Perpetual Bond, Call option, Put Options, Intrinsic Value, Extrinsic Value, Strike Price

7-2       Two investors are evaluating General Motors’ stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for General Motors’ stock. True or false? Explain.

The statement is true. Price of stock is present value of a stream of cash flow (dividend). Both investors are buying stock in the same year and both investors are agreed on value of D1, risk, and growth rate.

The price of constant growth stock is calculated as:

P^{^} ₀ =                           D₁ (Expected dividend in 1 year)

                        r_s (required rate of return) – g (growth rate)

Whether investor hold stock for two years or for 10 years value of stock in current year is the same. When the first investor sell his/her stock after two years value of stock will be different from P₀ because of growth in dividend. Similarly when the second investor sell his/her stock after ten years the prices of stock will be different than P₂.

7-3       A bond that pays interest forever and has no maturity date is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common stock, and to a share of preferred stock?

Bond has fixed time to maturity with fixed interest. A perpetual bond does not have maturity provides fixed interest for unlimited period of time. A no-growth stock is one that does not have growth in dividends. No growth stock holders also get fixed amount of dividend.

Preferred stock is hybrid type of security which has feature of both common stock as well as preferred stock. Preferred stock holder gets fixed income like bond holders. Perpetual bond, no growth stock and preferred stock give fixed amount of interest or dividend for unlimited period of time and hence they are similar on getting paid by corporation as well as their maturity period.

7-4       In this chapter and elsewhere we have argued that a stocks market price can deviate from its intrinsic value. Discuss the following questions if all investors attempt to behave in an entirely rational manner, could these differences still exist? In answering this question think about information that’s available to insiders versus outsiders, the fact that historical probabilities of financial events are “fuzzier” than probabilities related to physical items and the validity of concepts of animal spirits, herding and anchoring.

Answer:            Intrinsic value of stock is actual value or real worth of the company’s stock where as market value of stock is prices that are prevailing in the market which is determined by demand and supply of the stock and price that investors are ready to pay. The answer for question if all investors attempt to behave in an entirely rational manner, could these differences still exists is Yes, the differences still exists. The reasons are that we as investors are outsiders who can only acts based on given information from the company. Most of the time company window dresses their information to make them superior than their competitors. In reality Company’s position might not be better as they are presenting. Investors invest into stock looking the information but because of the bad financial condition company may go bankruptcy or go down though their financial information looks fine. In addition to that company might plan to lunch new product, extend their geographical locations or acquire their largest competitors as a result their performance could go up. Only the insider people know about all those information unless they are published that makes stocks demand different.

            However efficient market hypothesis theory assumes that all investors are not rational and stock market price reflects intrinsic values. New information causes stock’s intrinsic value to move to new intrinsic value. Whenever intrinsic value of stock differ from market price investors take advantages of undervalued/overvalued stock and start buying/selling stocks which increase/decrease demand of stocks and make stock price equilibrium.

8-1       Define each of the following items:

a.       Option; call option; put option

Option: Option is a contract between two parties (option writer and option holder) that gives holder right but not obligation to buy (in case of call option) or sell (in case of put option) underling assets (stocks, gold, commodities, currency and others) on predetermined price during a specified period of time. Price of option varies with the change in the price of underlying assets. At the time of maturity if option exercised the option writer is responsible to provide predetermined quantity of underlying assets. If holder does not exercise option, it expires at maturity date. In America and Europe options are exercised differently. In America option can be exercised any time during its maturity period while in Europe option can only be exercised at the maturity date.

Call Option: Call option is right but not obligation to buy underlying assets (stocks, gold, commodities, currency and others) at predetermined price during a specified period of time. During the time of continuous price rises of underlying assets call option protect holder to pay extra dollars because holder has right to buy underlying assets on predetermined fixed price. Price of call option depends on price of underlying assets. When price of underlying assets increases price of call option also increases and vice versa. Option holder can sell the option to third party at any time before it expires.

Put Option: Put option is right but not obligation to sell specified number of underlying assets at predetermined price during a specified period of time. Put option is favorable to holders at the time when price of underlying assets is decreased because holder can buy underlying assets in cheaper price from the market and sell them in predetermined higher price to option writer.

b.      Exercise value; strike price

Exercise Value:             Exercise Value is the maximum of either difference between current market price of stock (underlying assets) and strike price or Zero. In another word exercise value is worth of option if they are exercise now. The minimum of exercise value is zero; it will never go negative because holder will not exercise the option if current stock price is lower than strike price.  For example, if the current market price of stock is $35 and the strike price of the stock is $20 then exercise value is $15 ($35 - $20). Again suppose if the current market price of stock is $20 and the strike price of the stock is $35 then exercise value is 0.

Strike price:      Strike price is a predetermined agreed price on which holder of option is ready to buy (in case of call option) or sell (in case of put option) underlying assets, if holder decided to exercise option. In case of call option holder is profitable if market price is higher than strike price while in case of put option holder is profitable if market price is lower than strike price.

c.       Black-Scholes Option Pricing Model

Black-Scholes Option pricing model is developed by Fischer Black and Myron Scholes. This model focuses on concept of riskless hedges by buying shares of stocks and simultaneously selling call options on that stock. According to Fisher and Myron, investor can create a riskless investment position by offsetting losses on stock using call option. The rate of return on riskless hedged position should be equal to risk free rate of return otherwise arbitrage get opportunity to exist to equilibrium the price of option.

8-2       Why do options sell at prices higher than their exercise values?

Option gives holder right to buy or sell predetermined number of underlying assets in some specified price at some specified time in the future. Option is future oriented and it worth more in the future than in present. Option price has two components Exercise value [Max (Current market price – strike value), 0] and time value of option. Therefore options sell at prices higher than their exercise value. Further, longer the time of option to mature higher the chances that value of underlying assets will significantly go up.

           

8-3       Describe the effect on a call option’s price caused by an increase in each of the following factors:

(1)    Stock price: If stock price in the market increase, price of call option also increase because holder has right to buy stocks on predetermined strike price which is lower than prevailing market price.

(2)    Strike price: If strike price increase, price of call option decrease because holder are obligate to exercise call option only on strike price. 

(3)    Time to expiration: If time to expiration is long then price of call option increases because in long run there is greater chances that stock price could significantly go up.

(4)    Risk-free rate: Options are exercised in future but call option’s value depends upon present value of cost to exercise option. If risk-free rate increases that makes present value of cost of exercise low, that increase option’s value.

(5) Variance of stock return: Higher the variance of return more the price of call option. Stocks’ return is extremely volatile hence the stock price moves more volatile. There is a higher chance for call option holder to gain high profit if stock price go up significantly.

References

http://www.investorwords.com/3477/option.html

http://www.justanswer.com/questions/1v2lv-why-do-options-sell-at-prices-higher-than-their-exercise-v

http://www.best-stock-trading-systems.com/what-makes-stock-prices-rise.html

WACC, beta (or market) risk, within-firm (or corporate) risk

9-2 How can be the WACC an average cost? A marginal cost?

Weighted Average cost of capital is average of the cost of debt, equity, and preferred stock. To calculate WACC, the percentages of those securities that contribute on company’s cost of capital are multiplied by their own cost. Sum of all those multiplied is weighted average cost of capital.

            WACC is calculated by taking weighted average of the various components’ costs, therefore, is considered as average cost. In other word, WACC is average of the cost of all the sources of finance that company use to raise the finance.

9-3 How would each of the following affect a firm’s cost of debt, r_d(1-t); its cost of equity, r_s; and its weighted average cost of capital, WACC? Indicate by a plus (+), a minus (-), or a zero (0) if the factor would rise, lower, or have an indeterminate effect on the item in question. Assume other things are held constant. Be prepared to justify your answer, but recognize that several of the parts probably have no single correct answer; these questions are designed to stimulate thought and discussion.

	Effect on
	Rd (1 – T)	rs	WACC
a.       The corporate tax rate is lowered	(+)	(0)	(+)
b.      The federal Reserve tightens credit	(+)	(+)	(+)
c.       The firm uses more debt	(+)	(+)	(+)
d.      The firm doubles the amount of capital it raises during the year.	(+ or 0)	(+or 0)	(+ or 0)
e.       The firm expands into a risky new area	(+)	(+)	(+)
f.        Investors become more risk averse	(+)	(+)	(+)

a.       When corporate tax rate is lowered cost of debt after tax increase while cost of equity does not have any effect and WACC will increase as cost of debt increase.

b.      When federal reserve tightens credit, cost of debt increase as in the economy few funds are available hence increase interest rate as well as cost of debt, equity, and WACC.

c.       When the firm uses more debt, firm’s capital structure consists of more debt and hence seems more risky. It increases cost of debt, equity, WACC.

d.      When the firm doubles the amount of capital raise within a year cost of debt, cost of equity and WACC may increase or remain the same depending on purpose of raising the fund. In most of the case when company doubles its capital WACC, cost of debt and cost of equity tend to increase.

e.       When firm expands its business into risky area its cost of capital, cost of equity and WACC increase because of the variability in return.

f.        When investors become more risk averse cost of debt, cost of equity and WACC increase as it increases the interest rates.

9-4 Distinguish between beta (or market) risk, within-firm (or corporate) risk, and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?

Beta is a measurement of company’s risk relative to market risk or systematic risk. Beta also measure the risk associated with specified securities or portfolio.  In capital assets pricing model theory, securities or portfolios expected return is calculated based on that securities beta. The beta of market is always 1 and if the company is highly risky than that company’s beta is always higher than 1 representing high risk company and hence has higher expected return; while if the company is less risky than company’s beta is less than 1 representing lower risk company and hence has lower expected return.

Corporate (within – firm) risk is a risk associated with individual company. This risk consists of variability of projects return that contributes to corporation’s return. If all the projects that company operate have flexible return then company’s within-firm risk is higher.

Stand-alone risk is the variability of project’s expected return. More risky the project is, the higher flexibility of expected return of that project. Stand-alone risk is more powerful. If stand-alone risk is very high or projects return is highly volatile and it affects the return of other assets of the company or other assets in the economy then it will affect corporate as well as market risk. However, if stand-alone risk of project is higher but not correlated with the return of other assets of the company then it does not affect corporate risk.

Of the three measures, market risk is theoretically most relevant because market risk has direct effect on stock prices and hence reflects the changes on economy as a whole.

9-5 supposes a firm estimates its cost of capital for the coming year to be 10%. What might be reasonable costs of capital for average-risk, high-risk, and low –risk projects?

If firm estimates its cost of capital depending on riskiness of the projects then it is known as risk-adjusted cost of capital. Suppose a firm estimates its cost of capital 10% for coming year then cost of capital for average-risk project would be 10%, cost of capital of high-risk project would be higher than 10%, and cost of capital of low-risk project would be lower than 10%. For example, if cost of capital of firm is 12% then average-risk project will have cost of capital of 12%, high-risk project will have cost of capital of 15%, and low-risk project will have cost of capital of 9%.

This approach is better and well manages than no risk adjustment but in real practice it is very hard to specify exact risk as well as exact cost of capital. Therefore is approach is subjective and vary from firm to firm. 

Financial Management problem and solutions

5-2

The short term interest rate are more volatile then the long term interest rate so short term prices are more sensitive to interest changes than are long term  bonds prices. True or false? Explain.

Answer:            The statement is false. The possibility of interest rates change is higher in long run than in the short run. Therefore bonds with longer maturity period might need to sell in discount price or interest rate might go down/up. While in short run risk of changes (increase/decrease) in interest rate is low because possibility of significantly change in interest rate is very low. Since short term bond mature within 12 months it is convenient for investor to hold till maturity where as long term bond has maturity period 10 to 15 years and might need to sell in between and investor might have to sell their bonds on discount price. Hence long term bond prices are more sensitive to interest rate changes than are short term bonds price.

5-3

The rate of return you would get if you bought a bond and held it to its maturity date is called the bond’s yield to maturity. If interest rates in the economy rise after a bond have been issued, what will happen to the bond’s price and to its YTM? Does the length of time to maturity affects the extent to which a given change in interest rates will affect the bond’s price?

Answer:            If interest rates in the economy rise after a bond have been issued then bonds price will fell down because bond will pay less coupon interest than newly issued bonds hence bond would be offer in price below par.  

If interest rate in the economy rises yield to maturity also rises because yield to maturity and market interest rate is the same. Yield to maturity is sum of current yield and positive/negative capital gains yield. When market interest rate fall the price of bonds goes down that makes positive capital gain and hence increases yield to maturity.

Yes, length of time to maturity affects extent to which a change in interest affects the bond’s price. Bonds with longer term to maturity tend to have higher increase/decrease in to bond’s prices given the changes in interest rate than bonds with shorter term to maturity.

5-4

If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

Answer:            If interest rate decline in the market, the value of callable bonds will not rise as much as regular bond (bonds with no call option). The reason is that issuer of bonds has option to redeems the bond any time and when interest rate decline in the market this is the perfect time for them to redeem the bonds with high interest rate and issue new bonds with low prevailing market interest rate.

6-3

Suppose you owned a portfolio consisting of $250,000 worth of long-term U.S. Government bonds.

a.       Would your portfolio be riskless?

Answer:            While discussing about risk of portfolio it is necessary to know different types of risk that a portfolio could have. Some of the risk that security (portfolio) has is default risk, liquidity risk, inflation risk and others. U.S government bonds are backed by U.S government therefore these bonds does not have default risk and liquidity risk but in the long term inflation might increased significantly and interest rate might go up that cause the inflation premium (difference between expected and actual inflation rate)  to go up. Due to high inflation the value of portfolio may worth less in long-run. Hence a portfolio consisting of long-term U.S government bonds are not riskless.

b.      Now suppose you hold a portfolio consisting of $250,000 worth of 30-day Treasury bills. Every 30 days your bills mature, and you reinvest the principal ($250,000) in a new batch of bills. Assume that you live on the investment income from your portfolio and that you want to maintain a constant standard of living. Is your portfolio truly riskless?

Answer:            30-day Treasury bills can be considers riskless return but they still have reinvestment risk. If interest rate falls in the market then interest income will also fall down. Treasury bills are backed by U.S. government hence they don’t have default risk and liquidity risk. 

c.       Can you think of any asset that would be completely riskless? Could someone develop such an asset/ explain.

Answer:            It is not possible to develop riskless assets. Only U.S treasury bills are default and liquidity risk free because they are backed by U.S. government however in real life it is not possible to construct any assets or portfolio which does not have any risk.

6-5

If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase more or less than that on a low-beta stock? Explain.

Answer:            If investors’ aversion to risk increased then the risk premium on high-beta stock increase more than that on a low-beta stock. It is because the effect of the change in the risk aversion is stronger on more risky securities than in less riskier securities. Beside this, there is the positive relationship between risk aversion and the risk premium. If the risk aversion increases then the risk premium also goes up causing the slope of the security market line (SML) to become steeper. The steeper the Security market lines higher the required rate of return. Risk premium for stock x can be calculated as: Risk premium of market (RP_M) multiply by beta of stock x (β_x). For example,

 Market risk premium (RP_M) = 6%

Beta for stock X = 0.7

Beta for stock Y = 1.4

Now, calculation of risk premium for stock X and Y.

Risk premium for stock X = Market risk premium X beta

                                          = 6% X 0.7

                                          = 4.2%

Risk premium for stock Y = Market risk premium X beta

                                          = 6% X 1.4

                                          = 8.4%

Again, let’s suppose investors’ risk aversion increase that leads market risk premium to increase from 6% to 8% and beta for those stock remain the same.

Risk premium for stock X = Market risk premium X beta

                                          = 8% X 0.7

                                          = 5.6%

Risk premium for stock Y = Market risk premium X beta

                                          = 8% X 1.4

                                          = 11.2%

The above example clearly shows that risk premium for stock Y which has higher beta increase more than stock X which has lower beta. Therefore, risk premium on a high-beta stock increase more than low beta stock when investors’ aversion to risk increase.

6-6

If a company’s beta were to double, would its expected return double?

Answer:            No, expected return would not be doubled if company’s beta were to double. According to Security Market Line (SML) equation, Company’s expect return is Risk free return plus market risk premium (market risk – risk free return) times Company’s beta.

 For example, Risk free return = 8%

                        Market risk premium = 2%

                        Current beta of company (β) = 0.4

Then Company’s expected return = RF + (r_m – r_RF) β

                                                      = 8% + 2% X 0.4

                                                      = 8.8%

Now support Company’s beta (β) doubled from 0.4 to 0.8

Then Company’s expected return = RF + (r_m – r_RF) β

                                                      = 8% + 2% X 0.8

                                                      = 9.6%

Therefore, expected return of the Company increase when beta of the company increase but it would not be double if Company’s beta double.

6-7

Is it possible to construct a portfolio of stocks which has an expected return equal to the risk-free rate?

Answer:            It is only possible when the beta is zero but in the real world it is difficult to find an individual stock which has zero betas. Therefore, we can say that constructing a portfolio of stocks which has an expected return equal to the risk-free rate is impossible. A portfolio has two types of risk on it, first is diversifiable risk (unsystematic risk) and second is non diversifiable risk (systematic or market risk). Diversifiable risk can be eliminated by combining stocks which have negative correlation while market risk which is systematic risk cannot be eliminated. In real practice it is almost impossible to find out stocks which have negative correlation. When a portfolio has risk then its return should be higher than risk-free return. All kinds of portfolios have some unsystematic risk as well as systematic risk and hence it is impossible to construct a portfolio of stocks which has an expected return equal to risk- free rate. 

References

http://webcache.googleusercontent.com/search?q=cache:qgTSY1fJ2PAJ:business.fullerton.edu/finance/yunpark/Files/fin332/11e_sol/FM11%2520Ch%252004%2520Instructors%2520Manual.doc+If+investors%E2%80%99+aversion+to+risk+increased,+would+the+risk+premium+on+a+high-beta+stock+increase+more+or+less+than+that+on+a+low-beta+stock%3F+Explain.&cd=4&hl=en&ct=clnk&gl=us

Cyber Stalking, Electronic Surveillance

Question Number 1.

Taking the reference of the Michel A. Smyth v. The Pillsbury Company (US Dist. Ct 1996) Jodi can issue each employee their own company e-mail account, and then regularly check the messages sent to and from each account to ensure that no one is being critical or her and the company.

Jody, as an employers have many legitimate reasons for desiring to monitor their employees' e-mail usage, such as: Preventing and discouraging sexual or other illegal workplace harassment; Preventing "cyber stalking" by employees; Preventing possible defamation liability; Preventing employee disclosure of trade secrets and other confidential information; and Avoiding copyright and other intellectual property infringement from employees illegally down avoiding software, etc. These business justifications are compelling, but so are the reasons for protecting an individual's privacy. However, Jody should consider the breakeven point at which her company's monitoring program achieves necessary business objectives while also adequately protecting employee privacy, by applying right types of computer programs or software to monitor her employees' e-mail.

Question Number 2.

Taking the reference of the “Electronic Surveillance: The Law” on page 74 in our text book, Jodi can install new software called “Bad Employee Tracker” that will monitor her employee’s web viewing activities while on work computers, and alert her when they access certain sites.

Electronic surveillance refers to the overhearing or seeing of individuals and employing electronic or electrical devices to do so. The use of electronic or electric methods to keep watch over persons or organizations, termed “physical surveillance”, has obvious advantages for law enforcement. It is a means to prevent detection so as to be able to observe suspected individuals in normal, uninhibited states to gather possibly useful datum. The techniques and methods of electronic eavesdropping, offer the possibility of gathering evidence which would otherwise be unobtainable. Therefore, it makes sense to block certain sites outright for example, pornography sites are an obvious example, but companies may also consider gambling and game sites as utterly unrelated to work, potentially time-wasting and block them as well.

Question Number 3

            Taking the reference of case “State of New York v. Wal-Mart Stores, Inc.” in page 80 in our text book, Judy cannot fire the employees who caught looking at FoxNews.com because it falls within the definition of “legal recreational activities”. As in the case, “State of New York v. Wal-Mart Stores, Inc” NY Statute forbids employers discrimination against employees because of their participation in “legal recreational activities”. As an attorney I would suggest Jodi that she can install the “Bad Employee Tracker” software on her employee’s home computers but she cannot restrict her employees to involved in the activities which is defined as legal recreational activities by the law. For example, Colorado law makes it "a discriminatory or unfair employment practice for an employer to terminate the employment of any employee due to that employee's engaging in any lawful activity off the premises of the employer during nonworking hours"

Question Number 4

While, if Jodi is a die-hard vegan, then that doesn’t mean she can fire her employees for eating meat. If any act of an employees fall within the statutory definition of "recreational activities" which includes any lawful, leisure-time activity, for which the employee receives no compensation but it is done for recreational purposes, like sports, games, hobbies, exercise, reading and the viewing of television, movies, news and similar material then employers cannot fire them otherwise it would be a wrongful termination. Eating meat is not illegal act or offensive act. Therefore, as an attorney, I would convince Jody that it is not a legitimate to restrict employees to eat meat. In addition to this, taking reference of the case “KARRAKER v. RENT-A-CENTER, INC.” it is not legitimate to test the employees for whether they have eaten meat or not.

References

Halbert, J.D., Terry, Ingulli, ESQ., Elaine, (2006).  Law And Ethics In The Business Environment : South Western Cengage Learning.

http://www.lectlaw.com/files/emp08.htm