/4.80 = 10, so P = $48 per share.
• Investor now has 120 x 1.25 = 150 shares.
• Value = $48 x 150 = $7,200.
 97

Stock Dividends - Problem #2

What is the new stock price?

• Shares outstanding: 250,000.
• Net income = $750,000.
• Stock price = $84.
• 50% stock dividend.
 98

Before the 50% stock dividend:

• EPS = 750,000 / 250,000 = $3.
• P/E = 84 / 3 = 28.

After the 50% stock dividend:

• # shares = 250,000 x 1.50 = 375,000.
• EPS = 750,000 / 375,000 = $2.
• P/E = P / 2 = 28, so P = $56 per share.
(A 50% stock dividend is equivalent to a
3-for-2 stock split.)
 99

Does Dividend Policy Matter?

• Modigiliani and Miller suggest that without
taxes and transaction costs, cash dividends and
share repurchases are equivalent and the timing
of the distribution is unimportant.

• This is known as the Modigiliani and Miller

dividend irrelevancy proposition.
 100

The Irrelevance of the Distribution

Choice
• The distribution choice is irrelevant under
the following assumptions:
1. There are no taxes.
2. No transaction costs are incurred in
either buying or selling shares of stock.
3. The firm’s operating and investment
policies are fixed.
 101

The Irrelevance of the Distribution

Choice (cont.)
• The dividend irrelevancy proposition can
be illustrated in two ways:

1. Timing of dividend distributions does

not affect firm value.
2. In the absence of taxes and transaction
costs, a cash dividend is equivalent to a
share repurchase.
 102

Why Dividend Policy is Important?

Transactions are costly

▫ Since taxes are incurred when dividends are
received and transactions costs are incurred
when buying and selling shares, investors will
prefer to select companies whose dividend policy
match up with their own preferences. Because
firms with different dividends attract different
dividend clienteles, it is important that
dividend policy remain somewhat stable.
 103

Why Dividend Policy is Important?

• The Information Conveyed by Dividend and Share
Repurchase Announcement
▫ Investors and stock market are constantly trying
to decipher the information released by firms to
better understand what they imply about firm
values.
▫ Firms tend to increase their dividends when
dividends can be sustained in the future. In such
cases, dividend increase is clearly good news.
 104

Why Dividend Policy is Important?

• Share repurchases are also viewed very favorably
as it reveals that the firm has generated more
money than it currently needs. Share
repurchases may also reveal that the equity is
currently underpriced.
• The empirical evidence indicates that dividends
and share repurchases do in fact convey
favorable information to investors.
 105

Why Dividend Policy is Important?

• The Information Conveyed by Stock Dividends
and Stock Splits
▫ The announcement of stock dividends and stock
splits also tend to generate positive stock returns.
This increase is harder to explain as stock
dividends and stock splits do not affect firm’s cash
flows.
▫ Some researchers have suggested that firms have a
preferred trading range and stock splits help bring
stock prices to that trading range.
 106

Why Dividend Policy is Important?

• A second possibility is that stock splits and
stock dividends tend to attract attention.
Naturally, firm would like to attract attention
only when the prospects are favorable.

• Thus even though there is no direct effect on

cash flows, the market reacts favorably.
 109

Residual Dividend Policy

• With a residual dividend policy, the firm

first finances its investments using its own
earnings. Dividends are paid out of the
residual earnings that are not needed to
finance new investment opportunities.
• While this policy minimizes the cost of
financing, it can lead to unstable dividends
for shareholders.
 110

Other Factors Playing a Role in

How Much to Distribute
• Liquidity Position
▫ Because dividend payments and stock
repurchases are made with cash, and not
with retained earnings, the firm must
have cash available for payouts to be
made.
 111

Other Factors Playing a Role in How

Much to Distribute (cont.)
• Lack of Other Sources of Financing
▫ Many small or new companies may not
have access to the capital markets, and
must depend upon internally generated
funds to fund their investment
opportunities. As a result, the dividend
pay out ratio for such firms is generally
lower.
 112

Other Factors Playing a Role in How

Much to Distribute (cont.)
• Earnings Predictability
▫ A company’s payout ratio depends to
some extent on the predictability of a
firm’s profits over time. Firms with
stable earnings will typically pay out a
larger portion of its earnings.
 113

SECTION D
WORKING CAPITAL MANAGEMENT
 114

SECTION E
International Business Finance
 115

Foreign Exchange Markets and the

Currency Exchange Rates
• The foreign exchange (FX) market:
▫ Largest financial market with daily trading
volumes of more than $4 trillion.
▫ Organized as over-the-counter market with
participants located in major commercial and
investment banks around the world.
▫ Trading dominated by few currencies including
U.S. dollar, the British pound sterling, the
Japanese Yen, and the Euro.
 116

Foreign Exchange Markets and the

Currency Exchange Rates (cont.)
• Major participants in foreign exchange trading
include the following:
▫ Importers and exporters of goods and services,
▫ Investors and portfolio managers who purchase
foreign stocks and bonds, and
▫ Currency traders who make a market in one or
more foreign currencies.
 117

Foreign Exchange Rates

• An exchange rate is simply the price of
one currency stated in terms of another.

• For example, if the exchange rate of U.S.

dollar for Euro was $1.35 to 1, it means that
it would take $1.35 to purchase one Euro.
118
 119

Foreign Exchange Rates (cont.)

• Direct quote

▫ It indicates the number of units of the

local currency to buy 1 foreign currency
unit.

▫ In the table we see that it took US$0.97

to buy 1 Canadian dollar.
 120

Foreign Exchange Rates (cont.)

• Indirect Quote

▫ It indicates the number of foreign

currency units to buy one local currency
unit.
▫ For example, in the table it shows that it
will take 6.8276 Chinese yuan to buy 1
U.S. dollar
 121

Foreign Exchange Rates (cont.)

• We can compute the direct quote from the
indirect quote.
 122

Foreign Exchange Rates (cont.)

• The direct quote for Canadian dollars is $0.97.
The related indirect quote will be:

• Indirect quote = 1÷ $0.97 = $1.03

 123

Exchange Rates and Arbitrage

• Arbitrage is the process of buying and selling
in more than one market to make a riskless
profit.

• Simple arbitrage eliminates exchange rate

differentials across the markets for a single
currency.
Arbitrage Example 124

You currently have J$175,000 in

savings. The J$ spot exchange rate
in New York is US$0.0114 while the
US$ rate in Jamaica is J$87.2753.
Are arbitrage profits possible? If so,
set up an arbitrage scheme and
indicate your gain in Jamaican
dollars.
 125

Exchange Rates and Arbitrage

• The asked rate (also known as the selling
rate or the offer rate) is the rate the bank or
the foreign exchange trader “asks” the
customer to pay in home currency for
foreign currency when the bank is selling
and the customer is buying.
 126

Exchange Rates and Arbitrage

• The bid rate (also known as the
buying rate) is the rate at which the
bank buys the foreign currency from
the customer by paying in home
currency.
 127

Exchange Rates and Arbitrage

• The bank sells a unit of foreign currency for
more than it pays for it. The difference between
the asked quote and the bid quote is known as
the bid-asked spread.

▫ The spread will be relatively lower for

popular currencies that are frequently
traded.
 128

Cross Rates
• A cross rate is the computation of
an exchange rate for a currency from
the exchanges rates of two other
currencies.
129
 130

Types of Foreign Exchange

Transactions
• Spot exchange rate is the rate for immediate
delivery.

• Forward exchange rate is an exchange rate

agreed upon today but which calls for delivery or
payment at a future date.

.
 131

Types of Foreign Exchange

Transactions
• The forward rate is often quoted at a premium to
or a discount from the existing spot rate. For
example, the 30-day Switzerland franc will be
quoted as 0.0001 premium(0.9773-0.9772).

• This premium or discount is known as the

forward-spot differential.
 132

Types of Foreign Exchange

Transactions
• The forward-spot differential can be expressed
as:

• Where F= the forward rate, direct quote

S = the spot rate, direct quote
 133

Types of Foreign Exchange

Transactions
• The premium or discount can also be expressed
as an annual percentage rate, computed as
follows:
 134

Solve

= (1.6024 – 1.6028)/1.6028 × (12/1) × 100

= -0.299% (discount)
Interest Rate and
Purchasing Power
Parity

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

 136

Interest Rate Parity

• Interest rate parity is a theory that can be used
to relate differences in the interest rates in two
countries to the ratios of spot and forward
exchange rates of the two countries’
currencies.
• Specifically,
Differences in interest rates = Ratio of the
forward and spot
rates
 137

Interest Rate Parity (cont.)

 138

Interest Rate Parity

• Interest rate parity means that you get the
same total return for the following two
options:
▫ Invest directly in the US; or
▫ Convert dollars to Japanese Yens,
▫ Invest Yens in the risk-free rate in Japan, and
▫ Convert Yens back to U.S. dollars.
 139

Interest Rate Parity

• Example
You have $1,000,000 to invest and you
observe the following quotes in the market:
1$ = ¥ 106
180-day forward rate = 103.50
U.S. 180-day risk-free interest rate = 4.4%
Japan 180-day risk-free interest rate = 2%

• Determine whether interest rate parity

holds.
 140

Interest Rate Parity (cont.)

Option I: Invest directly in USA and earn 4.4%
1,000,000 * 1.044 = $1,044,000

Option II:
(a) Convert to Yen at spot rate = ¥ 106,000,000
(b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000
(c) Convert to $ at the forward rate = 108,120,000
÷103.5 =
$1,044,638

==> Difference of $638 ==> Interest Rate Parity does

not hold
 Problems on Interest Rate Parity 141
[For questions 1-3 assume that the local currency is euro. Also, assume
that interest rate parity holds for questions 1 and 2.]

1. Suppose that the price of the Swiss franc is €0.60. If the

one-year Swiss interest rate is 4% and the euro interest rate
is 7%, what should be the one-year forward price of the
Swiss franc?
2. Suppose that the indirect euro price of the dollar is 1.53. If
the one-year euro rate is 2% and the one-year dollar rate is
4%, what is the one-year forward price of the dollar (again,
in indirect terms)?
3. You observe that the spot price of the Russian ruble is
€0.03. The Russian one-year interest rate is 12% and the
euro interest rate is 5%. The one-year forward price of the
ruble is €0.032. Show how to carry out an arbitrage,
assuming you can borrow the equivalent of €600,000.
 142

Solutions – IRP Problems

3. Today:
Borrow €600,000 at 5% and buy 20,000,000 rubles
Invest rubles at 12% to earn 22,400,000 rubles
Sell 22,400,000 rubles 1-year forward at €0.032

At year-end:
Convert 22,400,000 rubles at €0.032 for €716,800
Repay loan with interest at €630,000
Retain profit of €86,800
 143

Purchasing Power Parity and the Law

of One Price
• According to the theory of
purchasing power parity (PPP),
exchange rates adjust so that
identical goods cost the same
amount regardless of where in the
world they are purchased.
 144

Purchasing Power Parity

• Let E[1 + iD(t)] = the expected value of 1 plus the
domestic inflation rate.
• Let E[1 + iF(t)] = the expected value of 1 plus the
foreign inflation rate.
• Let E[sDIF(t)] = the expected direct spot exchange
rate t periods hence.

E 1  iF t  S DIF

E 1  iD t  E S DIF t 
 145

Purchasing Power Parity and the Law

of One Price (cont.)
• Underling PPP theory is the law of one price,
which states that the same good should sell for
the same price in different countries after
making adjustments for the exchange rate
between the two currencies.
 146

Purchasing Power Parity and the Law

of One Price
• The differences in prices around the
world could be explained by:
▫ Tax differences among countries
▫ Differences in labor costs
▫ Differences in raw material costs
▫ Differences in rental costs
 147

Purchasing Power Parity and the Law

of One Price
• In general, we expect PPP to hold for
goods that can be cheaply shipped
between countries (for example,
expensive gold jewelry).
• PPP does not seem to hold for non-
traded goods like restaurant meals
and haircuts.
 148

The International Fisher Effect

• The International Fisher Effect (IFE)
assumes that real rates of return are the same
across the world, so that the differences in
nominal returns around the world arise
because of differences in inflation rates.
• Like purchasing power parity, IFE is just an
approximation that may not hold exactly.
 149

The International Fisher Effect (cont.)

• Example Assume that the real rate of interest is

equal to 2% in all countries. What will be the
nominal interest rate in UK and USA, if UK is
expecting an inflation rate of 6% and USA is
expecting an inflation rate of 3%.
 150

The International Fisher Effect

• Interest rate (USA) = .03 + .02 + [.03×.02]

= .0506 or 5.06%

• Interest rate (UK) = .06 + .02 + [.06×.02]

= .0812 or 8.12%
 151

The International Fisher Effect

• IFE cautions us that we should not invest in a
country just because it offers the highest interest
rates.

• IFE notes that such high interest rate is an

indication of high inflation. Accordingly, any
gain in interest rates will be offset by losses due
to foreign currency depreciation.
 152

Capital Budgeting for Direct Foreign

Investment
• Direct foreign investment occurs
when a company from one country
makes a physical investment into
building a factory in another country.
A multinational corporation
(MNC) is one that has control over
this investment.
 153

Capital Budgeting for Direct Foreign

Investment
• A major reason for direct foreign
investment is the prospect of higher rates
of return from these investments.

• The method used to evaluate foreign

investments is very similar to the method
used to evaluate capital budgeting
decisions in a domestic context.
 154

Foreign Investment Risks

• Risks in domestic capital budgeting arises from
two sources:
▫ Business risk related to the specific product or
service and the uncertainty associated with that
market.
▫ Financial risk is the risk imposed on the
investment as a result of how the project is
financed.
• Foreign direct investment includes both
business and financial risk, plus political risk
and exchange rate risk.
 155

Foreign Investment Risks

• Political risk can arise if the
business is conducted in a country
that is not politically stable leading to
changes in policies with respect to
businesses.
 156

Foreign Investment Risks

• Some examples of political risk are as
follows:
▫ Expropriation of plants and equipment
without compensation.
▫ Non-convertibility of the subsidiary’s
foreign earnings into the parent’s currency.
▫ Substantial changes in tax rates.
▫ Requirements regarding the local
ownership of business.
 157

Foreign Investment Risks

• Exchange rate risk is the risk that the value of
the firm’s operations and investments will be
adversely affected by changes in exchange rates.

• For example, if the Japanese Yen depreciates, it

will translate to fewer dollars when it is sent
back to the U.S.
 158

SECTION F

CORPORATE RISK MANAGEMENT

 159

Five Step Corporate Risk Management

Process
1. Identify and understand the firm’s major risks.
2. Decide which type of risks to keep and which to
transfer.
3. Decide how much risk to assume.
4. Incorporate risk into all the firm’s decisions and
processes.
5. Monitor and manage the risk that the firm
assumes.
 160

Step1: Identify and Understand the

Firm’s Major Risks

• Identifying risks relates to understanding the

factors that drive the firm’s cash flow volatility.
For example:
▫ Demand risk - fluctuations in demand
▫ Commodity risk – fluctuations in prices of raw
materials
▫ Country risk – unfavorable government policies
▫ Operational risk – cost overruns in firm’s operations
▫ Exchange rate risk – changes in exchange rates
 161

Step1: Identify and Understand the

Firm’s Major Risks

• All the listed sources of risk (except operational

risk) are external to the firm.

• Risk management generally focuses on

managing external factors that cause volatility in
firm’s cash flows.
 162

Step 2: Decide Which Type of Risk to

Keep and Which to Transfer

• This is perhaps the most critical step.

• For example, oil and gas exploration and

production firms have historically chosen to
assume the risk of fluctuations in the price of oil
and gas. However, some firms have chosen to
actively manage the risk.
 163

Step 3: Decide How Much Risk to Assume

• Figure 20-1 illustrates the cash flow

distributions for three risk management
strategies.

• The specific strategy chosen will depend upon

the firm’s attitude to risk and the cost/benefit
analysis of risk management strategies.
 164

Step 4: Incorporate Risk into All the

Firm’s Decisions and Processes

• In this step, the firm must implement a system

for controlling the firm’s risk exposure.

• For example, for those risks that will be

transferred, the firm must determine an
appropriate means of transferring risk such as
buying an insurance policy.
 165

Step 5: Monitor and Manage the Risk the

Firm Assumes

• An effective monitoring system ensures that the

firm’s day-to-day decisions are consistent with
its chosen risk profile.

• This may involve centralizing the firm’s risk

exposure with a chief risk officer who assumes
responsibility for monitoring and regularly
reporting to the CEO and to the firm’s board.
 166

Managing Risk with Insurance Contracts

• Insurance is a method of transferring risk from

the firm to an outside party, in exchange for a
premium.

• There are many types of insurance contracts that

provide protection against various events.
167
 168

Managing Risk by Hedging with Forward

Contracts

• Hedging refers to a strategy designed to offset

the exposure to price risk.

• Example If you are planning to purchase 1

million Euros in 6 months, you may be
concerned that if Euro strengthens it will cost
you more in U.S. dollars. Such risk can be
mitigated with forward contracts.
 169

Futures Contract
• A futures contract is a contract to buy or sell a
stated commodity (such as wheat) or a financial
claim (such as U.S. Treasuries) at a specified
price at some future specified time.

• These contracts, like forward contracts, can be

used to lock-in future prices.
170
 171

Futures Contract
• There are two categories of futures contracts:
▫ Commodity futures – are traded on
agricultural products, metals, wood products, and
fibers.
▫ Financial futures – include, for example,
Treasuries, Eurodollars, foreign currencies, and
stock indices.
 Financial futures dominate the futures market.
 172

Managing Default Risk in Futures Market

• Default is prevented in futures

contract in two ways:
1. Margin – Futures exchanges require
participants to post collateral called
margin.
2. Marking to Market – Daily gains or
losses from a firm’s futures contract are
transferred to or from its margin account.
 173

Marking to Market on Futures Contracts

Example:
• January 1, 1997, we buy a Gold futures contract.
Contract size is 100 ounces.
• Current futures price is $500 per ounce.
• Assume initial margin is $3,000 per contract
and maintenance margin is $2,000 per contract.
 174

Hedging with Futures Contract

• Similar to forward contracts, firms can use
futures contract to hedge their price risk.
• If the firm is planning to buy, it can enter into a
long hedge by purchasing the appropriate
futures contract.
• If the firm is planning to sell, it can sell (or
short) a futures contract. This is known as a
short hedge.
 175

Hedging with Futures Contract

• There are two practical limitations with futures
contract:
1. It may not be possible to find a futures contract
on the exact asset.
2. (a)The hedging firm may not know the exact date
when the hedged asset will be bought or sold.
(b)The maturity of the futures contract may
not match the anticipated risk exposure period
of the underlying asset.
 176

Hedging with Futures Contract

• Basis risk is the failure of the hedge for any of
the above reasons.

• Basis risk occurs whenever the price of the asset

that underlies the futures contract is not
perfectly correlated with the price risk the firm is
trying to hedge.
 177

Hedging with Futures Contract

• If a specific asset is not available, the best
alternative is to use an asset whose price
changes are highly correlated with the asset.

• For example, hedging corn with soybean future

if the prices of the two commodities are highly
correlated.
 178

Hedging with Futures Contract

• If a contract with exact duration is
not available, the analysts must select
a contract that most nearly matches
the maturity of the firm’s risk
exposure.
 179

Futures Hedge – Example #1

• Assume 20-year 8% T-Bond Futures are
currently selling at 108 16/32. Our firm
wishes to sell $500,000 of 20-year corporate
Bonds in 3-months time and market interest
rates are presently 11%. We are concerned
that interest rates will rise to 13% in 3
months and so decide to hedge with T-Bond
futures. Construct the hedge and show how it
would have performed with the interest rate
increase.
 180
1. In this situation, the firm would be hurt if interest rates were to rise, so it would
use a short hedge, or sell futures contracts.
2. With a rise in interest rates the bonds would now yield 13%.
With an 11% coupon rate, the bond issue would bring in only:
B = (PVIFA13%,20) x ($500,000 x 11%) + (PVIF13%,20) x $500k
= (7.0248 x $55,000) + (0.0868 x $500,000) = $429,764.
So the firm would lose $500,000 - $429,764 = $70,236

The value of the short futures position began at:

$500,000 x 1.085 = $542,500 (remember the price is 108 16/32 )
To estimate the new value in 3-months we must first calculate the present yield
on the T-Bond:
Par  P $500k  $542.5k
CPN  0
8%$500k 
YTM  n  20  0.072  7.2%
Par  2P 0
$500k  2$542.5k 
3 3
Now, the yield will increase by 2% to 9.2%, hence:
V = (PVIFA9.2%,20) x ($40000) + (PVIF9.2%,20) x $500,000
= (8.9999 x $40,000) + (0.1720 x $500,000) = $445,996
So the firm would gain ($542,500 - $445,996) = $96,504

On net, we gained $96,504 - $70,236 = $26,268

 181

Hedging with Futures: Example #2

On January 2 your firm decided to close out its

account at a Canadian Bank on February 28. The
firm expects to have Cdn$5 million in the account
at the time of withdrawal. It would convert the
funds to J$ and transfer them to its local bank.
The relevant forward rate is $56.525. The March
Cdn$ futures contract was priced at $56.442 .
Determine the outcome of a futures hedge if on
February 28 the spot rate was $53.857 and the
futures rate was $53.954. All prices are in J$ per
Cdn$ (direct quotes).
 Hedging with Futures: Example #2
The firm holds a long position in Cdn$, worth 5m($56.525) = $282.625m
and needs to protect against a decline in the value of the Cdn$.
Therefore, it needs to sell Cdn$ futures, which are priced at Cdn$5m x
$56.442 = $282.21m.

January 2
The firm takes a short position in the futures contract.

February 28
The 5m Cdn$ are converted at a rate of $53.857 = $269.285m; a decrease
in value of $13.34m. (i.e. $282.625m - $269.285m)
The futures contracts are bought at $53.954 for a total value of $269.77m.
This produces a profit on the futures of $12.44m (i.e. $282.21m -
$269.77m).

This reduces the loss on the currency conversion to only $900,000 (i.e.
$12.44m – $13.34m). The hedge eliminated 93 percent of the loss.

5-182
 183

Summarizing
 184

Summarising
• Futures and forwards are financial contracts which are very similar in
nature but there exist a few important differences:
• Futures contracts are highly standardized whereas the terms of each
forward contract can be privately negotiated.
• Futures are traded on an exchange whereas forwards are traded over-the-
counter.
• In a futures contract, the exchange clearing house itself acts as the
counterparty to both parties in the contract. To further reduce credit risk,
all futures positions are marked-to-market daily, with margins required to
be posted and maintained by all participants at all times. All this measures
ensures virtually zero counterparty risk in a futures trade.
• Forward contracts, on the other hand, do not have such mechanisms in
place. Since forwards are only settled at the time of delivery, the profit or
loss on a forward contract is only realized at the time of settlement, so the
credit exposure can keep increasing. Hence, a loss resulting from a default
is much greater for participants in a forward contract.
 185

Futures vs Forwards
 186

Option Contracts
• Options are rights (not an obligation) to buy or
sell a given number of shares or an asset at a
specific price over a given period.

• The option owner’s right to buy is known as a

call option while the right to sell is known as a
put option.
 187

Option Contracts - Definitions

• Exercise price: The price at which the asset can
be bought or sold.
• Option premium: The price paid for the option.
• Option expiration date: The date on which the
option contract expires.
• American option: These options can be
exercised anytime up to the expiration date of the
contract.
• European option: These options can be
exercised only on the expiration date.
 188

Option Contracts
• For example, if you buy a call option on 100 shares
of XYZ stock at a premium of $4.50 and exercise
price of $40 maturing in 90 days.

• You can buy the XYZ stock at $40, even though the
market price of the stock maybe above $40.
• If the stock price is below $40, you will choose not
to use your option contract and will lose the
premium paid.
 189

Option Contracts
• For example, if you buy a put option on 100 shares
of ABC stock at a premium of $10.50 and exercise
price of $70 maturing in 90 days.

• You can sell the ABC stock at $70, even though the
market price of the stock maybe below $70.
• If the market price of stock is above $70, you will
choose not to use your option contract and will lose
the premium paid.
 190

A Graphical Look at Option Pricing

Relationships
• Figures 20-5 to Figures 20-8 graphically illustrate
the expiration date profit or loss from the following
option positions:
▫ Buying a call option (figure 20-5)
▫ Selling or writing a call option (figure 20-6)
▫ Buying a put option (figure 20-7)
▫ Selling or writing a put option (figure 20-8)
 191

A Graphical Look at Option Pricing

Relationships
• The graphs are based on the following assumptions:

▫ Exercise price for call and put options = $20

▫ Call premium = $4
▫ Put premium = $3
 192

A Graphical Look at Option Pricing

Relationships

Buy Call Write Call Buy Put Write Put

Exercise
Maximum
Unlimited Premium Price - Premium
Profit
Premium
Exercise
Maximum
Premium Unlimited Premium Price -
Loss
Premium
Future
Market Bullish Bearish Bearish Bullish
Expectation
Exercise Exercise Exercise Exercise
Break-even
Price + Price + Price Price
Point
Premium Premium – Premium - Premium
193
194
195
196
 197

Checkpoint 20.2 - Determining the Break-Even Point

and Profit or Loss on a Call Option

You are considering purchasing a call option on

CROCS, Inc. (CROX) common stock. The exercise
price on this call option is $10 and you purchased
the option for $3. What is the break-even point on
this call option (ignoring any transaction costs but
considering the price of purchasing the option—the
option premium)? Also, what would be the profit or
loss on this option at expiration if the price dropped
to $9, if it rose to $11, or if it rose to $25?
 198

Checkpoint 20.2
 199

Checkpoint 20.2: Check Yourself

• If you paid $5 for a call option with an exercise

price of $25, and the stock is selling for $35 at
expiration, what are your profits and losses?
What is the break-even point on this call option?
 200

Solve
• Break-even Point = Exercise price + Premium
= $25 + $5
= $30
• Profit (at stock price of $35)
= (Stock Price – Exercise Price) – Premium
= ($35 - $25) - $5
= $5
 201
Reading Option Price Quotes
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Valuing Options and Swaps

• The value of option can be regarded as the
present value of the expected payout when the
option expires.

• The most popular option pricing model is the

Black-Scholes Option Pricing Model (BS-OPM).
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Black-Scholes Option Pricing Model

• There are six variables that impact the price of
an option:
1. The price of the underlying stock
2. The option’s exercise or strike price
3. The length of time left until expiration
4. The expected stock price volatility
5. The risk free rate of interest
6. The underlying stock’s dividend yield
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Black-Scholes Option Pricing Model

Value of Call Value of Put
What IF
option Option
Price of underlying stock
Increases Decreases
increases
Exercise price is higher Decreases Increases

Time to expiration is longer Increases Increases

Stock price volatility is higher

Increases Increases
over the life of the option

Risk-free rate of interest is

Increases Decreases
higher
The stock pays dividend Decreases Increases
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Black-Scholes Option Pricing Model

• Black-Scholes option pricing model for call options is
stated as follows:
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Checkpoint 20.3 - Valuing a Call Option Using the

Black-Scholes Model

Consider the following call option:

• the current price of the stock on which the call option is
written is $32.00;
• the exercise or strike price of the call option is $30.00;
• the maturity of the option is .25 years;
• the (annualized) variance in the returns of the stock is
.16; and
• the risk-free rate of interest is 4% per annum.
Use the Black-Scholes option pricing model to
estimate the value of the call option.
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Checkpoint 20.3 - Valuing a Call Option Using
the Black-Scholes Model

0.272693
 208

Swap Contract
• A swap contract involves the
swapping or trading of one set of
payments for another.

• A currency swap involves

exchange of debt obligations in
different currencies.
 209

Currency Swap: An Example

Suppose that Dow Chemical is looking to hedge some of its
euro exposure by borrowing in euros. At the same time,
French tire manufacturer Michelin is seeking dollars to
finance additional investment in the U.S. market. Both want
the equivalent of U$200 million in fixed-rate financing for 10
years. Dow can issue dollar-denominated debt at a coupon
rate of 7.5% or euro-denominated debt at a coupon rate of
8.25% Equivalent rates for Michelin are 7.7% in dollars and
8.1% in euros. Assume a current spot rate of €1.1/$.
• Construct a debt-service table assuming the two
companies enter into a swap.
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Currency Swap - Initial Cash Flows

$200 million
Mich. borrows €220
Dow borrows $200
million in the US DOW Mich. million in France

€220 million

• Dow borrows $200 million in the US at an APR of

7.5% - Annual interest = $15 million
• Michelin borrows €220 million in France at an
APR of 8.1% - Annual interest = €17.82 million
• Both companies swap the principal amount.
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Currency Swap - Interest Payments

€17.82 million
Mich. pays €17.82 m
Dow pays $15 million in
the US to its lenders DOW Mich to lenders in France

$15 million

• In each year 1 through 10, Dow receives $15 million

from Michelin.
▫ Dow then pays this to its U.S. lenders.
• Dow also pays €17.82 million to Michelin.
▫ Michelin pays this to its French lenders.
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Currency Swaps - Final Payments

€220 million
Mich. pays €220
Dow pays $200 million
in the US to its lenders DOW Mich. million to lenders

$200 million

• Dow receives $200 million from Michelin.

▫ It pays this out to its U.S. lenders.
• Dow also pays €220 million to Michelin.
▫ Michelin pays this out to its French lenders.
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Currency Swap Example - Summary
 214

Swap Contract
• An interest rate swap involves
trading of fixed interest payments for
variable or floating rate interest rate
payments between two currencies.
 215

Swap Contract
▫ Notional principal is the amount used to calculate
payments for the contract but this amount does not
change hands.

• The floating rate = 6-month LIBOR

• The fixed rate = 9.75%
• Interest is paid semi-annually.
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