Adv. Finance

compensation for financial risk

(Ro-Rd)

Longer time to expiration effect on Call and Put option value

- Call Option Value Higher - Put Option Value Higher

Increase in Stock Price S effect on Call and Put option value

- Call Option Value Increase - Put Option Value Decrease

Increase in stock's volatility effect on Call and Put option value

- Call Option Value Increase - Put Option Value Increase

Higher Strike Price K effect on Call and Put option value

- Call Option Value Lower - Put Option Value Higher

---

----

Covered Call

-----

Law of One Price

2 securities are supposed to pay the same therefore their prices should be the same

Whats more risky a call or a put?

A Call

Firm Value is made of

E+D

Bearish

Expect stock price to go down, gain money when stock goes down

Bearish Position:

Expect the stock price to go down, and position yourself to gain money when stock goes down

Vu =

FCF/Ro

V=

Firm Value

Equity Value=

Firm Value - Debt

Which firm has a riskier distribution of ROE and EPS?

Firm with debt

Which firms are more difficult to value in practice? - Firms with high current cash flows and low growth - Firms with low or negative current cash flows and high growth

Firms with low or negative current cash flows and high growth

Bullish

Gain money when stock price goes up

Bullish position:

Gain money when stock price goes up

Call option

Gives right, but not obligation to buy shares of corp at a pre-specified price within a pre-specified date

Preferred Stock ( Tax)

Has a huge tax disadvantage

All else equal, compared to debt that is not callable, callable debt should have...

Higher Interest Rate, Lender is going to want to be compensated for including the call option in the premium

No arbitrage condition

Identical stream of cash flows priced the same in financial market

C=

Intrinsic Value + Time Value

Conceptually, what is the largest possible value for the terminal growth rate? In the stable growth phase, the company's cash flows cannot grow faster than...

Long-run GDP growth

EPS=

Net Income/ # of Shares Outstanding

Return on Equity=

Net Income/ Equity

strike Price

Price specified, also called the exercise price.

Portfolio Formula

S+P-K

Take a guess: Which group of stakeholders has the strongest incentive to insist on liquidating, rather than reorganizing, a bankrupt firm?

Secured Lenders

Which group of stakeholders has the strongest incentive to insist on liquidating, rather than reorganizing, a bankrupt firm? (Participation points only)

Secured Lenders

No Arbitrage Condition

Securities that offer anidentical stream of cash flows will be priced thesame in the financial markets.

Please sort the following claims in the order in which they are repaid in the event of bankruptcy. Start with the claim that is repaid first and end with the claim that is repaid last.

Senior Secured Debt Senior Unsecured Debt Junior Debt Preferred Stock Equity

When do you not exercise

Stock greater than strike

K

Strike Price

Which option should be worth more?European options/ American

The American Option ( but not always worth more, but is always worth as much as the European Option)

trade-off theory

The capital structure theory that states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy

In reality, what do you think happens to the cost of debt if a firm takes on additional debt? (Participation points only)

The cost of debt increases if the amount of debt is large

T/F By making interest expenses tax deductible, the government gives corporations an incentive to finance themselves with debt.

True

Writing a Call has

Unlimited downside potential

Vu

Value of unlevered firm

Trade-Off Theory formula

Vl=Vu + Benefits of debt - Disadvantages of debt

NPV=

Vmarket- Vbook

When do you use APV method

When debt is known but debt ratio changes overtime

Which is Risker? Writing a call/put?

Writing a Call

Cash settlement:

You hand over the share price and they hand over the stock price

All else equal, compared to debt that is not callable, callable debt should have...

a higher interest rate

Naked Call

a written call not covered by the shares of the underlying security and not included as part of an overall strategy

Callable Debt

firm has option to buy back debt from creditor prior to maturity

Financial Distress

firm unable to service its debt

You wanna exercise right if stock price is

greater than option

A levered firm cost of equity will be ---- than that of an unlevered firm

higher

loan should have a --- interest rate than a bond that is callable

higher

The ROE of a Levered firm is --- than that of an Unlevered firm, because the financial risk is --- for a levered firm

higher, higher

Covered call option

is a situation where you write a call option on a stock you own

Ro

is the compensation for business risk

In Put Call Parity if MP for Option is more than Price Put Parity

its overvalued

In Put Call Parity if MP for Option is less than Price Put Parity

its undervalued

T Bill

k/ (1+r)^T

Direct Costs

legal and administrative costs

Writing a Put Option

limited downside

More volatility means

more risk

If the market price for an option is above the price the put parity says its

overvalued and you should short sell that option

Tp

personal tax rate

preferred stock

stock that entitles the holder to a fixed dividend, DOES NOT have voting rights

C

the call option price

More time to expiration,

the more the call option is worth

Open Interest

the number of contracts being held by investor

New Debt does not increase

total assets

Dividends are taxed

twice

If the market price for an option is below the price the put parity says its

undervalued and you should buy that option

Vl

value of levered firm

To buy treasury bill

we have to pay present value of treasury bill ( assume zero coupon)

Anytime stock is above the strike( Put option),

you don't exercise and the payoff would be 0

Naked Call option

you write a call option on a stock you dont own

Rd=

= Cost of Debt

Re=

= Cost of Equity

Ro=

= Cost of Unlevered Equity

Profit

= Payoff- C

Profit =

= payoff - premium

Payoff

= s-k

Top Hat: What is the theoretically optimal amount of debt when corporations do not pay taxes? (optimal = maximizes firm value) Zero An infinitely large amount A moderate amount All the above choices result in the same firm value

ANSWER: D, even when equity more expensive so its gonna all end up evening out, firm value never changes as we learn from Vl=Vu

Indirect Costs

Affect shareholder value, business disruptions

What is the theoretically optimal amount of debt when corporations have to pay income taxes? (optimal = maximizes firm value) - zero - An infinitely large amount - A moderate amount - All of the above choices result in the same firm value

An infinitely large amount

How much is a call option worth?

At least as much as the intrinsic value, i.e. C>=(S-K)

Protective Put

Buying a stock and a put on the stock to protect the decline of a stock's price

What is the appropriate discount rate when calculating the present value of a firm's tax shields from debt financing?

Cost of Debt

Sunk Cost:

Cost paid in the past

Lenders=

Debt C holders

When does Ro go away

Doesnt go away unless we change the nature of our business

What is the theoretically optimal amount of debt when corporations do not pay taxes? (optimal = maximizes firm value) - zero - An infinitely large amount - A moderate amount - All of the above choices result in the same firm value

dAll of the above choices result in the same firm value

When is it in the money Put Option

anything below the stock price

American Option

can be exercised on or before its expiration

European option

can be exercised only at expiration

CAPEX=

change net ppe+ depreciation OR change Gross PP&E