Description
patterns of corporate financing, what is common stock, Book Value vs. Market Value, What are different types of Corporate Debt?, How Corporations Issue Securities. It also covers topics like Venture Capital, The Initial Public Offering, Private Placements and Public Issues and rights issue, Dividend Irrelevance Theory, Bird-in-the-Hand Theory, Tax Preference Theory
1
An Overview of Corporate
Financing
Topics Covered
2
? Patterns of Corporate Financing
? Common Stock
? Preferred Stock
? Debt
? Financial Markets and Institutions
Patterns of Corporate Financing
3
? Firms may raise funds from
? external sources or
? plow back profits rather than distribute them to
shareholders.
? External financing - choose between debt or equity
sources.
Patterns of Corporate Financing
4
? A major source of financing for corporations in the US
are internally generated funds –
? which include depreciation and
? retained earnings.
? Debt is a major source of external funds.
? Generally, US corporations have used relatively low
levels of debt.
Patterns of Corporate Financing
5
Patterns of Corporate Financing
6
Aggregate balance sheet for manufacturing corporations
in the United States, 2001 (figures in Billions).
Current assets 1,547 $ Current liabilities 1,234 $
Fixed assets 2,361 Long term debt 1,038
Less 1,166 Other long term 679
deprecication liabilities
Net fixed assets 1,195 Total long term liabilities 1,717
Other long term 2,160 Stockholders' equity 1,951
Total assets 4,903 Total liabilities and 4,903
stockholders' equity
Patterns of Corporate Financing
7
60 .
903 , 4
717 , 1 234 , 1
assets Total
Debt
=
+
=
47 .
951 , 1 717 , 1
717 , 1
equity s liabilitie term Long
s liabilitie term Long
=
+
=
+
How do we define debt ?
Patterns of Corporate Financing
8
How do we define debt ?
Patterns of Corporate Financing
9
60 .
903 , 4
717 , 1 234 , 1
assets Total
Debt
=
+
=
47 .
951 , 1 717 , 1
717 , 1
equity s liabilitie term Long
s liabilitie term Long
=
+
=
+
How do we define debt ?
Patterns of Corporate Financing
10
DEBT TO TOTAL CAPITAL
Book Book, Market Market,
Adjusted Adjusted
Canada 39% 37% 35% 32%
France 48 34 41 28
Germany 38 18 23 15
Italy 47 39 46 36
Japan 53 37 29 17
United Kingdom 28 16 19 11
United States 37 33 28 23
Common Stock
11
Book Value vs. Market Value
? Book value is a backward looking measure.
? It tells us how much capital the firm has raised
from shareholders in the past.
? It does not measure the value that shareholders
place on those shares today.
? The market value of the firm is forward looking, it
depends on the future dividends that shareholders
expect to receive.
Common Stock
12
Example - Heinz Book Value vs. Market Value
(5/2000)
Total Shares outstanding = 347 million
Treasury shares are issued shares bought back by the corporation.
1,596 Value) (Book equity common Net
652 - s adjustment Other
2,920 - shares Treasury
4,757 earnings Retained
304 capital in paid Additional
108 par) ($1 Shares Common
Common Stock
13
Example - Mobil Book Value vs. Market Value
(5/00)
Total Shares outstanding = 347 million
billion $12.1 Value Market
347 x shares of #
$35/sh = price Market 2000 May
Preferred Stock
14
Preferred Stock - Stock that takes priority over
common stock in regards to dividends.
Floating-Rate Preferred - Preferred stock paying
dividends that vary with short term interest rates.
Corporate Debt
15
? Debt has the unique feature of allowing the
borrowers to walk away from their obligation to pay,
in exchange for the assets of the company.
? “Default Risk” is the term used to describe the
likelihood that a firm will walk away from its
obligation, either voluntarily or involuntarily.
? “Bond Ratings "are issued on debt instruments to
help investors assess the default risk of a firm.
Corporate Debt
16
? What are different types of Corporate Debt?
Corporate Debt
17
? Bank Term Loans
? Working Capital Finance
? Commercial Paper
? Debentures
? Convertible Debentures
? Foreign Currency Debts – ECB
? FCCB
? Unsecured Loans
? Fixed Deposits
Corporate Debt
18
Firms issue different types of debt like notes,
debentures, Eurobonds etc.
Corporate Debt
19
Terminology is very important.
Prime Rate - Benchmark interest rate charged by
banks.
Funded Debt - Debt with more than 1 year
remaining to maturity.
Sinking Fund - Fund established to retire debt
before maturity.
Callable Bond - Bond that may be repurchased by
firm before maturity at specified call price.
Corporate Debt
20
Subordinate Debt - Debt that may be repaid in
bankruptcy only after senior debt is repaid.
Secured Debt - Debt that has first claim on specified
collateral in the event of default.
Investment Grade - Bonds rated Baa or above by
Moody’s or BBB or above by S&P.
Junk Bond - Bond with a rating below Baa or BBB.
Corporate Debt
21
Eurodollars - Dollars held on deposit in a bank
outside the United States.
Eurobond - Bond that is marketed internationally.
Private Placement - Sale of securities to a
limited number of investors without a public
offering.
Protective Covenants - Restriction on a firm to
protect bondholders.
Lease - Long-term rental agreement.
Corporate Debt
22
Warrant - Right to buy shares from a company
at a stipulated price before a set date.
Convertible Bond - Bond that the holder may
exchange for a specified amount of another
security.
Convertibles are a combined security,
consisting of both a bond and a call
option.
Financial Markets
23
Primary
Markets
Secondary
Markets
OTC
Markets
Money
Financial Institutions
24
Company
Intermediaries
Banks
Insurance Cos.
Brokerage Firms
Obligations
Funds
Financial institutions provide funds for corporations by acting as financial intermediaries.
Financial Institutions
25
Intermediaries
Investors
Depositors
Policyholders
Investors
Obligations
Funds
Financial intermediaries pool funds from depositors, policyholders and investors.
Question
26
? Authorized Share cap ACC is 100,000 shares. The Equity is currently showing:
Common Stock Rs. 40,000
Additional paid-in Cap Rs. 10,000
Retained Earnings Rs. 30,000
Common Equity Rs. 80,000
Treasury Stock (2K) Rs. 5,000
Net Common Equity Rs. 75,000
? How many shares are issued?
? How many are Outstanding? Explain the diff from above
? Suppose ACC issues 10000 shares at Rs.2 a share. Which of the above figures
would be changed?
? Suppose ACC bought back 10000 shares at Rs. 5 a share. Which of the above
figures would be changed?
Question
27
? In 2007-08 Binda Corp earned Rs. 76 lacs gross profit.
? Suppose it is financed by a combination of equity and debt
of Rs. 1 crore. How much profit is available to shareholders
if interest on the debt is 10% and the Tax rate is 35%. The
depreciation is estimated to be Rs. 16 lacs.
? Now consider that instead of debt, it was financed by 8%
preferred stock, what would be the profit available to
shareholders.
28
How Corporations Issue Securities
Topics Covered
29
? Venture Capital
? The Initial Public Offering
? Other New-Issue Procedures
? Private Placements and Public Issues
? Rights Issue
Venture Capital
30
Venture Capital
Money invested to finance a new firm
These are high-risk, unproven businesses that
need financing.
Venture Capital
31
Venture capital firms often manage pools
of funds, contributed by pension funds
and other investors. Venture capital is
generally provided in many stages.
Venture Capital
32
Since success of a new firm is highly dependent on
the effort of the managers, restrictions are placed on
management by the venture capital company and
funds are usually dispersed in stages, after a certain
level of success is achieved.
Venture Capital
Money invested to finance a new firm
Venture Capital
33
2.0 Value 2.0 Value
1.0 equity original Your 1.0 assets Other
1.0 capital venture from equity New 1.0 equity new from Cash
Equity and s Liabilitie Assets
($mil) Sheet Balance Value Market Stage First
Venture Capital
34
14.0 Value 14.0 Value
5.0 equity original Your 9.0 assets Other
5.0 stage 1st from Equity 1.0 assets Fixed
4.0 stage 2nd from equity New 4.0 equity new from Cash
Equity and s Liabilitie Assets
($mil) Sheet Balance Value Market Stage Second
Initial Offering
35
Initial Public Offering (IPO) - First offering of stock to
the general public.
Underwriter - Firm that buys an issue of securities from
a company and resells it to the public.
Spread - Difference between public offer price and price
paid by underwriter.
Prospectus - Formal summary that provides
information on an issue of securities.
Underpricing - Issuing securities at an offering price
set below the true value of the security.
General Cash Offers
36
Seasoned Offering - Sale of securities by a
firm that is already publicly traded. An issue of
securities from an established company
whose existing shares have exhibited stable
price movements and substantial trading
volume over time, thereby earning a good
reputation.
General Cash Offer - Sale of securities open to
all investors by an already public company.
General Cash Offers
37
General Cash Offer - Sale of securities open to
all investors by an already public company –
usually without an Underwriter.
General Cash Offers
38
Shelf Registration - A procedure that allows
firms to file one registration statement for
several issues of the same security.
Private Placement - Sale of securities to a
limited number of investors without a public
offering.
39
0 Stage financing- represents the savings and personal loans
the company’s principals raise to start a firm..
1
st
or 2
nd
Stage financing- comes from funds provided by others
(often venture capitalists) to supplement the founders’
investment.
After the money valuation - valuation represents the estimated
value of the firm after the first-stage financing has been
received.
Mezzanine Financing- comes from other investors, after the
financing provided by venture capitalists.
Best Effort Offer - is an underwriter’s promise to sell as much as
possible of a security issue.
Qualified Institutional Buyer - is a large financial institution
which, is allowed to trade unregistered securities with other
qualified institutional buyers.
Private placements and public
issues
40
? A substantial fraction of corporate debt is placed privately.
(Private placements of stock are also common for small
companies.)
? Smaller firms tend to use the private placement market most
because they face the highest costs in a public issue and often
require specialized, flexible loan arrangements.
? On the other hand, the costs of investigation and negotiation
may be higher, and lenders in private placements expect some
compensation for holding an instrument with limited liquidity.
? It also allows large financial institutions to trade unregistered
securities among themselves.
Rights Issue
41
Rights Issue - Issue of securities offered only
to current stockholders.
Example - Lafarge Corp needs to raise
E1.1billionof new equity. The market price is
E99.65/sh. Lafarge decides to raise additional
funds via a 1 for 8 rights offer at E80 per
share. If we assume 100% subscription, what
is the value of each right?
Rights Issue
42
¬Current Market Value = 8 x E99.65 = E797.20
¬Total Shares = 8 + 1 = 9
¬Amount of funds = 797.20 + 80 = 877.20
¬New Share Price = (877.20) / 9 = E97.47
¬Value of a Right = 97.47 - 80 = 17.47
Example - Lafarge Corp needs to raise E1.1billionof new equity.
The market price is E99.65/sh. Lafarge decides to raise
additional funds via a 1 for 8 rights offer at E80 per share. If we
assume 100% subscription, what is the value of each right?
True or False
43
? Venture capitalists typically provide 1
st
stage financing
sufficient to cover all development expenses. 2
nd
stage
is provided by stock issued in an IPO.
? Large companies’ stocks may be listed and traded on
several international exchanges.
? Stock price generally falls when the company
announces a new issue of shares. This is attributable to
the information released by the decision to issue.
Question
44
? You need to choose between making a public issue and
arranging private placement. In each case the issue involves
Rs. 10 crores face value of 10 year debt.
? A public issue – the interest rate on debt would be 8.5% and debt
would be issued at par. The underwriting spread would be 1.5%
and other expenses be Rs. 8 lacs.
? Private placement – interest rate would be 9% and the total
issuing expenses would be Rs. 3 lacs.
? What is the difference in proceeds net of expenses?
? Which the better deal?
? What other factors would you wish to consider before
considering between the 2.
Question
45
? UB is planning to market a new beer. To finance the venture it
proposes to make a rights issue at Rs. 10 of 1 new share for
every 2 held (Currently 1 lac shares at CMP of Rs. 40).
Assuming that the new money is invested to earn a fair
return, give values for the following:
? Number of new shares
? Amount of new investment
? Total value of company after issue
? Total number of shares after issue
? Stock price after issue
? Price of the right to buy 1 new share
46
The Dividend Controversy
Topics Covered
47
? How Dividends Are Paid
? How Do Companies Decide on Dividend
Payments?
? Information in Dividends and Stock Repurchases
? The Dividend Controversy
Types of Dividends
48
?Regular Cash Div
?Special Cash Div
?Stock Div
?Stock Repurchase (3 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Private Negotiation (Green Mail)
Dividend Payments
49
Cash Dividend - Payment of cash by the firm
to its shareholders.
Dividend Payments
50
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a
dividend payment; anyone holding stock
before this date is entitled to a dividend.
Dividend Payments
51
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a
dividend payment; anyone holding stock
before this date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.
Dividend Payments
52
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Dividend Payments
53
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
Dividend Payments
54
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Repurchase - Firm buys back stock
from its shareholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
What is “dividend policy”?
55
? It’s the decision to pay out earnings versus
retaining and reinvesting them. Includes these
elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
Question
56
Do investors prefer high or low
payouts? There are three
theories:
57
? Dividends are irrelevant: Investors don’t care
about payout.
? Bird-in-the-hand: Investors prefer a high payout.
? Tax preference: Investors prefer a low payout,
hence growth.
Dividend Irrelevance Theory
58
? Investors are indifferent between dividends and retention-
generated capital gains. If they want cash, they can sell
stock. If they don’t want cash, they can use dividends to
buy stock.
? Modigliani-Miller support irrelevance.
? Theory is based on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true. Need empirical
test.
Bird-in-the-Hand Theory
59
? Investors think dividends are less risky than
potential future capital gains, hence they like
dividends.
? If so, investors would value high payout firms
more highly.
Tax Preference Theory
60
? Retained earnings lead to capital gains, which are
taxed at lower rates, in US, than dividends: 28%
maximum vs. up to 39.6%. Capital gains taxes are
also deferred.
? This could cause investors to prefer firms with low
payouts.
Implications of 3 Theories for
Managers
61
Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout
But which, if any, is correct???
Possible Stock Price Effects
62
Stock Price ($)
Payout 50% 100%
40
30
20
10
Bird-in-Hand
Indifference
Tax preference
0
Possible Cost of Equity Effects
63
Cost of equity (%)
Payout 50% 100%
15
20
10
Tax Preference
Indifference
Bird-in-Hand
0
Which theory is most correct?
64
? Empirical testing has not been able to determine
which theory, if any, is correct.
? Thus, managers use judgment when setting
policy.
? Analysis is used, but it must be applied with
judgment.
What’s the “information content,”
or “signaling,” hypothesis?
65
Question
66
? Managers hate to cut dividends, so won’t raise
dividends unless they think raise is sustainable.
? So, investors view dividend increases as signals of
management’s view of the future.
? Therefore, a stock price increase at time of a dividend
increase could reflect higher expectations for future
EPS, not a desire for dividends.
What’s the “clientele effect”?
67
? Different groups of investors, or clienteles, prefer
different dividend policies.
? Firm’s past dividend policy determines its current
clientele of investors.
? Clientele effects impede changing dividend policy.
? Taxes & brokerage costs hurt investors who have to
switch companies.
What’s the “residual dividend
model”?
68
? Find the retained earnings needed for the capital
budget.
? Pay out any leftover earnings (the residual) as
dividends.
? This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
Using the Residual Model to
Calculate Dividends Paid
Dividends = – .
Net
income
Target
equity
ratio
Total
capital
budget
[ ] ) ) ( (
69
How would a change in
investment opportunities affect
dividend under the residual
policy?
70
Question
71
? Fewer good investments would lead to smaller
capital budget, hence to a higher dividend
payout.
? More good investments would lead to a lower
dividend payout.
Advantages and Disadvantages of the
Residual Dividend Policy
72
? Advantages: Minimizes new stock issues and flotation
costs.
? Disadvantages: Results in variable dividends, sends
conflicting signals, increases risk, and doesn’t appeal to
any specific clientele.
? Conclusion: Consider residual policy when setting
target payout, but don’t follow it rigidly.
What’s a “dividend reinvestment
plan (DRIP)”?
73
? Shareholders can automatically reinvest their
dividends in shares of the company’s common
stock. Get more stock than cash.
? There are two types of plans:
? Open market
? New stock
Open Market Purchase Plan
74
? Money to be reinvested are turned over to trustee,
who buys shares on the open market.
? Brokerage costs are reduced by volume purchases.
? Convenient, easy way to invest, thus useful for
investors.
New Stock Plan
75
? Firm issues new stock to DRIP enrollees, keeps
money and uses it to buy assets.
? No fees are charged, plus sells stock at discount of
5% from market price, which is about equal to
flotation costs of underwritten stock offering.
Optional investments sometimes possible, up to
Rs. 15.0 crores or so.
Firms that need new equity capital use new stock
plans.
Firms with no need for new equity capital use
open market purchase plans.
76
Setting Dividend Policy
77
? Forecast capital needs over a planning horizon, often 5
years.
? Set a target capital structure.
? Estimate annual equity needs.
? Set target payout based on the residual model.
? Generally, some dividend growth rate emerges.
? Maintain target growth rate if possible, varying capital
structure somewhat if necessary.
Stock Repurchases
78
Reasons for repurchases:
? As an alternative to distributing cash as dividends.
? To dispose of one-time cash from an asset sale.
? To make a large capital structure change.
Repurchases: Buying own stock back from
stockholders.
Advantages of Repurchases
79
? Stockholders can tender or not.
? Helps avoid setting a high dividend that cannot
be maintained.
? Repurchased stock can be used in takeovers or
resold to raise cash as needed.
? Income received is capital gains rather than
higher-taxed dividends.
? Stockholders may take as a positive signal--
management thinks stock is undervalued.
Disadvantages of Repurchases
80
? May be viewed as a negative signal (firm has poor
investment opportunities).
? Govt. could impose penalties if repurchases were
primarily to avoid taxes on dividends.
? Selling stockholders may not be well informed, hence
be treated unfairly.
? Firm may have to bid up price to complete purchase,
thus paying too much for its own stock.
Stock Dividends vs. Stock Splits
81
? Stock dividend: Firm issues new shares in lieu
of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.
? Stock split: Firm increases the number of
shares outstanding, say 2:1. Sends
shareholders more shares.
Both stock dividends and stock splits increase the
number of shares outstanding, so “the pie is divided
into smaller pieces.”
Unless the stock dividend or split conveys information,
or is accompanied by another event like higher
dividends, the stock price falls so as to keep each
investor’s wealth unchanged.
But splits/stock dividends may get us to an “optimal
price range.”
82
When should a firm consider
splitting its stock?
83
Question
84
? There’s a widespread belief that the optimal price
range for stocks is Rs. 200 to Rs. 800.
? Stock splits can be used to keep the price in the
optimal range.
? Stock splits generally occur when management is
confident, so are interpreted as positive signals.
The Dividend Decision
85
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in
earnings.
4. Managers are reluctant to make dividend changes that
might have to be reversed.
Lintner’s “Stylized Facts”
Lintner has developed a simple model, which is consistent with the observations
below and explains dividend payments well
The Dividend Decision
86
? Attitudes concerning dividend targets vary
? Dividend Change
1
1
EPS ratio target
dividend target DIV
× =
=
0 1
0 1
DIV - EPS ratio target
change target DIV - DIV
× =
=
The Dividend Decision
87
? Dividend changes confirm the following
( )
0 1
0 1
DIV - EPS ratio target rate adjustment
change target rate adjustment DIV - DIV
× × =
× =
This model suggests that the dividend depends partly on
the firm’s current earnings and partly on the dividend
for the previous year.
Current dividends are related to a weighted average of
current earnings and past earnings
Dividend Policy
88
-15
-10
-5
0
5
10
15
Div Rise
Div Cut
Source: Healy & Palepu (1988)
C
h
a
n
g
e
E
P
S
/
P
r
i
c
e
a
t
t
=
0
a
s
%
Year
Impact of Dividend Changes on EPS
Dividend Policy is Irrelevant
89
? Since investors do not need dividends to convert
shares to cash, they will not pay higher prices for
firms with higher dividend payouts.
? In other words, dividend policy will have no impact on
the value of the firm.
? This is the homemade dividend argument.
Dividend Policy is Irrelevant
90
Example - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000+
New Proj NPV 2,000
# of Shares 1,000
price/share $12
Dividend Policy is Irrelevant
91
Example - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following balance
sheet information, show how the value of the firm is not altered when
new shares are issued to pay for the dividend.
Record Date Pmt Date
Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
Dividend Policy is Irrelevant
92
Example - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following balance
sheet information, show how the value of the firm is not altered when
new shares are issued to pay for the dividend.
Record Date Pmt Date Post Pmt
Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000+ 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
Dividend Policy is Irrelevant
93
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
Dividend Policy is Irrelevant
94
Example - continued - Shareholder Value
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
Dividend Policy is Irrelevant
95
Example - continued - Shareholder Value
Record Pmt Post
Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000
12,000
Stock = 1,091sh @ $115 = 12,000
? Assume stockholders purchase the new issue with the
cash dividend proceeds.
Dividends Increase Value
96
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks, but
it does not follow that any particular firm can benefit
by increasing its dividends. The high dividend
clientele already have plenty of high dividend stock
to choose from.
These clients increase the price of the stock
through their demand for a dividend paying stock.
Dividends Increase Value
97
Dividends as Signals
Dividend increases send good news about
cash flows and earnings. Dividend cuts send
bad news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow
to support it, dividend increases signal a
company’s good fortune and its manager’s
confidence in future cash flows.
Dividends Decrease Value
98
Tax Consequences
Companies can convert dividends into capital gains
by shifting their dividend policies. If dividends are
taxed more heavily than capital gains, as in US,
taxpaying investors should welcome such a move and
value the firm more favorably.
In such a tax environment, the total cash flow retained
by the firm and/or held by shareholders will be higher
than if dividends are paid.
Shareholders in high tax brackets prefer low dividend
paying stocks. Shareholders in low tax brackets
prefer high dividend paying stocks
Taxes and Dividend Policy
99
? Since capital gains are taxed at a lower rate than
dividend income, companies should pay the
lowest dividend possible.
? Dividend policy should adjust to changes in the
tax code.
Taxes and Dividend Policy
100
0 . 10 100 0 . 10 100 (%) return of rate After tax
78 . 9 ) 94 . 0 4 ( ) 72 . 4 10 ( 10 50 . 2 ) 50 . 12 0 (
taxes) - gain cap (div
income Tax After Total
94 . 0 72 . 4 .20 2.50 12.50 .20 20% @ Gain Cap on Tax
4.00 10 .40 0 50% @ div on Tax
05 . 15 100 5 . 12 100 (%) return of rate Pretax
4.72 12.50 gain Capital
97.78 100 price stock s Today'
112.50 112.50 payoff pretax Total
10 0 Dividend
102.50 112.50 price s year' Next
dividend) (high
B Firm
dividend) (no
A Firm
97.78
9.78
100
10
97.78
14.72
100
12.5
= × = ×
= + ÷ ÷ = ÷ +
+
= × = ×
= ×
= × = ×
Taxes and Dividend Policy
101
2000 Marginal Income Tax Brackets
Income Baracket
Marginal Tax Rate Single Married (joint return)
15% $0 - $26,250 $0 - $43,850
28 26,251 - 63,550 43,851 - 105,950
31 63,551 - 132,600 105,951 - 161,450
36 132,601 -288,350 161,451 - 288,350
39.6 over 288,350 over 288,350
Taxes and Dividend Policy
102
Cash Flow
Operating Income 100
Corporate tax at 35% 35
After Tax income (paid as div) 65
Income tax paid by investors at 39.6% 25.7
Cash to Shareholder 39.3
In U.S., shareholders are taxed twice (figures in dollars)
Taxes and Dividend Policy
103
Rate of Income tax
15% 30% 47%
Operating Income 100 100 100
Corporate tax (Tc=.30) 30 30 30
After Tax income 70 70 70
Grossed up Dividend 100 100 100
Income tax 15 30 47
Tax credit for Corp Pmt -30 -30 -30
Tax due from shareholder -15 0 17
Cash to Shareholder 85 70 53
Under imputed tax systems, such as that in Australia, Shareholders receive a
tax credit for the corporate tax the firm pays (figures in Australian dollars)
Dividend Policy
104
1. What is Dividend Policy?
The policy that a firm uses to determine whether or not to
distribute earnings to shareholders in the form of dividends
2. Why is it Important?
We know capital structure affects firm value. Increasing
shareholder equity by retaining earnings impacts capital
structure. Therefore, managers can indirectly influence
firm value and cost of capital by making dividend
payout/retention decisions
3. What are major determinants of Dividend
Policy?
Glad you asked – there are several. Lets go on to the next
slide
Determinants of Dividend Policy
105
? Variations in payout
? Legal constraints
? Restrictive covenants
? Tax considerations
? Liquidity and CF
considerations
? Earnings stability
? Growth prospects
? Inflation
? Shareholder preference
? Protection against
dilution
Passive Residual Policy
106
? Suggests that a firm should retain its earnings as long
as it has investment opportunities that promise higher
rates of return than the required rate (eg NPV > 0 or
IRR > WACC).
? Dividends can fluctuate significantly
Depends on the firm’s investment opportunities
? In practice dividends can be smoothed
? Growth firms will have low dividend payout
Stable Dollar Dividend Policies
107
? Reluctance to reduce dividends
? Increases in dividends tend to lag earnings
? Desirability
? Information content
? Many shareholders depend on dividends
? Stability tends to reduce uncertainty
? Legally desirable
Other Dividend Payment Policies
108
? Constant Payout Ratio
? Pays a constant % of earnings as dividends
? Fluctuating dividends
? Small Regular Dividends Plus Extras
? Stockholders can depend on regular payout
? Accommodates changing earnings and investment
requirements
? Small Firms and Dividends
? Tend to pay out a smaller % of earnings
? Rapid growth and limited access to capital markets
Different Types of Dividends
109
? Many companies pay a regular cash dividend.
? Public companies often pay quarterly.
? Sometimes firms will throw in an extra cash dividend.
? The extreme case would be a liquidating dividend.
? Often companies will declare stock dividends.
? No cash leaves the firm.
? The firm increases the number of shares outstanding.
? Some companies declare a dividend in kind.
? Wrigley’s Gum sends around a box of chewing gum.
? Dundee Crematoria offers shareholders discounted
cremations.
Procedure for Cash Dividend
Payment
110
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date
…
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is entitled to the
dividend.
Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.
Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 6 November.
Price Behavior around the Ex-Dividend
Date
111
? In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops by the
amount of the cash
dividend
-t
…
-2 -1 0 +1 +2
…
Taxes complicate things a bit. Empirically, the price drop is less
than the dividend and occurs within the first few minutes of
the ex-date.
Stock Dividends
Payment of additional shares of C/S
112
? Stock splits are similar to stock dividends
? Increases the number of shares outstanding
? Accounting transaction
? Transfer pre dividend market value from retained
earnings to other stockholders equity
? Market price of C/S should decline in proportion
to the # of new shares issued
Reasons for Declaring a Stock
Dividend
113
? Broaden the ownership of the firm’s shares
? May result in an effective increase in cash
dividends
? Provided the level of cash dividends is not reduced
? Reduction in share price may broaden the appeal
of the stock to investors
? Resulting in a real increase in market value
Stock Repurchase
114
? By a tender offer, in the open market, or by
negotiation with large holders
? Treasury stock
? Reduces the number of shares outstanding
? Increases EPS
? Usually announced
? Repurchase as investment
? Recent studies has shown that the long-term stock
price performance of securities after a buyback is
significantly better than the stock price performance of
comparable companies that do not repurchase.
Dividends and Investment Policy
115
? Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the
first time).
? Recall that on of the assumptions underlying the
dividend-irrelevance arguments was “The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.”
What We Know and Do Not
Know About Dividend Policy
116
? Corporations “Smooth” Dividends.
? Dividends Provide Information to the Market.
? Firms should follow a sensible dividend policy:
? Don’t forgo positive NPV projects just to pay a
dividend.
? Avoid issuing stock to pay dividends.
? Consider share repurchase when there are few better
uses for the cash.
Summary and Conclusions
117
? The optimal payout ratio cannot be determined
quantitatively.
? A firm should not reject positive NPV projects to
pay a dividend.
? Personal taxes and issue costs are real-world
considerations that favor low dividend payouts.
? Many firms appear to have a long-run target
dividend-payout policy. There appears to be some
value to dividend stability and smoothing.
? There appears to be some information content in
dividend payments.
Questions
118
? Companies decide on dividend payout by looking at
their capex requirements. Comment
? Is it true that most companies have some notion of
a target payout ratio?
? Why are investors and managers more interested in
dividend changes than in dividend levels?
Questions
119
? Companies set each year’s dividend equal to target
payout ratio times last year’s earnings. Comment
? Managers often increase dividends temporarily
when earnings are unexpectedly high for a year or
2.
? Companies undertaking substantial share
repurchases usually finance them with an off-setting
reduction in cash dividends.
Questions
120
? The dividend changes in AI Limited for the past 3
years have been described as follows:
D
t
– D
t-1
= 0.36 x (0.26 EPS
t
– D
t-1
)
? What is the target payout ratio?
? What is the rate at which the dividends are to be
adjusted?
Questions
121
? If Nikhil owns HBL 1000 shares and the
company has announced an increase of
dividend from Rs. 2 to Rs. 2.50 per share. The
current price is Rs. 150. If he doesn’t wish to
spend the extra cash, what should he do?
? If in the above the dividend were to be cut to
Rs. 1.50 per share and Nikhil were to maintain
his consumption, what should he do to offset the
dividend cut?
Questions
122
? LM Ltd has 1 cr shares outstanding, on which it
pays an annual dividend of Rs. 5 per share. The
CEO has recommended that the dividend be
increased to Rs. 7 per share. If the investment
policy & capital structure are not to be affected,
what must the Co to offset the dividend increase?
Questions
123
? AB Ltd. Has 50 lac shares outstanding. The Finance
Director proposes that given the large cash
holdings, the dividend should be increased from Rs.
5 to Rs. 10 per share. If you agree with the plans for
investment and capital structure, what else must the
company do as consequence of the dividend
increase?
Questions
124
? HM Ltd has 5000 shares outstanding and the Stock price
is Rs. 140. The company is expected to pay a dividend of
Rs. 20 per share next year and thereafter the dividends
are expected to grow by 5% for ever. The CEO makes a
surprise announcement that the Co would henceforth
distribute half the cash in form of dividends and
remainder buy back the shares.
? What is the total value of the Co before and after the
announcement?
? What would be the expected dividends for an investor
who plans to retain his shares rather than sell them
back?
125
Understanding Options
Topics Covered
126
? Calls, Puts and Shares
? Financial Alchemy with Options
? What Determines Option Value
? Option Valuation
Option Terminology
127
Put Option
Right to sell an asset at a specified exercise price on
or before the exercise date.
Call Option
Right to buy an asset at a specified exercise
price on or before the exercise date.
Option Obligations
128
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
Option Value
129
? The value of an option at expiration is a
function of the stock price and the exercise
price.
Option Value
130
? The value of an option at expiration is a
function of the stock price and the exercise
price.
Example - Option values given a exercise price
of $55
0 0 0 5 15 25 Value Put
25 15 5 0 0 0 Value Call
80 70 60 50 40 $30 Price Stock
Option Value
131
Call option value (graphic) given a $55 exercise price.
Share Price
C
a
l
l
o
p
t
i
o
n
v
a
l
u
e
55 75
$20
Option Value
132
Put option value (graphic) given a $55 exercise price.
Share Price
P
u
t
o
p
t
i
o
n
v
a
l
u
e
50 55
$5
Option Value
133
Call option payoff (to seller) given a $55 exercise price.
Share Price
C
a
l
l
o
p
t
i
o
n
$
p
a
y
o
f
f
55
Option Value
134
Put option payoff (to seller) given a $55 exercise price.
Share Price
P
u
t
o
p
t
i
o
n
$
p
a
y
o
f
f
55
Option Value
135
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long Stock
Option Value
136
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long Put
Option Value
137
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Protective Put
Long Put
Long Stock
Option Value
138
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Protective Put
Option Value
139
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long call
Option Value
140
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long put
Option Value
141
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Straddle
Option Value
142
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Straddle
Option Value
143
Upper Limit
Stock Price
Option Value
144
Upper Limit
Stock Price
Lower Limit
(Stock price - exercise price) or 0
which ever is higher
Time Decay Chart
Option Price
Stock Price
145
146
Valuing Options
Topics Covered
147
? Simple Valuation Model
? Binomial Model
? Black-Scholes Model
? Black Scholes vs. Binomial
148
Probability Up = p = (a - d) Prob Down = 1 - p
(u - d)
a = e
rD t
d =e
-s [D t]
.5
u =e
s [D t]
.5
Dt =
time intervals as % of year
Binomial Pricing
149
Example
Price = 36 s = .40 t = 90/365 D t = 30/365
Strike = 40 r = 10%
a = 1.0083
u = 1.1215
d = .8917
Pu = .5075
Pd = .4925
Binomial Pricing
40.37
32.10
36
37 . 40 1215 . 1 36
1 0
= ×
= ×
U
P U P
Binomial Pricing
150
40.37
32.10
36
37 . 40 1215 . 1 36
1 0
= ×
= ×
U
P U P
10 . 32 8917 . 36
1 0
= ×
= ×
D
P D P
Binomial Pricing
151
50.78 = price
40.37
32.10
25.52
45.28
36
28.62
40.37
32.10
36
1 +
= ×
t t
P U P
Binomial Pricing
152
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
36
28.62
36
40.37
32.10
Binomial Pricing
153
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
28.62
40.37
32.10
36
( ) ( ) | | ( )
t r
d d u u
e P U P O
A ÷
× × + ×
The greater of
Binomial Pricing
154
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
.19
28.62
0
40.37
2.91
32.10
.10
36
1.51
( ) ( ) | | ( )
t r
d d u u
e P U P O
A ÷
× × + ×
Binomial Pricing
155
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
.19
28.62
0
40.37
2.91
32.10
.10
36
1.51
( ) ( ) | | ( )
t r
d d u u
e P U P O
A ÷
× × + ×
Binomial Pricing
156
Option Value
157
Components of the Option Price
1 - Underlying stock price
2 - Striking or Exercise price
3 - Volatility of the stock returns (standard deviation of
annual returns)
4 - Time to option expiration
5 - Time value of money (discount rate)
Option Value
158
Black-Scholes Option Pricing Model
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
O
C
- Call Option Price
P
s
- Stock Price
N(d
1
) - Cumulative normal density function of (d
1
)
S - Strike or Exercise price
N(d
2
) - Cumulative normal density function of (d
2
)
r - discount rate (90 day comm paper rate or risk free rate)
t - time to maturity of option (as % of year)
v - volatility - annualized standard deviation of daily returns
Black-Scholes Option Pricing Model
159
(d
1
)=
ln + ( r + ) t
P
s
S
v
2
2
v t
32 34 36 38 40
N(d
1
)=
Black-Scholes Option Pricing Model
160
(d
1
)=
ln + ( r + ) t
P
s
S
v
2
2
v t
Cumulative Normal Density Function
(d
2
) = d
1
- v t
161
Call Option
162
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
Call Option
163
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
(d
1
) =
ln + ( r + ) t
P
s
S
v
2
2
v t
(d
1
) = - .3070 N(d
1
) = 1 - .6206 = .3794
Call Option
164
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
(d
2
) = - .5056
N(d
2
) = 1 - .6935 = .3065
(d
2
) = d
1
- v t
Call Option
165
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
O
C
= 36[.3794] - 40[.3065]e
- (.10)(.2466)
O
C
= $ 1.70
Put - Call Parity
166
Put Price = Oc + S - P - Carrying Cost + Div.
Carrying cost = r x S x t
Put - Call Parity
167
Example
ABC is selling at $41 a share. A six month
May 40 Call is selling for $4.00. If a May $
.50 dividend is expected and r=10%, what
is the put price?
Expanding the binomial model to allow more
possible price changes
168
1 step 2 steps 4 steps
(2 outcomes) (3 outcomes) (5 outcomes)
etc. etc.
Binomial vs. Black Scholes
How estimated call price changes as
number of binomial steps increases
169
No. of steps Estimated value
1 48.1
2 41.0
3 42.1
5 41.8
10 41.4
50 40.3
100 40.6
Black-Scholes 40.5
Binomial vs. Black Scholes
Options
170
? Many corporate securities are similar to
the stock options that are traded on
organized exchanges.
? Almost every issue of corporate stocks
and bonds has option features.
? In addition, capital structure and capital
budgeting decisions can be viewed in
terms of options.
Options Contracts: Preliminaries
171
? An option gives the holder the right, but not the obligation, to buy
or sell a given quantity of an asset on (or perhaps before) a given
date, at prices agreed upon today.
? Calls versus Puts
? Call options gives the holder the right, but not the obligation, to buy a
given quantity of some asset at some time in the future, at prices
agreed upon today. When exercising a call option, you “call in” the
asset.
? Put options gives the holder the right, but not the obligation, to sell a
given quantity of an asset at some time in the future, at prices agreed
upon today. When exercising a put, you “put” the asset to someone.
Options Contracts: Preliminaries
172
? Exercising the Option
? The act of buying or selling the underlying asset through the
option contract.
? Strike Price or Exercise Price
? Refers to the fixed price in the option contract at which the holder
can buy or sell the underlying asset.
? Expiry
? The maturity date of the option is referred to as the expiration
date, or the expiry.
? Spot Price
? The Price at which an option is currently valued (either in the
market or privately)
Options Contracts: Preliminaries
173
? In-the-Money
? The exercise price is less than the spot price of the
underlying asset.
? At-the-Money
? The exercise price is equal to the spot price of the
underlying asset.
? Out-of-the-Money
? The exercise price is more than the spot price of the
underlying asset.
Options Contracts: Preliminaries
174
? Intrinsic Value
? The difference between the exercise price of the
option and the spot price of the underlying asset.
? Speculative Value
? The difference between the option premium and the
intrinsic value of the option.
Option
Premium
=
Intrinsic
Value
Speculative
Value
+
Call Option Payoffs
175
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Buy a call
Exercise price = $50
Call Option Payoffs
176
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Write a call
Exercise price = $50
Call Option Profits
177
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Write a call
Buy a call
Exercise price = $50; option premium = $10
Put Option Payoffs
178
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Buy a put
Exercise price = $50
Put Option Payoffs
179
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
write a put
Exercise price = $50
Stock price ($)
Put Option Profits
180
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Buy a put
Write a put
Exercise price = $50; option premium = $10
10
-10
Selling Options
181
? The seller (or writer) of
an option has an
obligation.
? The purchaser of an
option has an option.
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Buy a put
Write a put
10
-10
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Write a call
Buy a call
Combinations of Options
182
? Puts and calls can serve as the
building blocks for more complex
option contracts.
? If you understand this, you can
become a financial engineer, tailoring
the risk-return profile to meet your
client’s needs.
Protective Put Strategy: Buy a Put and
Buy the Underlying Stock: Payoffs at
Expiry
183
Buy a put with an
exercise price of $50
Buy
the
stock
Protective Put
strategy has downside
protection and upside
potential
$50
$0
$50
Value at
expiry
Value of
stock at
expiry
Protective Put Strategy Profits
184
Buy a put with
exercise price
of $50 for $10
Buy the stock at $40
$40
Protective Put
strategy has
downside
protection and
upside potential
$40
$0
-$40
$50
Value at
expiry
Value of
stock at
expiry
Covered Call Strategy
185
Sell a call with
exercise price
of $50 for $10
Buy the stock at $40
$4
0
Covered call
$40
$0
-$40
$10
-$30
$30 $5
0
Value of stock at
expiry
Value at
expiry
Long Straddle: Buy a Call and a
Put
186
Buy a put with
an exercise price
of $50 for $10
$40
A Long Straddle only makes money if
the stock price moves $20 away
from $50.
$40
$0
-$20
$50
Buy a call with
an exercise
price of $50 for
$10
-$10
$30
$60 $30 $70
Value of
stock at
expiry
Value at
expiry
Put-Call Parity
187
Sell a put with an
exercise price of $40
Buy the stock at $40
financed with some
debt: FV = $X
Buy a call option with
an exercise price of $40
$0
-$40
$40-P
0
rT
Xe
÷
÷ 40 $
$40
Buy the
stock at $40
0
40 $ C +
) 40 ($
rT
Xe
÷
÷ ÷
-[$40-P
0
]
0
C ÷
0
P
In market equilibrium, it mast be the case that option prices
are set such that: Value of stock + Value of put - Value of call =
Present value of strike price discounted at r
F
Otherwise, riskless portfolios with positive payoffs exist.
Value of
stock at
expiry
Value at
expiry
Valuing Options
188
? The last section
concerned itself
with the value of
an option at expiry.
? This section
considers the
value of an option
prior to the
expiration date.
? A much more
interesting
question.
Option Value Determinants
189
Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate +
–
4. Volatility in the stock price + +
5. Expiration date + +
The value of a call option must fall within
max (stock price – exercise price, 0) < value of the option
< value of the stock.
The precise position will depend on these factors.
Option-Pricing Methods
190
? The binomial
option pricing
formula is used to
value options that
have two potential
future values – an
up-state and a
down-state
? The Black-Scholes
model provides a
normalized
approximation to
the binomial for
some real-world
option valuation.
Binomial Option Pricing Model
191
Suppose a stock is worth $25 today and in one period will
either be worth 15% more or 15% less. S
0
= $25 today
and in one year S
1
is either $28.75 or $21.25. The risk-
free rate is 5%. What is the value of an at-the-money
call option?
$25
$21.25
$28.75
S
1
S
0
Binomial Option Pricing Model
192
1. A call option on this stock with exercise price of
$25 will have the following payoffs.
2. We can replicate the payoffs of the call option.
With a levered position in the stock.
$25
$21.25
$28.75
S
1
S
0
C
1
$3.75
$0
Summary and Conclusions
193
? The most familiar options are puts and calls.
? Put options give the holder the right to sell stock at
a set price for a given amount of time.
? Call options give the holder the right to buy stock at
a set price for a given amount of time.
Summary and Conclusions
194
? The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Risk-free interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
? Much of corporate financial theory can be presented
in terms of options.
1. Common stock in a levered firm can be viewed as a call option
on the assets of the firm.
2. Real projects often have hidden option that enhance value.
Classic NPV calculations typically ignore the flexibility that real-
world firms typically have.
Using Options in International Finance
- Forward Market Hedge - Forward Sale of DM 1 Million
-60
-40
-20
0
20
40
60
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
195
Forward Market Hedge - DM Account
Receivable
196
-60
-40
-20
0
20
40
60
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Forward Market Hedge - Forward
Market Hedge of Receivable
197
-60
-40
-20
0
20
40
60
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
a
b
c
Forward sale Receivable
Hedged
receivable
Option Market Hedge - Put Option on
DM 1 million
198
-10
-5
0
5
10
15
20
25
30
35
40
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Premium
Option Market Hedge - Call Option on
DM 1 million
199
-20
-10
0
10
20
30
40
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Premium
Option Market Hedge - Option Market
Hedge of Receivable
200
-60
-50
-40
-30
-20
-10
0
10
20
30
40
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Put Receivable
Hedged receivable
201
Real Options
Topics Covered
202
? Follow Up Investments
? Abandon
? Wait
? Vary Output or Production
Corporate Options
203
4 types of “Real Options”
1 - The opportunity to make follow-up
investments.
2 - The opportunity to abandon a project
3 - The opportunity to “wait” and invest later.
4 - The opportunity to vary the firm’s output or
production methods.
Value “Real Option” = NPV with option
- NPV w/o option
Option to Wait
204
Intrinsic Value
Option
Price
Stock Price
Option to Wait
205
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option
Price
Stock Price
Option to Wait
206
More time = More value
Option
Price
Stock Price
Option to Abandon
207
Example - Abandon
Mrs. Mulla gives you a non-retractable offer
to buy your company for $150 mil at anytime
within the next year. Given the following
decision tree of possible outcomes, what is
the value of the offer (i.e. the put option) and
what is the most Mrs. Mulla could charge for
the option?
Use a discount rate of 10%
Option to Abandon
208
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4)
Option to Abandon
209
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 162
150 (.4)
Option Value =
162 - 145 =
$17 mil
Corporate Options
210
Reality
? Decision trees for valuing “real options” in
a corporate setting can not be practically
done by hand.
? We must introduce binomial theory & B-S
models
doc_443981527.pptx
patterns of corporate financing, what is common stock, Book Value vs. Market Value, What are different types of Corporate Debt?, How Corporations Issue Securities. It also covers topics like Venture Capital, The Initial Public Offering, Private Placements and Public Issues and rights issue, Dividend Irrelevance Theory, Bird-in-the-Hand Theory, Tax Preference Theory
1
An Overview of Corporate
Financing
Topics Covered
2
? Patterns of Corporate Financing
? Common Stock
? Preferred Stock
? Debt
? Financial Markets and Institutions
Patterns of Corporate Financing
3
? Firms may raise funds from
? external sources or
? plow back profits rather than distribute them to
shareholders.
? External financing - choose between debt or equity
sources.
Patterns of Corporate Financing
4
? A major source of financing for corporations in the US
are internally generated funds –
? which include depreciation and
? retained earnings.
? Debt is a major source of external funds.
? Generally, US corporations have used relatively low
levels of debt.
Patterns of Corporate Financing
5
Patterns of Corporate Financing
6
Aggregate balance sheet for manufacturing corporations
in the United States, 2001 (figures in Billions).
Current assets 1,547 $ Current liabilities 1,234 $
Fixed assets 2,361 Long term debt 1,038
Less 1,166 Other long term 679
deprecication liabilities
Net fixed assets 1,195 Total long term liabilities 1,717
Other long term 2,160 Stockholders' equity 1,951
Total assets 4,903 Total liabilities and 4,903
stockholders' equity
Patterns of Corporate Financing
7
60 .
903 , 4
717 , 1 234 , 1
assets Total
Debt
=
+
=
47 .
951 , 1 717 , 1
717 , 1
equity s liabilitie term Long
s liabilitie term Long
=
+
=
+
How do we define debt ?
Patterns of Corporate Financing
8
How do we define debt ?
Patterns of Corporate Financing
9
60 .
903 , 4
717 , 1 234 , 1
assets Total
Debt
=
+
=
47 .
951 , 1 717 , 1
717 , 1
equity s liabilitie term Long
s liabilitie term Long
=
+
=
+
How do we define debt ?
Patterns of Corporate Financing
10
DEBT TO TOTAL CAPITAL
Book Book, Market Market,
Adjusted Adjusted
Canada 39% 37% 35% 32%
France 48 34 41 28
Germany 38 18 23 15
Italy 47 39 46 36
Japan 53 37 29 17
United Kingdom 28 16 19 11
United States 37 33 28 23
Common Stock
11
Book Value vs. Market Value
? Book value is a backward looking measure.
? It tells us how much capital the firm has raised
from shareholders in the past.
? It does not measure the value that shareholders
place on those shares today.
? The market value of the firm is forward looking, it
depends on the future dividends that shareholders
expect to receive.
Common Stock
12
Example - Heinz Book Value vs. Market Value
(5/2000)
Total Shares outstanding = 347 million
Treasury shares are issued shares bought back by the corporation.
1,596 Value) (Book equity common Net
652 - s adjustment Other
2,920 - shares Treasury
4,757 earnings Retained
304 capital in paid Additional
108 par) ($1 Shares Common
Common Stock
13
Example - Mobil Book Value vs. Market Value
(5/00)
Total Shares outstanding = 347 million
billion $12.1 Value Market
347 x shares of #
$35/sh = price Market 2000 May
Preferred Stock
14
Preferred Stock - Stock that takes priority over
common stock in regards to dividends.
Floating-Rate Preferred - Preferred stock paying
dividends that vary with short term interest rates.
Corporate Debt
15
? Debt has the unique feature of allowing the
borrowers to walk away from their obligation to pay,
in exchange for the assets of the company.
? “Default Risk” is the term used to describe the
likelihood that a firm will walk away from its
obligation, either voluntarily or involuntarily.
? “Bond Ratings "are issued on debt instruments to
help investors assess the default risk of a firm.
Corporate Debt
16
? What are different types of Corporate Debt?
Corporate Debt
17
? Bank Term Loans
? Working Capital Finance
? Commercial Paper
? Debentures
? Convertible Debentures
? Foreign Currency Debts – ECB
? FCCB
? Unsecured Loans
? Fixed Deposits
Corporate Debt
18
Firms issue different types of debt like notes,
debentures, Eurobonds etc.
Corporate Debt
19
Terminology is very important.
Prime Rate - Benchmark interest rate charged by
banks.
Funded Debt - Debt with more than 1 year
remaining to maturity.
Sinking Fund - Fund established to retire debt
before maturity.
Callable Bond - Bond that may be repurchased by
firm before maturity at specified call price.
Corporate Debt
20
Subordinate Debt - Debt that may be repaid in
bankruptcy only after senior debt is repaid.
Secured Debt - Debt that has first claim on specified
collateral in the event of default.
Investment Grade - Bonds rated Baa or above by
Moody’s or BBB or above by S&P.
Junk Bond - Bond with a rating below Baa or BBB.
Corporate Debt
21
Eurodollars - Dollars held on deposit in a bank
outside the United States.
Eurobond - Bond that is marketed internationally.
Private Placement - Sale of securities to a
limited number of investors without a public
offering.
Protective Covenants - Restriction on a firm to
protect bondholders.
Lease - Long-term rental agreement.
Corporate Debt
22
Warrant - Right to buy shares from a company
at a stipulated price before a set date.
Convertible Bond - Bond that the holder may
exchange for a specified amount of another
security.
Convertibles are a combined security,
consisting of both a bond and a call
option.
Financial Markets
23
Primary
Markets
Secondary
Markets
OTC
Markets
Money
Financial Institutions
24
Company
Intermediaries
Banks
Insurance Cos.
Brokerage Firms
Obligations
Funds
Financial institutions provide funds for corporations by acting as financial intermediaries.
Financial Institutions
25
Intermediaries
Investors
Depositors
Policyholders
Investors
Obligations
Funds
Financial intermediaries pool funds from depositors, policyholders and investors.
Question
26
? Authorized Share cap ACC is 100,000 shares. The Equity is currently showing:
Common Stock Rs. 40,000
Additional paid-in Cap Rs. 10,000
Retained Earnings Rs. 30,000
Common Equity Rs. 80,000
Treasury Stock (2K) Rs. 5,000
Net Common Equity Rs. 75,000
? How many shares are issued?
? How many are Outstanding? Explain the diff from above
? Suppose ACC issues 10000 shares at Rs.2 a share. Which of the above figures
would be changed?
? Suppose ACC bought back 10000 shares at Rs. 5 a share. Which of the above
figures would be changed?
Question
27
? In 2007-08 Binda Corp earned Rs. 76 lacs gross profit.
? Suppose it is financed by a combination of equity and debt
of Rs. 1 crore. How much profit is available to shareholders
if interest on the debt is 10% and the Tax rate is 35%. The
depreciation is estimated to be Rs. 16 lacs.
? Now consider that instead of debt, it was financed by 8%
preferred stock, what would be the profit available to
shareholders.
28
How Corporations Issue Securities
Topics Covered
29
? Venture Capital
? The Initial Public Offering
? Other New-Issue Procedures
? Private Placements and Public Issues
? Rights Issue
Venture Capital
30
Venture Capital
Money invested to finance a new firm
These are high-risk, unproven businesses that
need financing.
Venture Capital
31
Venture capital firms often manage pools
of funds, contributed by pension funds
and other investors. Venture capital is
generally provided in many stages.
Venture Capital
32
Since success of a new firm is highly dependent on
the effort of the managers, restrictions are placed on
management by the venture capital company and
funds are usually dispersed in stages, after a certain
level of success is achieved.
Venture Capital
Money invested to finance a new firm
Venture Capital
33
2.0 Value 2.0 Value
1.0 equity original Your 1.0 assets Other
1.0 capital venture from equity New 1.0 equity new from Cash
Equity and s Liabilitie Assets
($mil) Sheet Balance Value Market Stage First
Venture Capital
34
14.0 Value 14.0 Value
5.0 equity original Your 9.0 assets Other
5.0 stage 1st from Equity 1.0 assets Fixed
4.0 stage 2nd from equity New 4.0 equity new from Cash
Equity and s Liabilitie Assets
($mil) Sheet Balance Value Market Stage Second
Initial Offering
35
Initial Public Offering (IPO) - First offering of stock to
the general public.
Underwriter - Firm that buys an issue of securities from
a company and resells it to the public.
Spread - Difference between public offer price and price
paid by underwriter.
Prospectus - Formal summary that provides
information on an issue of securities.
Underpricing - Issuing securities at an offering price
set below the true value of the security.
General Cash Offers
36
Seasoned Offering - Sale of securities by a
firm that is already publicly traded. An issue of
securities from an established company
whose existing shares have exhibited stable
price movements and substantial trading
volume over time, thereby earning a good
reputation.
General Cash Offer - Sale of securities open to
all investors by an already public company.
General Cash Offers
37
General Cash Offer - Sale of securities open to
all investors by an already public company –
usually without an Underwriter.
General Cash Offers
38
Shelf Registration - A procedure that allows
firms to file one registration statement for
several issues of the same security.
Private Placement - Sale of securities to a
limited number of investors without a public
offering.
39
0 Stage financing- represents the savings and personal loans
the company’s principals raise to start a firm..
1
st
or 2
nd
Stage financing- comes from funds provided by others
(often venture capitalists) to supplement the founders’
investment.
After the money valuation - valuation represents the estimated
value of the firm after the first-stage financing has been
received.
Mezzanine Financing- comes from other investors, after the
financing provided by venture capitalists.
Best Effort Offer - is an underwriter’s promise to sell as much as
possible of a security issue.
Qualified Institutional Buyer - is a large financial institution
which, is allowed to trade unregistered securities with other
qualified institutional buyers.
Private placements and public
issues
40
? A substantial fraction of corporate debt is placed privately.
(Private placements of stock are also common for small
companies.)
? Smaller firms tend to use the private placement market most
because they face the highest costs in a public issue and often
require specialized, flexible loan arrangements.
? On the other hand, the costs of investigation and negotiation
may be higher, and lenders in private placements expect some
compensation for holding an instrument with limited liquidity.
? It also allows large financial institutions to trade unregistered
securities among themselves.
Rights Issue
41
Rights Issue - Issue of securities offered only
to current stockholders.
Example - Lafarge Corp needs to raise
E1.1billionof new equity. The market price is
E99.65/sh. Lafarge decides to raise additional
funds via a 1 for 8 rights offer at E80 per
share. If we assume 100% subscription, what
is the value of each right?
Rights Issue
42
¬Current Market Value = 8 x E99.65 = E797.20
¬Total Shares = 8 + 1 = 9
¬Amount of funds = 797.20 + 80 = 877.20
¬New Share Price = (877.20) / 9 = E97.47
¬Value of a Right = 97.47 - 80 = 17.47
Example - Lafarge Corp needs to raise E1.1billionof new equity.
The market price is E99.65/sh. Lafarge decides to raise
additional funds via a 1 for 8 rights offer at E80 per share. If we
assume 100% subscription, what is the value of each right?
True or False
43
? Venture capitalists typically provide 1
st
stage financing
sufficient to cover all development expenses. 2
nd
stage
is provided by stock issued in an IPO.
? Large companies’ stocks may be listed and traded on
several international exchanges.
? Stock price generally falls when the company
announces a new issue of shares. This is attributable to
the information released by the decision to issue.
Question
44
? You need to choose between making a public issue and
arranging private placement. In each case the issue involves
Rs. 10 crores face value of 10 year debt.
? A public issue – the interest rate on debt would be 8.5% and debt
would be issued at par. The underwriting spread would be 1.5%
and other expenses be Rs. 8 lacs.
? Private placement – interest rate would be 9% and the total
issuing expenses would be Rs. 3 lacs.
? What is the difference in proceeds net of expenses?
? Which the better deal?
? What other factors would you wish to consider before
considering between the 2.
Question
45
? UB is planning to market a new beer. To finance the venture it
proposes to make a rights issue at Rs. 10 of 1 new share for
every 2 held (Currently 1 lac shares at CMP of Rs. 40).
Assuming that the new money is invested to earn a fair
return, give values for the following:
? Number of new shares
? Amount of new investment
? Total value of company after issue
? Total number of shares after issue
? Stock price after issue
? Price of the right to buy 1 new share
46
The Dividend Controversy
Topics Covered
47
? How Dividends Are Paid
? How Do Companies Decide on Dividend
Payments?
? Information in Dividends and Stock Repurchases
? The Dividend Controversy
Types of Dividends
48
?Regular Cash Div
?Special Cash Div
?Stock Div
?Stock Repurchase (3 methods)
1. Buy shares on the market
2. Tender Offer to Shareholders
3. Private Negotiation (Green Mail)
Dividend Payments
49
Cash Dividend - Payment of cash by the firm
to its shareholders.
Dividend Payments
50
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a
dividend payment; anyone holding stock
before this date is entitled to a dividend.
Dividend Payments
51
Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a
dividend payment; anyone holding stock
before this date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.
Dividend Payments
52
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Dividend Payments
53
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
Dividend Payments
54
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Repurchase - Firm buys back stock
from its shareholders.
Stock Splits - Issue of additional shares to
firm’s stockholders.
What is “dividend policy”?
55
? It’s the decision to pay out earnings versus
retaining and reinvesting them. Includes these
elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
Question
56
Do investors prefer high or low
payouts? There are three
theories:
57
? Dividends are irrelevant: Investors don’t care
about payout.
? Bird-in-the-hand: Investors prefer a high payout.
? Tax preference: Investors prefer a low payout,
hence growth.
Dividend Irrelevance Theory
58
? Investors are indifferent between dividends and retention-
generated capital gains. If they want cash, they can sell
stock. If they don’t want cash, they can use dividends to
buy stock.
? Modigliani-Miller support irrelevance.
? Theory is based on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true. Need empirical
test.
Bird-in-the-Hand Theory
59
? Investors think dividends are less risky than
potential future capital gains, hence they like
dividends.
? If so, investors would value high payout firms
more highly.
Tax Preference Theory
60
? Retained earnings lead to capital gains, which are
taxed at lower rates, in US, than dividends: 28%
maximum vs. up to 39.6%. Capital gains taxes are
also deferred.
? This could cause investors to prefer firms with low
payouts.
Implications of 3 Theories for
Managers
61
Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout
But which, if any, is correct???
Possible Stock Price Effects
62
Stock Price ($)
Payout 50% 100%
40
30
20
10
Bird-in-Hand
Indifference
Tax preference
0
Possible Cost of Equity Effects
63
Cost of equity (%)
Payout 50% 100%
15
20
10
Tax Preference
Indifference
Bird-in-Hand
0
Which theory is most correct?
64
? Empirical testing has not been able to determine
which theory, if any, is correct.
? Thus, managers use judgment when setting
policy.
? Analysis is used, but it must be applied with
judgment.
What’s the “information content,”
or “signaling,” hypothesis?
65
Question
66
? Managers hate to cut dividends, so won’t raise
dividends unless they think raise is sustainable.
? So, investors view dividend increases as signals of
management’s view of the future.
? Therefore, a stock price increase at time of a dividend
increase could reflect higher expectations for future
EPS, not a desire for dividends.
What’s the “clientele effect”?
67
? Different groups of investors, or clienteles, prefer
different dividend policies.
? Firm’s past dividend policy determines its current
clientele of investors.
? Clientele effects impede changing dividend policy.
? Taxes & brokerage costs hurt investors who have to
switch companies.
What’s the “residual dividend
model”?
68
? Find the retained earnings needed for the capital
budget.
? Pay out any leftover earnings (the residual) as
dividends.
? This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
Using the Residual Model to
Calculate Dividends Paid
Dividends = – .
Net
income
Target
equity
ratio
Total
capital
budget
[ ] ) ) ( (
69
How would a change in
investment opportunities affect
dividend under the residual
policy?
70
Question
71
? Fewer good investments would lead to smaller
capital budget, hence to a higher dividend
payout.
? More good investments would lead to a lower
dividend payout.
Advantages and Disadvantages of the
Residual Dividend Policy
72
? Advantages: Minimizes new stock issues and flotation
costs.
? Disadvantages: Results in variable dividends, sends
conflicting signals, increases risk, and doesn’t appeal to
any specific clientele.
? Conclusion: Consider residual policy when setting
target payout, but don’t follow it rigidly.
What’s a “dividend reinvestment
plan (DRIP)”?
73
? Shareholders can automatically reinvest their
dividends in shares of the company’s common
stock. Get more stock than cash.
? There are two types of plans:
? Open market
? New stock
Open Market Purchase Plan
74
? Money to be reinvested are turned over to trustee,
who buys shares on the open market.
? Brokerage costs are reduced by volume purchases.
? Convenient, easy way to invest, thus useful for
investors.
New Stock Plan
75
? Firm issues new stock to DRIP enrollees, keeps
money and uses it to buy assets.
? No fees are charged, plus sells stock at discount of
5% from market price, which is about equal to
flotation costs of underwritten stock offering.
Optional investments sometimes possible, up to
Rs. 15.0 crores or so.
Firms that need new equity capital use new stock
plans.
Firms with no need for new equity capital use
open market purchase plans.
76
Setting Dividend Policy
77
? Forecast capital needs over a planning horizon, often 5
years.
? Set a target capital structure.
? Estimate annual equity needs.
? Set target payout based on the residual model.
? Generally, some dividend growth rate emerges.
? Maintain target growth rate if possible, varying capital
structure somewhat if necessary.
Stock Repurchases
78
Reasons for repurchases:
? As an alternative to distributing cash as dividends.
? To dispose of one-time cash from an asset sale.
? To make a large capital structure change.
Repurchases: Buying own stock back from
stockholders.
Advantages of Repurchases
79
? Stockholders can tender or not.
? Helps avoid setting a high dividend that cannot
be maintained.
? Repurchased stock can be used in takeovers or
resold to raise cash as needed.
? Income received is capital gains rather than
higher-taxed dividends.
? Stockholders may take as a positive signal--
management thinks stock is undervalued.
Disadvantages of Repurchases
80
? May be viewed as a negative signal (firm has poor
investment opportunities).
? Govt. could impose penalties if repurchases were
primarily to avoid taxes on dividends.
? Selling stockholders may not be well informed, hence
be treated unfairly.
? Firm may have to bid up price to complete purchase,
thus paying too much for its own stock.
Stock Dividends vs. Stock Splits
81
? Stock dividend: Firm issues new shares in lieu
of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.
? Stock split: Firm increases the number of
shares outstanding, say 2:1. Sends
shareholders more shares.
Both stock dividends and stock splits increase the
number of shares outstanding, so “the pie is divided
into smaller pieces.”
Unless the stock dividend or split conveys information,
or is accompanied by another event like higher
dividends, the stock price falls so as to keep each
investor’s wealth unchanged.
But splits/stock dividends may get us to an “optimal
price range.”
82
When should a firm consider
splitting its stock?
83
Question
84
? There’s a widespread belief that the optimal price
range for stocks is Rs. 200 to Rs. 800.
? Stock splits can be used to keep the price in the
optimal range.
? Stock splits generally occur when management is
confident, so are interpreted as positive signals.
The Dividend Decision
85
1. Firms have longer term target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run, sustainable
levels of earnings rather than short-run changes in
earnings.
4. Managers are reluctant to make dividend changes that
might have to be reversed.
Lintner’s “Stylized Facts”
Lintner has developed a simple model, which is consistent with the observations
below and explains dividend payments well
The Dividend Decision
86
? Attitudes concerning dividend targets vary
? Dividend Change
1
1
EPS ratio target
dividend target DIV
× =
=
0 1
0 1
DIV - EPS ratio target
change target DIV - DIV
× =
=
The Dividend Decision
87
? Dividend changes confirm the following
( )
0 1
0 1
DIV - EPS ratio target rate adjustment
change target rate adjustment DIV - DIV
× × =
× =
This model suggests that the dividend depends partly on
the firm’s current earnings and partly on the dividend
for the previous year.
Current dividends are related to a weighted average of
current earnings and past earnings
Dividend Policy
88
-15
-10
-5
0
5
10
15
Div Rise
Div Cut
Source: Healy & Palepu (1988)
C
h
a
n
g
e
E
P
S
/
P
r
i
c
e
a
t
t
=
0
a
s
%
Year
Impact of Dividend Changes on EPS
Dividend Policy is Irrelevant
89
? Since investors do not need dividends to convert
shares to cash, they will not pay higher prices for
firms with higher dividend payouts.
? In other words, dividend policy will have no impact on
the value of the firm.
? This is the homemade dividend argument.
Dividend Policy is Irrelevant
90
Example - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following
balance sheet information, show how the value of the firm is not
altered when new shares are issued to pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000+
New Proj NPV 2,000
# of Shares 1,000
price/share $12
Dividend Policy is Irrelevant
91
Example - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following balance
sheet information, show how the value of the firm is not altered when
new shares are issued to pay for the dividend.
Record Date Pmt Date
Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
Dividend Policy is Irrelevant
92
Example - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current
investment needs. Using M&M Theory, and given the following balance
sheet information, show how the value of the firm is not altered when
new shares are issued to pay for the dividend.
Record Date Pmt Date Post Pmt
Cash 1,000 0 1,000 (91 sh @ $11)
Asset Value 9,000 9,000 9,000
Total Value 10,000+ 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
Dividend Policy is Irrelevant
93
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
Dividend Policy is Irrelevant
94
Example - continued - Shareholder Value
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
Dividend Policy is Irrelevant
95
Example - continued - Shareholder Value
Record Pmt Post
Stock 12,000 11,000 12,000
Cash 0 1,000 0
Total Value 12,000 12,000
12,000
Stock = 1,091sh @ $115 = 12,000
? Assume stockholders purchase the new issue with the
cash dividend proceeds.
Dividends Increase Value
96
Market Imperfections and Clientele Effect
There are natural clients for high-payout stocks, but
it does not follow that any particular firm can benefit
by increasing its dividends. The high dividend
clientele already have plenty of high dividend stock
to choose from.
These clients increase the price of the stock
through their demand for a dividend paying stock.
Dividends Increase Value
97
Dividends as Signals
Dividend increases send good news about
cash flows and earnings. Dividend cuts send
bad news.
Because a high dividend payout policy will be
costly to firms that do not have the cash flow
to support it, dividend increases signal a
company’s good fortune and its manager’s
confidence in future cash flows.
Dividends Decrease Value
98
Tax Consequences
Companies can convert dividends into capital gains
by shifting their dividend policies. If dividends are
taxed more heavily than capital gains, as in US,
taxpaying investors should welcome such a move and
value the firm more favorably.
In such a tax environment, the total cash flow retained
by the firm and/or held by shareholders will be higher
than if dividends are paid.
Shareholders in high tax brackets prefer low dividend
paying stocks. Shareholders in low tax brackets
prefer high dividend paying stocks
Taxes and Dividend Policy
99
? Since capital gains are taxed at a lower rate than
dividend income, companies should pay the
lowest dividend possible.
? Dividend policy should adjust to changes in the
tax code.
Taxes and Dividend Policy
100
0 . 10 100 0 . 10 100 (%) return of rate After tax
78 . 9 ) 94 . 0 4 ( ) 72 . 4 10 ( 10 50 . 2 ) 50 . 12 0 (
taxes) - gain cap (div
income Tax After Total
94 . 0 72 . 4 .20 2.50 12.50 .20 20% @ Gain Cap on Tax
4.00 10 .40 0 50% @ div on Tax
05 . 15 100 5 . 12 100 (%) return of rate Pretax
4.72 12.50 gain Capital
97.78 100 price stock s Today'
112.50 112.50 payoff pretax Total
10 0 Dividend
102.50 112.50 price s year' Next
dividend) (high
B Firm
dividend) (no
A Firm
97.78
9.78
100
10
97.78
14.72
100
12.5
= × = ×
= + ÷ ÷ = ÷ +
+
= × = ×
= ×
= × = ×
Taxes and Dividend Policy
101
2000 Marginal Income Tax Brackets
Income Baracket
Marginal Tax Rate Single Married (joint return)
15% $0 - $26,250 $0 - $43,850
28 26,251 - 63,550 43,851 - 105,950
31 63,551 - 132,600 105,951 - 161,450
36 132,601 -288,350 161,451 - 288,350
39.6 over 288,350 over 288,350
Taxes and Dividend Policy
102
Cash Flow
Operating Income 100
Corporate tax at 35% 35
After Tax income (paid as div) 65
Income tax paid by investors at 39.6% 25.7
Cash to Shareholder 39.3
In U.S., shareholders are taxed twice (figures in dollars)
Taxes and Dividend Policy
103
Rate of Income tax
15% 30% 47%
Operating Income 100 100 100
Corporate tax (Tc=.30) 30 30 30
After Tax income 70 70 70
Grossed up Dividend 100 100 100
Income tax 15 30 47
Tax credit for Corp Pmt -30 -30 -30
Tax due from shareholder -15 0 17
Cash to Shareholder 85 70 53
Under imputed tax systems, such as that in Australia, Shareholders receive a
tax credit for the corporate tax the firm pays (figures in Australian dollars)
Dividend Policy
104
1. What is Dividend Policy?
The policy that a firm uses to determine whether or not to
distribute earnings to shareholders in the form of dividends
2. Why is it Important?
We know capital structure affects firm value. Increasing
shareholder equity by retaining earnings impacts capital
structure. Therefore, managers can indirectly influence
firm value and cost of capital by making dividend
payout/retention decisions
3. What are major determinants of Dividend
Policy?
Glad you asked – there are several. Lets go on to the next
slide
Determinants of Dividend Policy
105
? Variations in payout
? Legal constraints
? Restrictive covenants
? Tax considerations
? Liquidity and CF
considerations
? Earnings stability
? Growth prospects
? Inflation
? Shareholder preference
? Protection against
dilution
Passive Residual Policy
106
? Suggests that a firm should retain its earnings as long
as it has investment opportunities that promise higher
rates of return than the required rate (eg NPV > 0 or
IRR > WACC).
? Dividends can fluctuate significantly
Depends on the firm’s investment opportunities
? In practice dividends can be smoothed
? Growth firms will have low dividend payout
Stable Dollar Dividend Policies
107
? Reluctance to reduce dividends
? Increases in dividends tend to lag earnings
? Desirability
? Information content
? Many shareholders depend on dividends
? Stability tends to reduce uncertainty
? Legally desirable
Other Dividend Payment Policies
108
? Constant Payout Ratio
? Pays a constant % of earnings as dividends
? Fluctuating dividends
? Small Regular Dividends Plus Extras
? Stockholders can depend on regular payout
? Accommodates changing earnings and investment
requirements
? Small Firms and Dividends
? Tend to pay out a smaller % of earnings
? Rapid growth and limited access to capital markets
Different Types of Dividends
109
? Many companies pay a regular cash dividend.
? Public companies often pay quarterly.
? Sometimes firms will throw in an extra cash dividend.
? The extreme case would be a liquidating dividend.
? Often companies will declare stock dividends.
? No cash leaves the firm.
? The firm increases the number of shares outstanding.
? Some companies declare a dividend in kind.
? Wrigley’s Gum sends around a box of chewing gum.
? Dundee Crematoria offers shareholders discounted
cremations.
Procedure for Cash Dividend
Payment
110
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date
…
Declaration Date: The Board of Directors declares a payment of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is entitled to the
dividend.
Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend.
Record Date: The corporation prepares a list of all individuals believed to be
stockholders as of 6 November.
Price Behavior around the Ex-Dividend
Date
111
? In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops by the
amount of the cash
dividend
-t
…
-2 -1 0 +1 +2
…
Taxes complicate things a bit. Empirically, the price drop is less
than the dividend and occurs within the first few minutes of
the ex-date.
Stock Dividends
Payment of additional shares of C/S
112
? Stock splits are similar to stock dividends
? Increases the number of shares outstanding
? Accounting transaction
? Transfer pre dividend market value from retained
earnings to other stockholders equity
? Market price of C/S should decline in proportion
to the # of new shares issued
Reasons for Declaring a Stock
Dividend
113
? Broaden the ownership of the firm’s shares
? May result in an effective increase in cash
dividends
? Provided the level of cash dividends is not reduced
? Reduction in share price may broaden the appeal
of the stock to investors
? Resulting in a real increase in market value
Stock Repurchase
114
? By a tender offer, in the open market, or by
negotiation with large holders
? Treasury stock
? Reduces the number of shares outstanding
? Increases EPS
? Usually announced
? Repurchase as investment
? Recent studies has shown that the long-term stock
price performance of securities after a buyback is
significantly better than the stock price performance of
comparable companies that do not repurchase.
Dividends and Investment Policy
115
? Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the
first time).
? Recall that on of the assumptions underlying the
dividend-irrelevance arguments was “The
investment policy of the firm is set ahead of time
and is not altered by changes in dividend policy.”
What We Know and Do Not
Know About Dividend Policy
116
? Corporations “Smooth” Dividends.
? Dividends Provide Information to the Market.
? Firms should follow a sensible dividend policy:
? Don’t forgo positive NPV projects just to pay a
dividend.
? Avoid issuing stock to pay dividends.
? Consider share repurchase when there are few better
uses for the cash.
Summary and Conclusions
117
? The optimal payout ratio cannot be determined
quantitatively.
? A firm should not reject positive NPV projects to
pay a dividend.
? Personal taxes and issue costs are real-world
considerations that favor low dividend payouts.
? Many firms appear to have a long-run target
dividend-payout policy. There appears to be some
value to dividend stability and smoothing.
? There appears to be some information content in
dividend payments.
Questions
118
? Companies decide on dividend payout by looking at
their capex requirements. Comment
? Is it true that most companies have some notion of
a target payout ratio?
? Why are investors and managers more interested in
dividend changes than in dividend levels?
Questions
119
? Companies set each year’s dividend equal to target
payout ratio times last year’s earnings. Comment
? Managers often increase dividends temporarily
when earnings are unexpectedly high for a year or
2.
? Companies undertaking substantial share
repurchases usually finance them with an off-setting
reduction in cash dividends.
Questions
120
? The dividend changes in AI Limited for the past 3
years have been described as follows:
D
t
– D
t-1
= 0.36 x (0.26 EPS
t
– D
t-1
)
? What is the target payout ratio?
? What is the rate at which the dividends are to be
adjusted?
Questions
121
? If Nikhil owns HBL 1000 shares and the
company has announced an increase of
dividend from Rs. 2 to Rs. 2.50 per share. The
current price is Rs. 150. If he doesn’t wish to
spend the extra cash, what should he do?
? If in the above the dividend were to be cut to
Rs. 1.50 per share and Nikhil were to maintain
his consumption, what should he do to offset the
dividend cut?
Questions
122
? LM Ltd has 1 cr shares outstanding, on which it
pays an annual dividend of Rs. 5 per share. The
CEO has recommended that the dividend be
increased to Rs. 7 per share. If the investment
policy & capital structure are not to be affected,
what must the Co to offset the dividend increase?
Questions
123
? AB Ltd. Has 50 lac shares outstanding. The Finance
Director proposes that given the large cash
holdings, the dividend should be increased from Rs.
5 to Rs. 10 per share. If you agree with the plans for
investment and capital structure, what else must the
company do as consequence of the dividend
increase?
Questions
124
? HM Ltd has 5000 shares outstanding and the Stock price
is Rs. 140. The company is expected to pay a dividend of
Rs. 20 per share next year and thereafter the dividends
are expected to grow by 5% for ever. The CEO makes a
surprise announcement that the Co would henceforth
distribute half the cash in form of dividends and
remainder buy back the shares.
? What is the total value of the Co before and after the
announcement?
? What would be the expected dividends for an investor
who plans to retain his shares rather than sell them
back?
125
Understanding Options
Topics Covered
126
? Calls, Puts and Shares
? Financial Alchemy with Options
? What Determines Option Value
? Option Valuation
Option Terminology
127
Put Option
Right to sell an asset at a specified exercise price on
or before the exercise date.
Call Option
Right to buy an asset at a specified exercise
price on or before the exercise date.
Option Obligations
128
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
Option Value
129
? The value of an option at expiration is a
function of the stock price and the exercise
price.
Option Value
130
? The value of an option at expiration is a
function of the stock price and the exercise
price.
Example - Option values given a exercise price
of $55
0 0 0 5 15 25 Value Put
25 15 5 0 0 0 Value Call
80 70 60 50 40 $30 Price Stock
Option Value
131
Call option value (graphic) given a $55 exercise price.
Share Price
C
a
l
l
o
p
t
i
o
n
v
a
l
u
e
55 75
$20
Option Value
132
Put option value (graphic) given a $55 exercise price.
Share Price
P
u
t
o
p
t
i
o
n
v
a
l
u
e
50 55
$5
Option Value
133
Call option payoff (to seller) given a $55 exercise price.
Share Price
C
a
l
l
o
p
t
i
o
n
$
p
a
y
o
f
f
55
Option Value
134
Put option payoff (to seller) given a $55 exercise price.
Share Price
P
u
t
o
p
t
i
o
n
$
p
a
y
o
f
f
55
Option Value
135
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long Stock
Option Value
136
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long Put
Option Value
137
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Protective Put
Long Put
Long Stock
Option Value
138
Protective Put - Long stock and long put
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Protective Put
Option Value
139
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long call
Option Value
140
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Long put
Option Value
141
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Straddle
Option Value
142
Straddle - Long call and long put
- Strategy for profiting from high volatility
Share Price
P
o
s
i
t
i
o
n
V
a
l
u
e
Straddle
Option Value
143
Upper Limit
Stock Price
Option Value
144
Upper Limit
Stock Price
Lower Limit
(Stock price - exercise price) or 0
which ever is higher
Time Decay Chart
Option Price
Stock Price
145
146
Valuing Options
Topics Covered
147
? Simple Valuation Model
? Binomial Model
? Black-Scholes Model
? Black Scholes vs. Binomial
148
Probability Up = p = (a - d) Prob Down = 1 - p
(u - d)
a = e
rD t
d =e
-s [D t]
.5
u =e
s [D t]
.5
Dt =
time intervals as % of year
Binomial Pricing
149
Example
Price = 36 s = .40 t = 90/365 D t = 30/365
Strike = 40 r = 10%
a = 1.0083
u = 1.1215
d = .8917
Pu = .5075
Pd = .4925
Binomial Pricing
40.37
32.10
36
37 . 40 1215 . 1 36
1 0
= ×
= ×
U
P U P
Binomial Pricing
150
40.37
32.10
36
37 . 40 1215 . 1 36
1 0
= ×
= ×
U
P U P
10 . 32 8917 . 36
1 0
= ×
= ×
D
P D P
Binomial Pricing
151
50.78 = price
40.37
32.10
25.52
45.28
36
28.62
40.37
32.10
36
1 +
= ×
t t
P U P
Binomial Pricing
152
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
36
28.62
36
40.37
32.10
Binomial Pricing
153
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
28.62
40.37
32.10
36
( ) ( ) | | ( )
t r
d d u u
e P U P O
A ÷
× × + ×
The greater of
Binomial Pricing
154
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
.19
28.62
0
40.37
2.91
32.10
.10
36
1.51
( ) ( ) | | ( )
t r
d d u u
e P U P O
A ÷
× × + ×
Binomial Pricing
155
50.78 = price
10.78 = intrinsic value
40.37
.37
32.10
0
25.52
0
45.28
5.60
36
.19
28.62
0
40.37
2.91
32.10
.10
36
1.51
( ) ( ) | | ( )
t r
d d u u
e P U P O
A ÷
× × + ×
Binomial Pricing
156
Option Value
157
Components of the Option Price
1 - Underlying stock price
2 - Striking or Exercise price
3 - Volatility of the stock returns (standard deviation of
annual returns)
4 - Time to option expiration
5 - Time value of money (discount rate)
Option Value
158
Black-Scholes Option Pricing Model
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
O
C
- Call Option Price
P
s
- Stock Price
N(d
1
) - Cumulative normal density function of (d
1
)
S - Strike or Exercise price
N(d
2
) - Cumulative normal density function of (d
2
)
r - discount rate (90 day comm paper rate or risk free rate)
t - time to maturity of option (as % of year)
v - volatility - annualized standard deviation of daily returns
Black-Scholes Option Pricing Model
159
(d
1
)=
ln + ( r + ) t
P
s
S
v
2
2
v t
32 34 36 38 40
N(d
1
)=
Black-Scholes Option Pricing Model
160
(d
1
)=
ln + ( r + ) t
P
s
S
v
2
2
v t
Cumulative Normal Density Function
(d
2
) = d
1
- v t
161
Call Option
162
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
Call Option
163
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
(d
1
) =
ln + ( r + ) t
P
s
S
v
2
2
v t
(d
1
) = - .3070 N(d
1
) = 1 - .6206 = .3794
Call Option
164
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
(d
2
) = - .5056
N(d
2
) = 1 - .6935 = .3065
(d
2
) = d
1
- v t
Call Option
165
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
S = 40 t = 90 days / 365
O
C
= P
s
[N(d
1
)] - S[N(d
2
)]e
-rt
O
C
= 36[.3794] - 40[.3065]e
- (.10)(.2466)
O
C
= $ 1.70
Put - Call Parity
166
Put Price = Oc + S - P - Carrying Cost + Div.
Carrying cost = r x S x t
Put - Call Parity
167
Example
ABC is selling at $41 a share. A six month
May 40 Call is selling for $4.00. If a May $
.50 dividend is expected and r=10%, what
is the put price?
Expanding the binomial model to allow more
possible price changes
168
1 step 2 steps 4 steps
(2 outcomes) (3 outcomes) (5 outcomes)
etc. etc.
Binomial vs. Black Scholes
How estimated call price changes as
number of binomial steps increases
169
No. of steps Estimated value
1 48.1
2 41.0
3 42.1
5 41.8
10 41.4
50 40.3
100 40.6
Black-Scholes 40.5
Binomial vs. Black Scholes
Options
170
? Many corporate securities are similar to
the stock options that are traded on
organized exchanges.
? Almost every issue of corporate stocks
and bonds has option features.
? In addition, capital structure and capital
budgeting decisions can be viewed in
terms of options.
Options Contracts: Preliminaries
171
? An option gives the holder the right, but not the obligation, to buy
or sell a given quantity of an asset on (or perhaps before) a given
date, at prices agreed upon today.
? Calls versus Puts
? Call options gives the holder the right, but not the obligation, to buy a
given quantity of some asset at some time in the future, at prices
agreed upon today. When exercising a call option, you “call in” the
asset.
? Put options gives the holder the right, but not the obligation, to sell a
given quantity of an asset at some time in the future, at prices agreed
upon today. When exercising a put, you “put” the asset to someone.
Options Contracts: Preliminaries
172
? Exercising the Option
? The act of buying or selling the underlying asset through the
option contract.
? Strike Price or Exercise Price
? Refers to the fixed price in the option contract at which the holder
can buy or sell the underlying asset.
? Expiry
? The maturity date of the option is referred to as the expiration
date, or the expiry.
? Spot Price
? The Price at which an option is currently valued (either in the
market or privately)
Options Contracts: Preliminaries
173
? In-the-Money
? The exercise price is less than the spot price of the
underlying asset.
? At-the-Money
? The exercise price is equal to the spot price of the
underlying asset.
? Out-of-the-Money
? The exercise price is more than the spot price of the
underlying asset.
Options Contracts: Preliminaries
174
? Intrinsic Value
? The difference between the exercise price of the
option and the spot price of the underlying asset.
? Speculative Value
? The difference between the option premium and the
intrinsic value of the option.
Option
Premium
=
Intrinsic
Value
Speculative
Value
+
Call Option Payoffs
175
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Buy a call
Exercise price = $50
Call Option Payoffs
176
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Write a call
Exercise price = $50
Call Option Profits
177
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Write a call
Buy a call
Exercise price = $50; option premium = $10
Put Option Payoffs
178
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
Buy a put
Exercise price = $50
Put Option Payoffs
179
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
O
p
t
i
o
n
p
a
y
o
f
f
s
(
$
)
write a put
Exercise price = $50
Stock price ($)
Put Option Profits
180
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Buy a put
Write a put
Exercise price = $50; option premium = $10
10
-10
Selling Options
181
? The seller (or writer) of
an option has an
obligation.
? The purchaser of an
option has an option.
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Buy a put
Write a put
10
-10
-20
100 90 80 70 60 0 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
O
p
t
i
o
n
p
r
o
f
i
t
s
(
$
)
Write a call
Buy a call
Combinations of Options
182
? Puts and calls can serve as the
building blocks for more complex
option contracts.
? If you understand this, you can
become a financial engineer, tailoring
the risk-return profile to meet your
client’s needs.
Protective Put Strategy: Buy a Put and
Buy the Underlying Stock: Payoffs at
Expiry
183
Buy a put with an
exercise price of $50
Buy
the
stock
Protective Put
strategy has downside
protection and upside
potential
$50
$0
$50
Value at
expiry
Value of
stock at
expiry
Protective Put Strategy Profits
184
Buy a put with
exercise price
of $50 for $10
Buy the stock at $40
$40
Protective Put
strategy has
downside
protection and
upside potential
$40
$0
-$40
$50
Value at
expiry
Value of
stock at
expiry
Covered Call Strategy
185
Sell a call with
exercise price
of $50 for $10
Buy the stock at $40
$4
0
Covered call
$40
$0
-$40
$10
-$30
$30 $5
0
Value of stock at
expiry
Value at
expiry
Long Straddle: Buy a Call and a
Put
186
Buy a put with
an exercise price
of $50 for $10
$40
A Long Straddle only makes money if
the stock price moves $20 away
from $50.
$40
$0
-$20
$50
Buy a call with
an exercise
price of $50 for
$10
-$10
$30
$60 $30 $70
Value of
stock at
expiry
Value at
expiry
Put-Call Parity
187
Sell a put with an
exercise price of $40
Buy the stock at $40
financed with some
debt: FV = $X
Buy a call option with
an exercise price of $40
$0
-$40
$40-P
0
rT
Xe
÷
÷ 40 $
$40
Buy the
stock at $40
0
40 $ C +
) 40 ($
rT
Xe
÷
÷ ÷
-[$40-P
0
]
0
C ÷
0
P
In market equilibrium, it mast be the case that option prices
are set such that: Value of stock + Value of put - Value of call =
Present value of strike price discounted at r
F
Otherwise, riskless portfolios with positive payoffs exist.
Value of
stock at
expiry
Value at
expiry
Valuing Options
188
? The last section
concerned itself
with the value of
an option at expiry.
? This section
considers the
value of an option
prior to the
expiration date.
? A much more
interesting
question.
Option Value Determinants
189
Call Put
1. Stock price + –
2. Exercise price – +
3. Interest rate +
–
4. Volatility in the stock price + +
5. Expiration date + +
The value of a call option must fall within
max (stock price – exercise price, 0) < value of the option
< value of the stock.
The precise position will depend on these factors.
Option-Pricing Methods
190
? The binomial
option pricing
formula is used to
value options that
have two potential
future values – an
up-state and a
down-state
? The Black-Scholes
model provides a
normalized
approximation to
the binomial for
some real-world
option valuation.
Binomial Option Pricing Model
191
Suppose a stock is worth $25 today and in one period will
either be worth 15% more or 15% less. S
0
= $25 today
and in one year S
1
is either $28.75 or $21.25. The risk-
free rate is 5%. What is the value of an at-the-money
call option?
$25
$21.25
$28.75
S
1
S
0
Binomial Option Pricing Model
192
1. A call option on this stock with exercise price of
$25 will have the following payoffs.
2. We can replicate the payoffs of the call option.
With a levered position in the stock.
$25
$21.25
$28.75
S
1
S
0
C
1
$3.75
$0
Summary and Conclusions
193
? The most familiar options are puts and calls.
? Put options give the holder the right to sell stock at
a set price for a given amount of time.
? Call options give the holder the right to buy stock at
a set price for a given amount of time.
Summary and Conclusions
194
? The value of a stock option depends on six factors:
1. Current price of underlying stock.
2. Dividend yield of the underlying stock.
3. Strike price specified in the option contract.
4. Risk-free interest rate over the life of the contract.
5. Time remaining until the option contract expires.
6. Price volatility of the underlying stock.
? Much of corporate financial theory can be presented
in terms of options.
1. Common stock in a levered firm can be viewed as a call option
on the assets of the firm.
2. Real projects often have hidden option that enhance value.
Classic NPV calculations typically ignore the flexibility that real-
world firms typically have.
Using Options in International Finance
- Forward Market Hedge - Forward Sale of DM 1 Million
-60
-40
-20
0
20
40
60
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
195
Forward Market Hedge - DM Account
Receivable
196
-60
-40
-20
0
20
40
60
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Forward Market Hedge - Forward
Market Hedge of Receivable
197
-60
-40
-20
0
20
40
60
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
a
b
c
Forward sale Receivable
Hedged
receivable
Option Market Hedge - Put Option on
DM 1 million
198
-10
-5
0
5
10
15
20
25
30
35
40
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Premium
Option Market Hedge - Call Option on
DM 1 million
199
-20
-10
0
10
20
30
40
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Premium
Option Market Hedge - Option Market
Hedge of Receivable
200
-60
-50
-40
-30
-20
-10
0
10
20
30
40
0.58 0.6 0.62 0.64 0.66 0.68
Exchange rate ($/DM)
G
a
i
n
o
r
l
o
s
s
i
n
d
o
l
l
a
r
s
(
0
0
0
s
)
Put Receivable
Hedged receivable
201
Real Options
Topics Covered
202
? Follow Up Investments
? Abandon
? Wait
? Vary Output or Production
Corporate Options
203
4 types of “Real Options”
1 - The opportunity to make follow-up
investments.
2 - The opportunity to abandon a project
3 - The opportunity to “wait” and invest later.
4 - The opportunity to vary the firm’s output or
production methods.
Value “Real Option” = NPV with option
- NPV w/o option
Option to Wait
204
Intrinsic Value
Option
Price
Stock Price
Option to Wait
205
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option
Price
Stock Price
Option to Wait
206
More time = More value
Option
Price
Stock Price
Option to Abandon
207
Example - Abandon
Mrs. Mulla gives you a non-retractable offer
to buy your company for $150 mil at anytime
within the next year. Given the following
decision tree of possible outcomes, what is
the value of the offer (i.e. the put option) and
what is the most Mrs. Mulla could charge for
the option?
Use a discount rate of 10%
Option to Abandon
208
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4)
Option to Abandon
209
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 162
150 (.4)
Option Value =
162 - 145 =
$17 mil
Corporate Options
210
Reality
? Decision trees for valuing “real options” in
a corporate setting can not be practically
done by hand.
? We must introduce binomial theory & B-S
models
doc_443981527.pptx