Cost of Capital Unlevered Using the binomial pricing model, calculate the price of a 2-year PUT option on Kinston

stock with a strike price of S9. Illustration of Valuation Methods

E + D = U = A Binomial Model: Risk- Neutral ®
£ ? *? ? & ? '? ° Boston Uwwnity
S< N»I o» Management

l) 8 r|? f 8 8 J? Suppose SMG, Inc. is considering an acquisition that

= ru+ - ( - ) 1. Stock price S goes up to Su or down to Sd l is expected to increase SMG 's free cash flow by $5

F. ru rn
rp. million the first year, and its contribution is expected
7 Io , $ 7 C u =- u Io n to grow at 3% per year from then on . SMG has

/:
.
2 Find option payoffs by working backwards I Sf *|"« ? ? ?
negotiated a purchase price of $50 million (of which
$30 million are debt-financed at a rate of 7.94%).
n
. o
* 2 * g; * * ? s| After the deal, it will adjust its capital structure to
— rA — rU ~ E+ D*E + E+ Dr° For example, call pays Co = max (Su-K,0 ) or C maxtSrf-K O )
H i_* -
riHKt maintain a constant debt equity ratio. Its tax is 35%.
^ a+ k b
* § If the acquisition has similar risk to the rest of SMG's
S fe
3. Find risk- neutral probability of up state
( 1 + rfys - 5, | i|
< a
s C°5
a
=
•
activities, then you can use its WACC of 9 %. The
unlevered WACC is 10% and its equity cost of caplti

Pl'
I:
DPe+ E°+ D fin PE = PU + /: ( PO - PD ) ^
I)
P =
s, - sd
5 I 1° *
c;
11
Is 11.16%. Value of this deal by the three methods.

E+
Interest Tax Shield
4. Get option value as expected present value
pc„ + (i - pycd
I1 = I
S
S
c: APV Method

PV ( ITS )
= Tc X D c = •2
0 s .
1 Value without leverage.
I + rf •2
V" - S5
- S71.43 million
10% - 3%
V ' = Vu + /*141merest l ax Shield) 5. Repeat 1.-4. if there are multiple periods .
2 Determine the value of interest tax shield .
-
Verify that your answers to 10) and 11) satisfy put-call parity. PnrrS ) [( 30*0.0794)*35%j / (10% 3%) 11.90 -
VL - - -£ + £> 140
WACC g
FCF
- 1. Stock price S goes up to Su or down to Sd
NPV = NPVwithout growth option + PVgrowth option
Put Option + Stock Price = Call Option + PVCStrike Price) $0.707483 + $10 = $2.544218 +
$9/1.052 = $10.707483
.
3 Add the unlevered value (1) to the present
value of the interest tax shield ( 2)
V‘ -
V" 11‘ nrrs ) S83.33 million -
.
Vv - - pretax WACC g
FCF 2. Find option payoffs by working backwards
For example, call pays C„ - - max (S„-K,0 ) or Cd = max(S<-K,0)
3. Find replicating portfolio of stock and bond
Profitability Index =
NPV
In YR1, AMC’s EBIT= S2000 & grow 3%/year. The firm will make no net investments
(i.e., capital expenditures = depreciation ) or changes to net working capital. Corporate tax
-
rate = 40%. Right now , firm has S5000 in risk-free debt. It plans to keep a constant ratio
The acquisition has an NPV of $33.33 million .

-
E
f +
i>
E + D' E+ D
E
f/)( l

D
- ,)
T

D
.
= •V* V,
A
c c ,
-. -- -
,
= *I + r*
L „
< and II
c
4. Get option value as initial cost of portfolio
- S .A
-. . — Initial Investment of debt to equity even year, so that on average debt will also grow by 3%/year. Suppose
risk-free rate = 5%, expected return on the market = 11%, asset beta = 1.11.
a. If AMC were an all-equitv (unlevered) firm , what would its market value be?
AMC has unlevered FCF of S2.000 x 0.6 = SI, 200 .
WACC Method

. .
E+ D rF. E + D n
+ > ~ T T, 1 The free cash flow Is $5 million
E+ D / C = SA + «
Practice Exam From the CAPM, AMC’s unlevered cost of capital is 5%+ l llx(ll % 5%) 11.66%. . - - .
2 The WACC is 9% .
Pretax WACC Reduction Pin- 5. Repeat 1.-4. if there are multiple periods .
3 So the value of the investment is
to Interest Tax Shield
,
Discounting the FCF as a growing perpetuity tells us that the value of the firm, assuming
-
Personal Taxes - effective tax advantage of debt
1 ) Which of the following is NOT a real option? A) A stock option B ) An abandonment
—
C) An investment timing option D ) An expansion option ,200
option ww h of 3% v 9%t-53% - S83.33 million -
marginal personal tax VifKquity ) = SI = S13,857.
( 1 - Tf ) ( l ~ Te ) 2) Which of the following statements is FALSE? A) If there is a lot of uncertainty, the benefit
on income from debt 0.1166-0.03 Given the purchase price of $50 million, the
acquisition has an NPV of $33.33 million.
T* = 1~ irtr of waiting is diminished. B ) In the real option context, the dividends correspond to any value b. Assuming the debt is fairly priced, what Is the amount of interest AMC will pay next
(1 -Tt ) 7’ effective tax advantage
from the investment that we give up by waiting. C ) By delaying an investment, we can base oiyear? If AMC’s debt is expected to grow by 3% per year, at what rate are its interest
decision on additional information. D ) Given the option to wait , an investment that currently payments expected to grow ? B/c debt is risk-free, the interest rate paid on it must = risk-free
Tf nurgin.il corporate tax
of debt
has a negative NPV can have a positive value.
3) A firm can repurchase shares through a(n)
rate of 5% (or else there would be an arbitrage opportunity). Debt next year $5,000; interest
in which it offers to buy shares at a pre- payment will be 5% of that ($250). If the debt grows by 3%/year, so will the interest payments.
Flow To Equity ( FTE ) Method -
Optimal capital structure
- -
specified price during a short time period - generally within 20 days. A) tender offer B ) open C ® ven though AMC’s debt is riskless ( the firm will not default ), the future growth of .
.-.
.
1 Free cash flow to equity :
V' = V" + PHInicrot Tax Shield) - PV(Financbl Dimes Com) market share repurchases C ) targeted repurchase D ) Dutch auction share repurchase AMC’s debt is uncertain, so the exact amount of the future interest payments is risks FCFEQ ~ Purchase Price + Debt Issue 50 + 30 = 20 -
— P\\Agency of Debt) + Pt Agcncy Benefits of Debt) 4) Which of the following statements is FALSE? A) Modigliani and Miller's conclusion
^
Assuming the future interest payments have the same beta as AMC’s assets, what is the
e? ax sh e ted value year’s U* sh eld w ll ,
FCFEt FCFX After-Tax Interest + Debt Change
= 5 - ( l 35%X30*0.0794) + 3%(30)

*Sf '
^^ ^^ ^
va of
P "* * ‘ “f
Debt overhang - shareholders not willing to finance
+ NPV projects, shareholders only benefit if:
„
verified the common view , which stated that
would affect a firm's value. B ) We can evaluate the
r .. . . .. . . .
even with perfect capital markets, leverage
relationship
between risk and return more
. . . . .,
formally by computing the sensitivity of each security s return to the systematic risk of the
0x of drtrt) at a rate
^
exact amount of the tax shield is uncertain, since AMC may add new debt or repay some debt
.
4.35
2. Equity cost of capital is 11.16%.
D
rf. = ru + fSrv ~ r ) „
NPV P l )
,
durin
economy. C ) Investors in levered equity require a higher expected return to compensate for its risky (even
depending on flows This makes the actual amount of the tax shield
^ ^^
±e debt itself is not). since ±e oflhe tax shield due to debt is 1.11, the 3. Equity value ( equals NPV already) .
I PE increased risk. D ) Leverage increases the risk of equity even when there is no risk that the firn appropriate discount rate is 5% + 1.11 (11% - 5%) = 11.67%. We can now use the growing ^ -
- -
05
- 20 + II . 16$ %
- 3% -
NPV ( FCFE ) $ 33.33 million
Effective dividend tax rate
will default. perpetuity formula and conclude that PV(ITS) $100/(0.1166-0.03) $1,155
5) Rearden Metal currently has no debt and an equity cost of capitaI of 14%. Suppose that d. Using the APV method, what is AMC’s total market value, VL? What is the market
. --
— - .
77 livideiul ux I.HC a
/ TZ TA Rearden decides to increase its leverage and maintain market debt to value ratio of 1/ 2 value of AMC ’s equity ? The APV tells us that the value of a firm with debt equals the sum of
T; - -
7f e.i|> iul gains ux rale
Suppose Rearden' s debt cost of capital is 8% and its corporate tax rate is 40%. Assuming Binomial Model: Risk Neutral
<
I I
the value of an all equity firm and the tax shield. From previous work (parts (a) and (c)), we
' ^ TX 7 TV effective tlivitlenil ux rate -
that Rearden' s pre tax WACC remains constant, then with the addition of leverage its get: VL YLAMC) $13,857 + $1,155 $15,012; VL - D $15,012 - $5000 $10,012. - - -
1. Stock price S goes up to Su or down to Sd
- -
-
Effective tax disadvantage of retaining cash

mam
-( I-
( I - Tf ) ( l - Tx )
( I ~ Tj ) )
effective after tax WACC will be closest to: A ) 10.8% B) 12.4% ( rWArr = j

^ = -
rdTr 14% 0.5(8%)(40%)) C ) 12.8% D ) 13.4%

Kinston Industries - pilot production & test marketing phase - S 500 000 &
+ rd |re
^ ^
VL V(AMC) $ l ,200/(rWACC 0.03) $15,000 WACC 11 %.
,
-
e. What Is AMC’s WACC? ( Hint : Work backward from the FCF aud VL.) Next year’s

f. Using the WACC method, what Is the expected return for AMC equity?
-
FCF is $2,000x0.6 $1,200. It is expected to grow at 3%, so the WACC must satisfy:
- -
2. Find option payoffs by working backwards

- -
For example, call pays C„"max(Sl - K ,0) or Ctf ^max(Sy- K,0)

3. Find risk-neutral probability oMjp state - (

Project Valuation using WACC ( best for constant debt

%]
will last for 1 year.
•
50% chance test marketing will be successful and sufficient demand.
FWACC lj> + roXl Tc);
Qe5%; D $5,000, V $15,000, E $10,000. we get:
-£
- ^ -- . --
P = & &<
4. Get option value as expected present value
c PC + 0 - PK
_ .
!-
. 1 + r/
-^
vi = PWcr ) = 1 +f WACC + (1 +KOVACCF + (1 +KOWCC * K + $10000 SS 000
If successful, invest $3 million in YR1 to build plant that will generate expected 11%’ S1S000 (£E) + $15,000(5%U l 0.4) - 15%.
• 5. Repeat 1. -4. if there are multiple periods
>
Optimal capital structure '
V' = V" + /’I'Umcroi l ax Shield ) - / Financial DiurcH Com)
^
)*
annual after tax cash flows of $400,000 in perpetuity beginning in YR 2.
•
If unsuccessful , build new plant , but expected annua! after tax cash flows
g. Show that the following holds for AMC: PA p( Pr ) + ( PD ) From CAPM, 15% 5% +
(PEX11% 5%) > 1.66 = - - . Illustration of Risk-Neutral Pricing -
Suppose the stock price of SMG, Inc. is currently S50 ^ -
$ 200 ,000 in perpetuity beginning in YR2. CHECK: ($10,000/$15,000) x 1.66=1.11, and pD = 0. per share. In each of the next two years, the price will

_
- /*11Agency CAMS of Debt ) + / BAgency Renelilc of Debt )
’
Debt overhang - shareholders not willing to finance
•
option to stop project at any time and sell prototype for $300,000. h. Assuming that the proceeds from any increases in debt are paid out to equity holders, either increase by 20 % or decrease by 10% .
•
Kinston's cost of capita! is 10%. svhat cash flows do the equity holders expect to receive in one year? At what rate are those The one-year, risk-free rate of interest is
+ NPV projects, shareholders only benefit if: cash flows expected to grow? Use that information plus your answer to part ( f j to derive 5%. What is the price of a two-year
Assuming ability to sell the prototype iu YR1 for S300,000, what is NPV?
NPV P » ,, the market value of equity using the FTE method. How does that compare to your answer European call option with a strike price
/ PfE
Value if test is successful
Build plant: NPV $3,000,000 + .
$400,000
-- = $
in part ( d)? The debt is expected to increase to $5.000x(1+0.03) $5.150 equity holders get S50? The final payoffs of the call option
$150 due to the increase in debt. These proceeds will increase by 3% annually. (The YR2 debt are: Cuu = 22 ; Cud = 4; Cdd = 0
- .
Effective dividend tax rate 10
1 ,000,000
will be $5.000x( l +0.03)A2 $5.304.5. with an increase in debt of $154.5, 3% higher than the -
The risk-neutral probabilities are:
77 dividend lax rale Value if test unsuccessful
$150 proceeds of YR1.) The expected FCF to equity at the end of the fust year is therefore
-
EBIT Interest - Taxes + Debt proceeds, or FCFE = (2000 250)x( l 40) + 150 = $1200. P
(1 + 5%)50 - 45
initially
- -- -
Tj 7> capital pains tax tate

77 effective dividend tax rate

Effective tax disadvantage of retaining cash

Build plant NPV $ 3,000 ,000 +
$ 200 ,000
~- = $ 1,000 ,000 —— -
=
This cash flow is expected to grow at 3% per year. Thus, another way to compute the value of
equity is to discount these cash flows directly at the MCR for the equity of 15% (from (f )):
-
Don't Build (Sell Prototype) NPV $300,000 Since S300,000 > $1,000,000 you E = FCFE/(rE g) U00/(15% 3%) = $10,000 (This is the same value we computed in (d)) - -
60 - 45
(1 -4- 5%)6Q
72 - 54
-
(1 + 5%)4S - 405
54
up state

down state
-
54 - 40.5
- Tf )( l - T<) should sell prototype if test is unsuccessful
main " (- 1
(1
( 1 ~ Ti ) ) NPV
— 1.10
KD Industries is an all - equity firm that has 30 million shares outstanding with a market
(.5)$1 ,( IH ), UH ) 4 ( .5)$3im,( MX)
-
price of S20/share and no debt. KD has had consistently stable earnings, and pays a 35 T
$500,000 = $90,909
tax rate. Management plans to borrow $200 million on a permanent basis through a
= 0.5

R(*(EA’)+Rd (DA )*( l -t) Ssaar -

Project Valuation using WACC ( best for constant debt Kinston abandons the prototype in YR1 if it is unprofitable, what is NPV? leveraged recapitalization in which they would use the borrowed funds to repurchase P10 ject X a lu a tio1111sin g WACC -
%1 Value if test is successful outstanding shares.
What is the value of KD’s unlevered equity? VU (30M shares) x $20/share S600M
(incorporates tax savings from debt):
VL=FCFI 1 +r) + FCF2/( 1 +r)2 + “”n - - ‘
= ^- ^
$400,000
Vi - PVo( FCF ) 1 1
(ir £ !b irrlb
+ + Build plant: NPV - $3,000,000 +
.10 = $1,000,000 -What is the present value of KD’s interest tax shield ?
Tax Shield = Debt x ]£ $200M* .35 $70M
V = ( FCFt+ i + VLH1 )/ l +rwacc
Debt Capacity = ( D/V )*VL - -
- After recapitalization, what is the total value of KD as a levered firm ?
- - -
Project valuation using APV ( best for pre determined
Value if test unsuccessful Rt =R,,„-, pretax
debt ] $200,000 VL VU + Interest Tax shield 600M + 70M 670M
Build plant NPV $3,000,000 + 10 = -$1,000,000 =- TS = Interest Tax rate "
Vo = APVo = V + PVo( TS )
,
?
After recapitalization, what is the value of KD’s levered equity ?
.
E VL D = 670M - 200M = $470 M

— - -
PV( Tax Shield ) = TSi /( 1 + ) +
ru .
ru ‘

m- „
I , FCF
+
FCF2
+
FCFJ
,
+
-
Don't Build (Abandon Prototype) NPV $0 Since SO > $1,000,000 you should After the recapitalization with an offer (buy back) price of S20, svhat is the value of a TS2/( l + )2. .

— rs. —
l + rA (l + o p (l + rA)* " abandon
S 500 . 5,455 .
share of KD’s stock? Would any shareholder participate at this price ? The debt issuances
of S200M = buyback of 10M shares at a price of $20, so share price would be $470M/(30-10
TJ* *— - -
pVn( TS ) -+
Project valuation using FTE
+
^, + ... Kinston abandons the prototy pe iu YR1 if it is unprofitable, what is NPV?
Value if test is successful
shares) $23.50 but no one would tender shares at $20 if not tendering creates a higher value.
What is the “fair” price that makes shareholders indifferent between participating and
not participating in the recap? VL = VU + Interest Tax shield = 670M is the equity value of
Under the FTE method we eompute the NPV of
the FCF to equity holders:
FCFE ( NPV) = FCFEo+FCFE /( 1 +re) > + ,

^
NPV0( FCFE ) FCFEo $400,000 30M shares upon announcement of the recap , so the price jumps to $670M/30M = 22.33 > 20.
+ (f i + ’ Build plant: NPV $3,000,000 + .
10
$1,000,000 =- =
KD will repurchase 200M/22 33 =8.9552M shares (instead of 10M) The shares that are not FCFE 2/( l +r,)2...
tendered therefore are worth 470/(30-8.9552) = 22.33 which means it is a “fair” price. Where FCFE is the Free Cash Flow to Equity
, ,- -
FCFE FCF (1 rc) x ( Interest Payments ) + Net Borrowing Value if test unsuccessful , Assume that the tc= 40%, personal tax rate on income from equity is 20%, personal rate that remains after adjusting for interest
on interest income is 36%. What is effective tax advantage of a corporation issuing debt ?
„' = NPVo $200 ,000
-
payments, debt issuance, and debt repayment:
V ( FCFE ) f Initial Investment Build plant NPV $3,000,000 + 10 = $1,000,000 =- t* » l
(1 tcHl W
1
(I - .40HI - .20)
. 25% - ---
FCFE,= FCF,-( 1 -tc)*( Interest payments)+ Net
-- -
Cap structure with debt policies
V1 = E + D
Don’t Build (Abandon Prototype) NPV $0 Since $0 > $1,000,000
( 5 $ 1 UI( ( ( U 5 > l
= >
_
(I It ) (1 - 26)
Google has no debt on its balance sheet in 2008, but paid S1.6 billion in taxes. Assume that
- -
Google's marginal tax rate is 35% and Google’s borrow ing cost is 7%. Assume that
< >s
Borrowing, whileNet Borrowing = DrD,.i
VL = FCF/(D%-g%) = FCF/twacc-g)
Rxs is the expected return associated with the

rWACC =
VL = V l PV ( TS )
TS = TCX ( r x D i )
E
E+ D
re + £7
,
(1 Tc)
"
NPV • ' '
„ ,
$500,000 $45,455 you should abandon il
immediately. Assuming probability of high /low demand is 50 %, what is NpV ?rate =
Df° ( 5)$4( KMXH ) » (.5)$2U ),( M )()
^ =-
investors hold Google stock in retirement accounts that are free from personal taxes. If
Google were to issue sufficient debt to reduce its taxes by SI billion per year permanently,
Ignores pilot production aud test marketing aud builds their manufacturing p hen how much does Google needs to borrow? Interest tax shield = Amount X Interest X Tax
Jxbmjonx 7% x 35% = $1 billions amount needed to borrow = x = $40.8163 billion

-
-
interest tax shield
,
RTs=fijin the case of perpetual debt. RTS=£A,
when adjusting debt to maintaina target
leverage ratio
'

rrs = CD
c. constant $ amount of debt
Crs = CA
a. constant % of debt to value
NPV .10 $3,000 ,000 $ =
0 - =
Put Call Parity Summary of APV Method -
Ignores pilot production and test marketing and builds their manufacturing plant
PV ( TS ) = TCD pv/ ( rs) = TCCDD
rA - g
r- 7 Tcr0 D A
,-
" ,
immediately. Assuming probability- of high /low demand is 50 %. Kinston has ability to
Er==1 (l + r0 yi sell prototy pe in YR1 for S300,000, what is value of option to do pilot production and
• Derivation by the Law of One Price
P + S C + PV ( K )

•Call option for a non -dividend-paying stock

1. Determine the value without leverage.
2. Determine the value of interest tax shield .
-
test marketing?
The NPV of going ahead and building today (No pilot production and test marketing
C P + S - PV ( K ) - .
a Determine the expected interest tax shield
b.Discount the interest tax shield.
.
re = fA + §( CA - ro )(l - Tc ) ft = rg + §( CA - rc ) • Put option for a non -dividend - paying stock
option):
- - 3. Add the unlevered value ( I ) to the present

—
P C S + PV ( K )
(.5)$400,0IH> + (5)$200,000 value of the interest tax shield ( 2 ) to

' WACC =' A ~ $ ( TC x rf ) 'WACC =' A - $ { TC I X rD )

NPV .10 - $3,000,000 = $0 Replicating portfolio: A portfolio consisting of a stock and a bond that has the same value and determine the value with leverage.
payoffs in one period as an option written on the same stock. LOOP implies that the current For predetermined ($ debt ) policy, constant
NPV with pilot production and test marketing option: value of the call and the replicating portfolio must be equal interest coverage, and financing side effects.
Predetermined debt ( APV method is best )
Summary of Flow To Equity ( FTE)
VL = E + D Value if test is successful
$400,000 Summary of WACC Method
VL = VU + PV ( TS ) Build plant: JVPK = $3,000,000 +- .10 = $1,000,000 1. Determine the free cash flow to equity of
the investment.
Don't Build (Sell Prototype) NPV = $300,000 1. Determine the free cash flow ( FCF).
TSt = TC x ( ro x Dt i)
Since $300,000 > -S500.000 you should sell prototype 2. Determine the equity cost of capital .
E D Value if test unsuccessful 2. Compute the weighted average cost of
3. Compute the equity value by discounting .
' E + E + D TD (1 - TC )
capital (WACC)
I"WACC = E+ D Build plant NPV = -$3,000,000 +
$200.000
= -$1,000 ,000 the free cash flow to equity using the
rrs = ty
b. predetermined $ amount of debt
)
.10
Npv

The current price of Kinston Corporation stock is $10. In each of the next 2 years, stock price
.
(. 5)$ l UH),UHU (.5)$3U ),0m
1.10
can wither go up by $ 3.00 or go down by $ 2.00. Kinston stock pays no dividends. The 1year
- $500,000 - $90,909
equity cost of capital.
If the values of other securities in the firm's
capital structure or the interest tax shield are
3. Compute the value of the investment,
including the tax benefit of leverage, by
discounting the free cash flow using the
WACC (sometimes called DCF as well ).
themselves difficult to determine.

PV ( TS ) = Y .h TcCl ) Dt 1
(1 + roY
risk-free interest rate is 5% and will remain constant.
Using the binomial pricing model, calculate the price of a 2- year CALL option on Kinston stock
Up branch Down Branch
For D/ E (% debt) policy and projects of same
risk and same debt capacity as firm's assets.

Cu - Cd $7 - $2 Cu - Cd _ $2 - $0 Different Leverage Policies

D=
Su - Sd $16 - $11 = 1 D= = .4 Call
~
- Su - S j $11 - $6
CE — rA +
D PV ( TS )
E ( CA ~ rD )
B=
C d ~ S d D $2 - $11 (1 )
= -8.571429 B=
Q - Sd D $1) - $6( .4)
max (16 - 9, 0) = $7 Constant D/ E, permanent D, predetermined D
1+ 1.05 1+ 1.05 = -2.285714 policies are used , but first is most common :
7 7
= rA - Vt {Tc * CD ) - FHCA - Co )
C = SD + B = $13(1) + (-8.571429) = $4.428571 C = SD + B = $8(.4) + (-2.285714) = $0.914286
Equity Return: rt = rv + — rv - r„
( )
CWACC

Value of call/put option at expiration

^ Value at year 0
Cu - Cd $ 4.43 - $0.91
D = Sj -
/ sd $13 - $8 = .702857
Stock $10 max (11 - 9, 0) = $2
Firm Return ( WACC):
W
E D
- yr, + yr„0„ - r )
Asset Return ( Pre-Tax or Unlevered WACC):
.
- rA --D r„xt
C = max (5 - K , 0) P = ma\ ( K - 5, 0)
Put Call Parity Equity as a Call: E = C( K ) = max( V - K ,0)
0
K = debt owed
PV ( K ) - P( K ) '= V - C( K )
Q - Sd D $0.91 - $8( 704 )
B= i +
7 1.05 = 4.484354 - max (6 - 9 , 0 ) = $0
E
rA rU E + D A + E + D-D
~ ' rn
P + S = C + PV ( K ) Debt as call = C = SD + B = $10(.702857) + (-4.484354) = $2.544218
 - _
• In the up ( u ) state we therefore have:
c pC„ + ( l - p)C„ 0.5(22)1.05+ 0.5(4) 12.38 - 4. The current price of Natasha Corporation stock is $6. In each of the next two years, this stock price
1 + r/ can either go up by $2.50 or go down by $2. The stock pays no dividends. The one year risk-free -
• In the down (d ) state we therefore have:
c- * (1 ~ P )CU 0.5(4) + 0.5(0) 1.90
- interest rate is 3% and will remain constant. Using the Binomial Model , calculate the price of a two -
1 +r , 1.05 year call option on Natasha stock with a strike price of $7.
• In the initial state we therefore have: Draw binomial tree for stock ( S ). bond ( B ), and call (C ).
.
c PC * ( 1 - PK 0 5(12.38) + 0.5(1.90) g 9Q
1 * rf
- 1.05
S B C
The binomial tree for the call option is:

12.38 C . 22.00 c
_ 11 100 4
6.80 C 4 (H) Cw
1.90 Cj
0.00 CM
The put-call parity gives put option value:

--
p c -
s + p y( K )
;
6.80 - 50 + 50 / 1.05
6.50 100 0
- 2.15
The binomial tree for the put option is:

o.oo/> . o.oo/>. .
2.15 p o.oo
4.52 Pj
9.50
IF WE SHORT THE DEAL
The binomial tree for the put option is:

Financial option: contract that gives owner the right ( but not obligation ) to purchase sell a financial asset at a fixed price at Up state at time 1 : A = ( 4 - 0 )/( l 1 - 6.50 ) = 0.889 , B = ( 0 - 6.50 x 0.889 )/ 1.03 = -5.61 , therefore C„ = 0.889
some future date x 8.50 - 5.61 = $1.95.
Real option: situation that gives an owner opportunity ( but not the obligation ) to purchase sell a real asset at a fixed price at
some future date ( i.e. adding additional value to an activity like a capital investment ). In the down state at time 1 the option is worth nothing and therefore Q = 0.
Call option: financial option that gives its owner the right to an asset
The call option at time 0 is equivalent to the replicating portfolio A = ( 1.95 - 0)/( 8.50 - 4 ) = 0.433 , B = ( 0
Put option: A financial option that gives its owner the right to sell an asset.
Strike Price ( K ): Price an option holder buys sells a share of stock when option is exercised. - 4 x 0.433 )/1.03 = -1.68 and so, by the Law of One Price, the initial option price is C = 0.433 x 6 - 1.68 =
Option price ( premium ) ((' or P): Amount the buyer has to pay to the seller. $0.92.
Option buyer ( holder): holds the right to exercise the option and has LONG position in the contract . 5 . Rebecca is interested in purchasing a European call on a hot new stock, Up , Inc. The call has a strike
Option seller ( w riter): Sells the option and has a SHORT position in the contract . Because the long side has the option to
price of $100 and expires in 90 days . The current price of Up stock is $120, and the stock has a standard
option tlie exercise, the short side has an obligation to fulfill the contract if it is exercised. The buyer writes the premium .
deviation of 40% per year. The risk - free interest rate is 6.18% per year.
Long position in a call option: C= max(S-K 0). Put Is opposite ( K -S O ) . . -
- .
Put Call Parity: C P + S PV( K ) Price of a European call is equal to the price of an otherwise identical put plus the price
a
a.
llsinn tha Rlark R r h n l p «s

Using the Black -Sholes formula:

formula rnmnntp thp nr
In
120
of the underlying asset minus the price of the bond with face value and maturity equal to the strike price and the option
expiration date ( replicating portfolio ). 98.487 0.4V90 / 365
PV( K ) = 100 / (1.0638) 365 98.487, dx = = 1.094
Practice 2
I . Suppose Alcatel - Lucent has an equity cost of capital of 10%. market capitalization of SI 0.8 billion,
and an enterprise value of $ 14.4 billion . Suppose Alcatel - Lucent ’s debt cost of capital is 6.1 % and its
d, = 1.094 - 0.4x/90 / 365 = 0.895
C = S x N ( d , ) ~ P V ( K ) N ( d , ) = 120 x 0.863 - 98.487 x 0.815 = $23.29
^
0.4 90 / 365 2

marginal tax rate is 35%. b. Use put -call parity to compute the price of the put with the same strike and expiration date .
a. What is Alcatel Lucent’s WACC? - 10.8
=| 10% +
14.4 10.8
rwacc
6.1%(1 - 0.35) = 8.49% - P = C + PV(K) - S = 23.29+98.487-120 = $1.78
14.4 14.4
b. If Alcatel - Lucent maintains a constant debt -equity ratio, what is the value of a project with 6. Your company is planning on opening an office in Japan . Profits depend on how fast the economy in
average risk and the following expected free cash flows? Japan recovers from its current recession . There is a 50% chance of recovery this year. You are trying to
decide whether to open the office now or in a year. Construct the decision tree that shows the choices
Year 0 1 2 3 you have to open the office either today or one year from now.

FCF 100 50 -100 70

Using the WACC method , the levered value of the project at date 0 is

VL . 50
+
100
7+
70
r
1.0849 1.08492 1.0849*
185.86. Given a cost of 100 to initiate, the project
J
‘
’
s NPV is 185.86 100 85.86.
Economy
Recovers
50%
c. What is Alcatel - Lucent 's current debt - to- value ratio ( d )?
Alcatel - Lucent ’s debt - to - value ratio is d = ( 14.4 - 10.8 ) / 14.4 = 0.25.
Open 50%
d. - -
If Alcatel Lucent maintains its debt equity ratio, what is the debt capacity of the project in part b? Office No
The project ’ s debt capacity is equal to d times the levered value of its remaining cash flows at each Recovery
date .
Open
Office
2 . Consider Alcatel- Lucent 's project in the previous problem .
a . What is Alcatel-Lucent’s unlevered cost ofcapital ? Economy
b. What is the unlevered value of the project ? Oo Not Recovers ' Do Not
Open 50% Open
c. What are the interest tax savings from the project : Office Office
d . What is the present value of the interest tax shield ? 50% Open
e. Show that the APV of Alcatel- Lucent ’s project matches the value computed using the WACC No Office
inpllind Recovery
Year 0 1 2 3 Do Not
Open
FCF 100 50 100 70 Office
VI . 185.86 151.64 64.52 0
I ) = d*VL 46.47 37.91 16.13 0.00
7. It is the beginning of September and you have been offered the following deal to go heli- skiing. If you
Interest 2.83 2.31 0.98 pick the first week in January and pay for your vacation now, you can get a week of heli - skiing for $2500.
c. Tax Shield 0.99 0.81 0.34 However, if you cannot ski because the helicopters cannot fly due to bad weather, there is no snow, or you
get sick, you do not get a refund. There is a 40% probability that you will not be able to ski. If you wait until
10.8 14.4 - 10.8 the last minute and go only if you know that the conditions are perfect and you are healthy, the vacation will
a. ru = 14.4 10% + 14.4
6.1% = 9.025% cost $ 4000. You estimate that the pleasure you get from heli- skiing is worth $6000 per week to you (if you
had to pay any more than that, you would choose not to go). If your cost of capital is 8% per year, should
you book ahead or wait ?
50 100 70 o
b. vu = 1.09025 1.090252 1.090253
= 184.01 If you book now, your expected benefit from skiing in 4 months is:
Month
* 2

$6 ,000
6.000( 0.60) + 0( 0.40) = S3.600
d. 1 he present value ot the interest tax shield is Ski
The NPV of booking today is therefore : 60 %
0.99 0.81 0.34 3, 600
$2 ,500 00
PV( ITS) = + = 1.85 NPV = r - 2, 500 = SI. 008.82 40 %
1.09025 1.090252 1.090253 1.081- Dont Ski
$0
e. VL = APV = 184.01 + 1.85 = 185.86 If you wait to book the expected benefit in 4 mont
2.000 ( 0.60 ) + 0 ( 0.4 ) 0 = $ 1 200
The Prokter and Gramble ( PKGR ) has historically maintained a debt -equity ratio of approximately
,
4.
0.20. Its current stock price is $50 per share, with 2.5 billion shares outstanding. The firm enjoys very The PV of this today is
$6 ,000- $ 4 ,00 = $2 000
,

Ski
stable demand for its products, and consequently it has a low equity beta of 0.50 and can borrow at S1, 2 60 %
4.20%, just 20 basis points over the risk - free rate of 4%. The expected return of the market is 10%, " j“ = SL 169.6!
and PKGR 's tax rate is 35 % . 1.0812 40 %
Don't Ski
a . This year, PKGR is expected to have free cash flows of S6.0 billion . What constant expected So you should wait .
$0
growth rate of free cash flow is consistent with its current stock price?
E = $50 x 2.5 B = $125 B
D = 0.20 x 125 B = $25 B 8. Consider again the electric car dealership in Section 22.3. Suppose the current value of a dealership is
$5 million because the first- year free cash flow is expected to be $500,000 rather than $600,000. What is the
V1 = E +D = $ 150 B beta of a corporation whose only asset is a one- year option to open a dealership? What is the beta if the first
vear ’s cash flows are exDected to be $700 000. so a workina dealershiD is worth $7 million?
,

First , you must compute the current value of the asset without the dividends that will be missed:
From CAPM : Equity Cost of Capital = 4% + 0.5 ( 10 % - 4% ) = 7%
S0.5 million
WACC = (125 / 150 ) 7% + ( 25 / 150 ) 4.2% ( 1 - 35% ) = 6.29% ~ -
S X S PV ( Div ) = $5 million -
1.12
= S4.55 million

V 1
= FCF/( rwacc - g) => g = rwacc - FCF/ F = 6.29% - 6/150 = 2.29% Next, using the information from Table 22.1 calculate the value of the call option to open the dealership:

ln[ 5 v / /> r( A')] ayff ln( 4.5S/ 4.76 )

b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a
higher debt -equity ratio of 0.50, it believes its borrowing costs will rise only slightly to 4.50%. If
d\ m
O 4T
<
2 0.40 -
+ 0.20 0.087

PKGR announces that it will raise its debt -equity ratio to 0.5 through a leveraged recap,
determine the increase in the stock price that would result from the anticipated tax savings. d2 ~ di - ayfr ~ 0.087 - 0.40 - -0.313
S ' XJV ( rfj )
Initial Unlevered cost ofcapital (Eq. 18.6) = ( 125 / 150) 7% + ( 25 / 150) 4.2% = 6.53%
New Equity cost ofcapital ( Eq. 18.10) = 6.53% + (0.5)(6.53% - 4.5%) = 7.55%
- -
C SxN ( dl ) PV ( K ) N ( d 2 )
= S4.55 x 0.535 - S4.76 x 0.377
P.corporation c ftdealership
$4.55 x 0.535
$0.64
x 2 = 7.6

= $0.64
New WACC = ( 1 / 1.5) 7.55% + (0.5 / 1.5) 4.5% ( 1 - 35%) = 6.01% When the value of the firm is $7 million than it is optimal to invest immediately. We can see this by
V1 = FCF / (rwacc - g ) = 6.0 / (6.01% - 2.29%) = 161.29 ,
computing the value of the call similar to above: S' = $6.38, d = 0.932, d2 = 0.532, C = $1.91. The value
This is a gain of 161.29 - 150 = $ 11.29 B or 11.29/2.5 = $4.52 per share. exercising immediately ($7 - $5 = $2 million ) is greater than the value of the call ($ 1.91 million ) so the
Thus, share price rises to $54.52/share. beta of the corporation is equal to the beta of the dealership : 2 .