t

Cashflow

C
PV =
rg
Discount rate

PV =
1

Growth
rate

(1 + r )t

Potential problem:
multiple IRRs

NPV

r such that
NPV = 0

DFt =

Annuity

RoI = Book Income

Book Assets
Accounting
Rate of Return

(1 + rt )t

IRR

equivalent
annual cost

Project Valuation

EAC
Interest Rates

also known as
break-even rental

(1 + r )(1 + ) = (1 + i )
inflation

r + i

nominal

APR
r = EAR = 1 +

T
effective

RoI

CashOut
1
InitialInvestment
C1 + L + Ct
1
RoI =
C0
RoI =

annual rate

b = plowback ratio
Dividends = E(1-b)
RoE > r : positive growth opportunities
RoE < r : value being destroyed

Market Value

D0 (1 + g )
(RE g )

Dividend
Growth Model

PV (COSTS )
AnnuityFactor

RoE =

Market Value of Equity

Book Value of Equity

Ratios

FCF

Equity FCF
(EFCF)

VE + VD = VA

Corporate
Valuation

Cost = Cash PV (B )
Gain Cost = PV ( AB ) PV ( A) Cash

The economic Gain is required to

calculate true cost, since share price
may change with merger.

Cost of STOCK Acquisition / Premium (A buying B)

Cost = x PV ( AB ) PV (B )

Gain Cost = PV ( AB ) PV ( A) x PV ( AB )

True cost can also be calculated

from computing gain to shareholders
of company B.

x = fraction of combined firm stock going to

shareholders of B

Valid Motives
Shareholders are better off
Value Creation
Operating synergies horiz:
market power and vert: market
foreclosure.
Complimentary resource
synergies
Cheaper external financing
Correct management failure
Wealth Transfers
Bondholders to shareholders
Employees to shareholders
(wage concessions)
Customers to shareholders
(market power)
Taxes to shareholders (unused
taxshield)

Tax = T (EBIT Interest )

= T EBIT T Interest
[Interest = RD D]

Cost = [Cash MV (B )] + [MV (B ) PV (B )]

Premium paid
over market value

R D

WACC = R A 1 T D
RTS V

Thus annual tax savings are:

TS = T RD D

Dubious Motives
Agency empire building, larger
companies, prestige, perks, compen.
Diversification declining cash rich
industry. Funds should be returned to
shareholders.
Increase EPS number of shares
traded may not be equal.

PV (TS ) =

VU = VL PV (TS )

Real additional
cashflows from TS

When T=0

T RD D
RTS

R A = RD

D
E
+ RE
V
V

RE = R A +
When RTS

RTS approximates to RD when risk of

NOT using tax shields is minimal

= RA

S$ : $/ spot exchange rate ($x:1)

F$ :$/ forward exchange rate
r : nominal interest rate
r$ : nominal interest rate $
i : UK inflation rate
i$ : the US inflation rate.
[S$ x S$ = 1]

To UK

$1

+1 year

Back to US

No riskless arbitrage

1
1
(1 + r ) 1 (1 + r )F$

S$
S$
S$

(1 + r$ )

$1

Expected
future
spot rate

(1 + r$ ) = F$
(1 + r ) S$

Estimating
future
forward
rates

) E(S$
)
F$ = E(S$

Purchasing
Power Parity

Bonds
coupon
%

terminal
period

coupon

Zero-Coupon Bonds
Use ZCBs to get r-values for each
year (spot values) when
calculating bond prices if there is
non-flat term structure.
(could use annuity only when
term-structure is flat)

P=
t =1

RE = RA +

PSEMI =
t =1

Forward
Rates

(1 + ) (1 +
rt

F
r2 T

Expected interest
rates in the future $1

(1+ r2 )2

2T

Discount Factor
Interest Rate Term Structure
Graph of YTM for
ZCBs over time

Market
price T

D
E
+ RE
V
V

Only consider
Interest bearing
debt

(1+ 2 r3 )

Taxes Paid
EBT

CAPM

RE = RF + E (RM RF )

Earnings
before tax

+ ST Debt

D = t wt

Bonds &
Fixed Income

What value of r gives

the market price P
equal to the discounted
cash flows for the bond?

t =1

wt =

Duration
The weighted average of the
time taken to get payments

C
F
P=
+
t
(1 + YTM )T
t =1 (1 + YTM )

(if ST debt is not

related to workng
captial)

ZCB Duration

Interest Rate Sensitivity

Treasury Securities

Interest rates are more sensitive:

- when maturity is longer
- when the coupon is lower

1yr <= T-Bills

10yr <= T-Notes
10yr > T-Bonds

Forward Rates
Nomenclature:

r f (0,2,3)

2 3

cashflow
at time t

used
for working capital
it could be used to
pay off debt
holders)

V
r
= D
V
1+ r
ratio of change
in interest rate

Cash
(if cash is not

1 Ct

P (1 + rt )t

ratio of change
in value

The duration of a ZCB is the same

as its time to maturity

Risk Shifting
2 +ve NPV projects with different risk
D fear funds will be allocated to hi-risk
(ltd liability of E means D loses)
D thus require higher RD and no
projects now have +ve NPV
Soln: Debt covenants etc

Tax

Debt

The tax rate to be used

may not be the
corporate tax rate.
Strictly speaking it
should be the effective
tax rate

In principle the market

value of the debt, but in
practice this hard to
find. Book value is a
valid proxy unless
company is in distress.

Actual Returns:

Standard Deviation:

i = Ri [RF + i (RM RF )]

This allows us to make RA = WACC

[w1 + w2 = 1]
[V (R ) = 2 ]

Leverage
Gearing = Leverage = D/V

D1 , E1

D2 , E2

E1, D1, A1 E 2 , D2 , A2
L=

D1
D
L= 2
V1 w %
V2 w2 %
1

DC , EC , EC , DC , L =

DC
VC

Beta

P = w1 1 + w2 2 + 2w1w2 1, 2
2

Risk of bankruptcy due to debt

payments makes debt more risk

Company

Portfolio Theory

(RP ) = w12V (R1 ) + w2 2V (R2 ) + 2w1w2 COV (R1 , R2 )

2

wacc
D/V

AC = w1 A1 + w2 A2

RP = w1 R1 + w2 R2

RA

Divisional Leverage

D
E
+ E
V
V

Equity Beta

E (RP ) = w1 E (R1 ) + w2 E (R2 )

Variance: V

Abnormal Returns

Modigliani-Miller
MMI Capital Structure Irrelevant
Perfect Capital Markets:
Individuals can borrow at the same
rate as corporations.
No bankruptcy costs / distress costs
No agency problems
Symmetric information
NO TAXES

Asset Beta = unlevered

Equity Beta = levered

D
( A D )
E

Typically ~ 5%

Expected Returns:

Efficient Market
Hypothesis

Depreciation is not inflated in

nominal/real calculations.

Optimum Leverage

Given by the covariance of

the stock with a give index
(usually via regression
analysis)

The difference between the

return expected from
investing in shares and the
risk free rate.

Equity

D = LT Debt

Sunk costs ignore, but market value if

sold is relevant.
Opportunity costs (incremental) should
be included (not allocated). Excess
capacity is not free.
Inflation cashflows need to be matched
to rates of return (nominal usually)
Financing costs taken into account in
WACC (e.g. dividends and interest)

D/E

Can be assumed to
be 0 if debt is risk-free

Market Risk Premium

The market value of the

equity of the company
E = share price * number of
shares outstanding

Notes on FCF
Essentially cash generated before
payment is made to debt holders

PV( BCFD ) << PV(TS )

PV( AC ) << PV(TS )

E = A +

Risk Free Rate

Debt

Contributions: Mike Rizzo, Mark Carroll

Thus RA does not change due to capital

structure but this does not hold in the
real world of taxes etc.

VU

A = D

Given by short term

treasury bills (up to 1 year
maturity) in the US, or gilts
in the UK.

Yield to
Maturity

PV(TS)
PV(TS)-PV(BCFD)-PV(AC)

(1 + r3 )3

3
(1+2 r3 ) = (1 + r3 )2 = DF2
(1 + r2 ) DF3

Debt Overhang
New E raised goes to D shortfall if project
successful. E insures D.
Soln: Issue more D, use E to buy back D,
convertibles
Overinvestment
FCF which should go to D is risked by E on
risky project.
Downside goes to D, upside to E (ltd liability)

= RD

D
( R A RD )
E

RD = YTM on the
debt of the company

Tax Rate

r3

ZCB

Pricing

1
B(0, t ) =
(1 + rt )t

Company Value

Optimum Leverage

RA = RF + A (RM RF )

r2

(1 + rt )t (1 + rT )T
2T

B(0,t) is equivalent to
$1 ZCB for t years

yield
curve

face

P = PV (C ) + PV ( F )

(1 + r$ ) S
(1 + r ) $

P$
P S $ P S $
P
)
E (1 + i$ ) E (S$

E (1 + i )
S$

Price = P(C,T)

WACC = RD (1 T )

P(ExpectedCost )
RBC

Reduced financing capacity (D & E)

Higher cost of capital
Loss of customers / suppliers / talent

D
(RA RD )(1 T )
E

R A RTS RD

Covered Interest Parity

Created Matt McNeill 2007

mmcneill.semba2008@london.edu

Agency Costs (AC)

When RTS

Leverage

Interest Rates

PV( BC ) =

VL = VU + PV(TS ) PV(BCFD) PV(AC)

RAVU + T RD D = RD D + RE E

= T EBIT T RD D

Difference between
MV and value as
separate entity (PV)

Unlevered

Note: APV assumes D constant over time,

iterative WACC assumes D/V ratio constant, so
values may be slightly different.

Financial Distress Costs (FD)

Note: Perpetuities bring back 1 period (T = last

period of FCF model)

R A RTS RD

Tax Shields

Does the Market Value of the firm reflect

takeover premium?

1
FCFT (1 + g )

(1 + WACC )T (WACC g )

Creative Commons
Attribution-ShareAlike 3.0
http://creativecommons.org/licenses/by
-sa/3.0/

APV = NPV ( AllEquity) + PV (TS )

FCF insufficient to meet RD.D (interest)

Direct Costs Legal, Accounting,
Trustee, Management fees etc
Indirect Costs Production inefficiencies
(e.g. supplier terms), lost investment
opportunities, talent loss etc
Typically 1-20%, =3-4%, young firms

Based on the PV of a constant FCF (as in

last period) with constant growth

FCF1
FCF2
FCFT
V = FCF0 +
+
+ L+
(1+ WACC) (1+ WACC)2
(1 + WACC)T

Adjusted Present Value (APV)

Value project as if all equity financed use
Operating FCF, discount at RA = RE all equity
firm. Add PV(TS) generated by new project

Bankruptcy Costs (BC)

Terminal Value

Cost of CASH Acquisition / Premium (A buying B)

Stock Acquisitions

for all equity firm :

Note: VE = Free Cash Flows available to equity holders

Funds available in company after:
-Building up NWC
-New investments
-Paying off old debt / Issuing new debt
Funds available in form of dividends or share
repurchases

Gain = PV ( AB ) [PV ( A) + PV (B )]

Note: that the cost to firm A cannot

be calculated from the stock price
ratio.

EBIT (1 T )
( RE g )

[WACC = RA = RE ]

EFCF = FCF Interest (1 T ) + NetDebtIssues

Free Cash
Flows

V2.2 - Licence / Copyright

NPV (All Equity)

VE =

EFCF = NetIncome + Depreciation CAPX NWC + NetDebt

Overall / Economic Gain

MV = PV + P*C

Revenues
Costs
EBITDA (operating income)
Depreciation
EBIT (operating profit)
Interest Expense
Pretax Income
Taxes
Net Income
Dividends (& share buy-backs)
Addition to Retained Earnings

FCF = NOPAT + DEPREC CAPX NWC

VA VD = VE

(WACC g )

Accounting Statement
=
=
=
=
=

[NOPAT = EBIT (1 T )]

Operating FCF
(FCF)

V=

Taxes and NOPAT

If actual taxes are known then we
can use
EBIT Tax Expense
Instead of NOPAT

Note: VA = Free Cash Flows of the company

Funds that would be available to equity holders if D = 0:
Funds from company free cash flows
= NOPAT
+ Depreciation
- Change in NWC ( = current assets current liabilities)
+ New investments

Net Income
Stockholders Equity

Use a ratio for a given

industry or similar firms
and apply.

Mergers & Acquisitions

Market Value (MV) could be a

combination of PV and expectation
(P) of takeover premium (C):

Calculating Share Value

To value shares, divide dividends and
repurchases by number of shares
outstanding

P (1 b )
(1 b )
=
=
E RE g RE RoE b

V / EBITDA

Firm Value
Comprises of value of all
its projects - The present
discounted value of all its
cashflows.

(rate of return)
T

Plowback Ratio

Payback

Equivalent to
perpetuity at time 1 perpetuity at time t

real

Ratios / Perpetuities
Ratios can be equivalent to a
perpetuity resulting in
Ratio = r g
=> beware same assumptions as
DGM

V=

discount
factor

C
C (1 + g )t
PV =

(r g) (r g) (1 + r)t

Dividend Growth Model

AKA the Gordon Growth Model or
constant growth model. Assumes
constant growth, ok for mature or
stable industries

Cost of capital

Perpetuity

1, 2

= 1, 2 1 2 ]

[ rho]
Correlation
between two
stocks

Risk of
share

Risk of
portfoli
o

I x Rm
Market
risk of
share
Market
risk of
share
p x Rm

Major Part
Specific
risk of
share
Specific
risk of
share

A measure of how much a stock

contributes to portfolio risk, i.e. how much
the stock moves when the market moves.
1 = same as market
0 = unrelated to the market
-1 = inverse to the market

i =

corr(mkt, stk ) stk

Negligible

mkt

Portfolio Terms
Risk = covariance / correlation

Abnormal Returns
Abnormal returns: i

Portfolio Risk and Diversity

Risk

But if capital markets are

efficient then

Ri = RF + i (RM RF )

E ( ARi ) = 0

Market
Risk

Idiosyncratic Risk
Specific Risk
(Diversifiable Risk)

Portfolio Performance
RP

RP

Correlation
rho = -1 (max benefits from
diversification)
-1 < rho < 1 (some benefits
from diversification)

Market Risk
(Systematic Risk)

# Stocks
20
A portfolio of about 20 stocks can diversify
almost all specific risk

rho = 1 (no benefits from

diversification)

0%

100% w1:w2
(Mix)

Risk
(StdDev)

= mean return =

VAR =

1 T
rt
T t =1

1 T
2
(rt )
T t =1

StdDev = SQRT(VAR)

Call Option
S>K = In the money
S=K = at the money
S<K = out of the money

Call = buy at given price

Put = sell at given price
Strike = Exercise = K
Premium = Cost = P, C
Stock Price = S

Long Call
C
K

Long Put

P = Max{0, K - S}

St

St

This can be used to

calculate replicating
portfolio for use in pricing
options

Black-Scholes

1-P%

Using replicating portfolio,

solve simultaneously for , B

C1D = max{0, S1D K } = S1D + (1 + RF )B

Normal
cumulative
density
distribution

d1 =

European Put option

St

P = S N( d1 ) + PV(K ) N( d 2 )

= Long C(X)
+ 2 x Short C(Y)
+ Long C(Z)

= $

K S

+$

K
S

Equity Issues
IPO = Initial Public Offering, a
companys first offering of shares to the
general public.
Primary Shares new shares
issued by company where money
raised is invested in the firm
Secondary Shares insiders selling
stake in company where money
raised goes to the previous owners
SEO = Secondary/Seasoned Equity
Offering, an equity issue by a firm that is
already public.
Pecking Order:
(1) Internal Funds,
(2) Debt, (3) Equity

Underwriters
Investment banks which advise the firm
and provide independent monitoring of
quality of firm to the market.
Also handles:
Roadshows for signalling
considerations and demand
evaluation
Bookbuilding bids during BB
period (~2 weeks) can be revised
and cancelled.
Price and Allocation following BB
period.
Alternatives to BB might be allocations by
auctions, but no discretion to underwriter
on final price and allocations (Google)
UW formally buy shares from firm and sell
to public at higher price.
Various sales models:
Firm commitment all shares (see
Underwriters put)
Best Efforts sale and return
All-or-none
Price premium covers UW responsibility:
Market maker liquidity in first
trading days
Research coverage after IPO
Price premium covers UW risks:
Stabilising prices if they fall below
offer price
Buying unallocated stock
Mitigated by green shoe option
(option to purchase additional ~15%
shares from company at offer price if
demand high within ~30 days of
IPO)
IPO Fees usually a fixed % of the issue
(~7% in US, ~5% in UK, ~3.5% in Europe)
SEO fees about half IPO very varied
Rights fees usually ~2%
Underpricing IPOs (-12% UK, -15.8% US)
UW favour current / potential clients
Signalling/Reputation (future SEO)
Dispersion/Liquidity on lower prices
Attract less informed investors
(mitigating winners curse problem)

Black-Scholes Shorthand

Can be exercised before maturity date

Call options
- No dividends = European Call
- Price: calc euro call options maturing
at all dividend paying & expiry dates
and choose largest
Put options
- no dividends: may still exercise early
- value larger than euro put

+
+
+
+

Advantages of IPO

Exercise price drivers:

low as possible to ensure that always in money
and all rights are exercised (income)
not so low as to signal the market that the
managers think the share price will drop a lot in the
next 3 weeks
shareholders not bothered, since right value will
always balance dilution of current share price.

Disadvantages of IPO
Costly admin fees (4%) & underwriters fees
Loss of control
Legal reqs. disclosure rules etc
Value of firm subject to external perception
Easier target for hostile takeovers

E0
ET
S0
ST

= number of existing shares

= issue ratio (rights issued per share)
= number of rights (m = i.n)
= number of shares per right (r = 1)
(conversion ratio)
K = exercise price
= dilution factor (% fraction of E that goes to
new stockholders)
n
i
m
r

Value of exercising
a right now

ET = E0 + nK
ST =

S = Stock price at time 0

K = Strike price / exercise price
T = Time to maturity (years)
Rf = Risk free rate
= volatility

Rights = short warrants (~3 weeks) issued at zero price

UK ~60% equity issues, US <5%
Rights issued are proportional to shares owned
Shares trade cum rights, but later can be split and
traded separately.

= value of pre-rights company (all equity)

= value of pos-rights company (all equity)
= value of each pre-rights stock
= value of each post-rights stock

FUW

= underwriters fees

V0
W0

= value of exercising a right immediately

= value of the option of exercising a right at maturity

Valuing Rights

Black-Scholes Assumptions

V0 < W0

S 0 = ST + V0 i

Options increase
value of the rights

Shareholders are
not bothered

C right owner

K*

ST

P firm

Futures Contract is a standardised forward

contract traded on an organised exchange.
S0
F

Return on asset S for 1 period

P% (S1U S0 ) + (1 P%) (S1D S0 )

S0

V (S1D )

Full Hedge

Current value of the firm

P%V (S1U ) + (1 P%) V (S1D )

V0 =
1+ RS

F = S0 (1 + r )

r = risk free rate

V (S1U ) V (S1U F ) = V (F )

V0
1-P%

V (S1D ) V (S1D F ) = V (F )

Futures Swaps
No
Yes
No**
No
High
High***
Low
High

Options
No*
Yes
High
Low

F
(1 + r )T

F = S0 (1 + r )

Value of firm (ET*)

FD/
holds
bonds

converts
to shares

ET > F
KD =

If C0 > S0-K then the option to

defer the project and miss
possible cash-flows is more
valuable. i.e. Wait and see.

Discount at RF

Discount at RP

PV0(FCF)

FCFT+1 FCFT+2

Find expected return

P%

S1U

S0
1-P%

S1D

Payout Policy
This is how a firm distributes cash to the
shareholders in one of two ways:

Share repurchases should only be used to

distribute extraordinary surplus cash-flow, but
since mid 1980s US firms now redistribute
50%. Europe is 20%.

InvT

PV0(inv)

S = Value of project
D = cashflows from project
during period 1
Rf = Risk free rate
P% = chance of going high

(S + D )
(S + D1U )
RP = P% 1U
1 + (1 P%) 1D 1D 1
S0
S0

To find P%, set RP = RF (for example)

C = P% max{0, S1U - K}

+ (1 P%) max{0, S1D - K}

Exercised when value

recovered from projects assets
si greater than the PV of
continuing the project for at
least 1 more period.

Extremely liquid due to use of exchange

Firms can quickly rebalance risk
management portfolios at low cost
BUT: we do not know counterparty and
default risk.
THUS: exchanges require collateral and
typically daily settlements (potentially
requiring some cash now)

Dividends firm distributes cash (or stocks) to

shareholders in proportion to number of
shares held.
DPS dividends per share
Dividend Yield: DPS / share price
Payout Ratio: DPS / EPS
Share repurchases firm buys shares from
shareholders (US = treasury shares / UK
eliminated, unless reserved to balance stock
options etc.)
Open market repurchases
Fixed Price Tender Offer
Dutch Auction Tender Offer

S = NPV of FCFs (at t=0)

K = PV(expected investment) t=0
T = Time of inventment (years)
Rf = Risk free rate
= volatility (comparable stocks)

Cashflows equivalent to
dividends from a stock. When a
projects forecasted cashflows
are sufficiently large the
investment is made right away
(option is called)

Real Options

PV(FCF) PV(Inv)

Abandonment Options

Hedging Instruments
Forwards
Yes
No
Low
High

Payout Policy Irrelevance

In perfect capital markets and dividends and
cap gains tax are zero or the same, payout
policy is irrelevant.
Dividends: shareholders could use dividends
to buy more shares, or could sell shares for
cash to simulate dividend.
Share repurchase: shareholders total wealth
unchanged whether they sell shares or not.
Also equal to dividend distributions. If shares
repurchased at premium there is no wealth
transfer between shareholders unless some
fail to participate in bid.

Payout Policy Relevance

When dividends and capital gains are taxed
differently, payout policy is not irrelevant.
Dividends: pay taxes on full cash distribution.
Share repurchases:
Pay cap gains tax rate only (typically lower)
Only pay tax on part of distribution (the gain)
Only pay tax if chose to sell
Depends on investors tax bracket, e.g.
pension funds are indifferent (but may like
predictability of dividends)

Tax Clienteles
Investors with different dividend tax treatment
will hold shares of firms with different
dividend-payout ratios.

Underwriters Put

Preferred Stocks

Optimal hedging

When firms get a firm commitment from the

underwriters, then it is equivalent to the firm
putting a put option on the rights it is selling

Shares with fixed dividend (like debt)

Junior claim to debt, but senior to ordinary stocks
Dividend may not be paid, but only if ordinary stock dividend not paid
Limited voting rights (usually become normal voting rights if dividend not
paid)
Often viewed as flexible leverage (classified as equity, limited control,
cashflow flexibility if dividends not paid)
Often bought by institutions, corporations or low income tax bracket
(income tax < cap gains tax)

Optimal hedging depends of structure of costs associated with low

cash flow.
Inability to service interest payments, increasing costs of financial
distress and decreasing debt capacity (tax savings) of the firm.
Inability to take advantage of profitable investment opportunities
Inability to perform dividend smoothing.

Different investors might pay different tax

rates on dividend income and capital gains:
In most countries individual investors pay
higher tax rates on dividends than on capital
gains.
Pension funds are tax exempt.
Corporations typically pay lower tax rates on
dividends than individuals.

Note: These are only valid of there is a cost of obtaining outside

financing.

This creates different tax clienteles for

dividends: e.g. attracting institutional
investors.

UP is typically a very small part of the fee.

Advice and monitoring is usually much more
significant.

Futures

S0 =

C = C BS (S , K , T , R f , )

upside of
investment

V (F )
V0 =
1+ r

Payoff structure should cancel underlying risk as much as possible

Cunstomised
Upfront Payment
Liquidity
Default Risk

FD

F = [S0 PV(income) + PV(storage costs)] (1 + r )T

Follow-On Investment

Timing Options

V (S1U )

monies raised
by convertible
issue

And now accounting for the costs of

storage and income from the asset:

Real Options

(*) Unless traded OTC, but then they are (much) less liquid.
(**) However they do require a margin account.
(***) Huge demand for swaps makes them extremely liquid.

P underwriter

= current spot price (t=0)

= cost of T-period forward contract

Cost of carry:
F S0 > 0 Market is in Contango
F S0 < 0 Market is in Backwardation

No Hedge
P%

Contributions: Mike Rizzo

* F
= max ET D ,0

Assuming both strategies of

buying now and storing (at
zero cost) and buying a
forward contract on the
asset are both 100%
riskless then:
(risk of underlying asset
already incorporated in S0)

Assume firm value V, depends on asset price S:

UP

UP = PBS (E0 FUW , nK , T , R f , )

Forward Contract is commitment to deliver

predetermined asset at a future time for a
predetermined price.

Although a project may not

look as if it will payoff at t=0, the
volatility and upside risk profile
may still make the option very
valuable.
The risk downside is not
relevant since option would not
be exercised in that case.

S1D

Creative Commons
Attribution-ShareAlike 3.0
http://creativecommons.org/licenses/by
-sa/3.0/

Created Matt McNeill 2007

mmcneill.semba2008@london.edu

CB = max ET FD ,0

coupons before
*
E0 = E0 PV
PV (dividends)
maturity
E0 = (n S0 ) + (m FB )

Value of hedging usually depends on the need for a stable

cashflow to take on other projects.
If the hedge will provide the capital for the stable project it is a
good thing to do. Risk is bad.
If the hedge eliminates the chance of raising the capital for a
project it is a bad thing to do. Risk is good.

P%
Rights issues where K is closer to
ST have higher (W0) option values
since the downside is more limited
(value of a call option decreases
as K is further from S)

Follow-on investment (Call option / BS)

Timing options (American calls / Binomial)
Abandonment Options (Put option / binomial)

RS =

FD

Conversion exercised if:

( )

E0 = PV ET

W0 = C BS (E0 , nK , T , R f , )

We usually want to hedge:

Interest rate risk (inflation / real rate changes)
Currency risk
Fluctuation of commodity prices (inputs / complementary
products)

1-P%

V0 = ST K

WT = max[ET nK ,0]

These are options as applied to business

decisions:

S0

= Face value of debt (#bonds * FB)

= Exercise (strike) price of debt
= Value of initial equity
= Adjusted value of initial equity
= Adjusted value of equity at maturity

default

VT = ET + mrK

Forward & Future Contracts

Stock variance 2 is constant

Rf is constant
No dividends
Frictionless trading (no transaction
costs)
Note: is not an observed quantity
in market, and BS is often used to
find implied volatility.

S1U

FD
KD
E0
E0*
ET *

V2.2 - Licence / Copyright

(1 + R )
f

V0

1
W0 = C BS (E0 FUW , nK , T , R f , )
m

existing
equity

Hedging

1-P%

ET
(n + mr )

Hedging is obtaining insurance against some exogenous risk by

taking an offsetting risk.
Risk Management is defining an optimal set of hedges

P%

Value of option of
exercising a right at
maturity

See bond pricing

on other side

W = C BS E0 , K D , T , R f ,

V0 = E0 + m (price of warrants)

mr
=
n + mr

d2 d1

ln S

PV(K ) + T
2
T

PV(K ) =

Rights Issue

Obtain cash bank finance, venture capital not

enough
Cheaper financing higher liquidity and lower
info asymmetry (disclosure reqs.)
Other financing cheaper (as above)
Insiders can cash out
Easy future access to equity markets

E0 = S 0 n

C = C BS (S , K , T , R f , )

Effect on CBS if the given

variable increases in value:

Payoff

P(K ) + S = C(K ) + PV(K )

$

American Options

B(0, K )

(1 + RF )T
P(K ) = C(K )

CB = W + B(C , T )

Need to solve
recursively
[where F = CB
???]

d 2 = d1 T

Incorporating
dividends into BS

P = (S PV(D )) N( d1 ) + PV(K ) N( d 2 )
PV(K ) =

Value of all
warrants

Incorporating
dividends into BS

C = (S PV(D )) N(d1 ) PV(K ) N(d 2 )

convertible = warrant + straight

bond
bond

n = number of existing shares

m = number of warrants
r = number of shares per warrant
(conversion ratio)
K = exercise price
= dilution factor (% fraction of E that goes to
new stockholders)
Value of all
equity firm

Mitigate agency problems of debt

Mitigate signalling problems
Can obtain debt at lower current cost (coupon
discount related to value of warrant)

Treat same as Options for pricing but need to

adjust for share increases and purchase price

C1U = max{0, S1U K } = S1U + (1 + RF )B

P not known, thus cannot
use weighted average for C0

C = S N(d1 ) PV(K ) N(d 2 )

e.g. Butterfly

St

= S2 D + (1 + RF ) B

C2D = max{0, S2D K}

n
m
r
FB
FB/r
KB

Equivalent to a package of a:
straight bond + warrant

Delayed equity issue (mitigates signalling

problem)
Exec stock options are warrants
Equity rights issues are special
warrants.

Note: that ,B in each period will

Change depending on outcome of
previous period (Dynamic Replication)

European Call option

Derived from
binomial with
infinitely small
periods (and
assumptions)

Put-Call Parity

= S2M + (1 + RF ) B

European Call
option

Long Call = +45 (L R)

Short Call = -45 (L R)
Long Put = +45 (L R)
Short Put = -45 (L R)
e.g. Straddle

C1M = max{0, S2M K}

C1D = S1D + (1 + RF ) B
= S1D + B

C0 = S 0 + B

Combining options requires

going long / short on options
with different strike prices.

P%

-X

C(X)
+
P(X)

= S2M + (1 + RF ) B

= number of existing shares

= number of bonds
= conversion ratio: number of shares per bond
= face value of each bond
= conversion price
= conversion value: market price of bond
divided by r (strike price of each share).
Usually calculations worked out with complete
company values:

Convertible Bonds

Equiv. To Call option except:

Issued by company so company gets
purchasing price
On exercise company issues new shares
and gets exercise price

C1U = S1U + (1 + RF ) B

Binomial Model

Warrants

= S2U + (1 + RF ) B

= S1U + B

V = S + B

Payoff
Profit

If two combinations of
assets have same
cashflows in every period
and every outcome, then
they must have the same
price.

Arbitrage Principle

+ $

C0 = S0 + B

Option
Pricing

Short Put

maturity = expiration

Call: > 0, B < 0 (long S, short B)

Put: < 0, B > 0 (short S, long B)

C = Max{0, S - K}

St

American
Can exercise any time up
to (and on) the given
maturity date.

For European Call Option

value of
option

C2U = max{0, S2U K}

2 Period Binomial Model

Use arbitrage principle.

= proportion of stock
(aka hedge ratio / option delta)
B = value of risk free Bonds

St

Option types
European
Can exercise only on
given maturity date

Options

Short Call

Replicating Portfolio

Put Option
S<K = In the money
S=K = at the money
S>K = out of the money

Value of
Convertible (CB)

Terminology
Long = Buy the right to
Short = Sell the right to

Swaps
A swap is an agreement by which 2 parties exchange
cash-flows of 2 securities (without changing their
ownership)
Interest Rate Swap is an exchange of interest
payments on debt (most commonly the coupon swap:
fixed rate with floating rate)
Currency Swap is an exchange of payments in
different currencies.
Interest Rate Swap Example
Assume that the floating coupon is 8% in first
semester and increases 1% every period
The net payments from X to firm Y are
Floating rate
Xs payment
Ys payment
Y pays to X

S1
8%
$5
$4
$1.0

S2
9%
$5
$4.5
$0.5

S3
10%
$5
$5
$0.0

S4
11%
$5
$5.5
-$0.5

By entering the rate swap, Y borrows at floating rate

(to which it has access) but eliminates interest rate
risk.

Signalling Methods
Dividends: most effective since they set future
commitment.
Shares repurchases with auction: very effective, if the
shares are bought at a premium and management
precommits not to tender (i.e. not selling own stock at
a premium).
Open-market share repurchases: weakest signal.
Shares are bought at their current market price.
50% of announcements do not follow through, and
10% repurchase less than 5% of the value announced.

Signalling and Dividends

Investors react sharply to changes in dividends
Omission: -9.5%
Reduction of more than 25%: -6.4%
Reduction: -1.2%
Increase: 0.7%
Increase of more than 25%: 1.0%
Initiation: 3.9%
A superior firm has higher payouts to signal wealthy
and confident. Less profitable firm cannot sustain large
dividends over long run.
A less profitable firm will eventually have to cut
dividends, miss investments, issue equity or debt to
finance dividends (inefficient!)
Implications select conservative ratios, and avoid
raising dividends if risk of having to reverse it.
Dividend change should be smaller than change
implied by earnings (smoothing). Avoid dividend cuts if
cost is small.

Stock Splits
Stock Splits: Increasing the number of the
outstanding shares by reducing its nominal value.
Example: In a 2:1 split, investors receive two new
shares in exchange for each old one. The stock price
drops by 50% (no money ever changes hands!).
A rationale for a stock split is that it makes stocks
cheaper for small investors.
However, this liquidity effect is not well supported
by the existing empirical evidence: there is no
significant price response to a stock split.

Tax Cost of Excess Cash

Excess cash is effectively generating a negative tax
saving for the investors.
If firms have more cash than what they actually need
to finance their business and have financial flexibility,
then they should distribute it to shareholders.
Important caveat: cash required to finance the
business and cash required for financial flexibility are
not exactly well-defined quantities!