FINANCIAL MANAGEMENT PART 7

1. The Valuation and Characteristics of Stock Chapter 7

7. The Basis of Value—Example Q: Joe Simmons is interested in the stock of Teltex Corp. He feels it is going to have two very good years because of a government contract, but may not do well after that. Joe thinks the stock will pay a dividend of $2 next year and $3.50 the year after. By then he believes it will be selling for $75 a share, at which price he'll sell anything he buys now. People who have invested in stocks like Teltex are currently earning returns of 12%. What is the most Joe should be willing to pay for a share of Teltex? A: Joe shouldn’t pay more than the present value of the cash flows he expects: $2 at the end of one year and $3.50 plus $75 at the end of two years. Example

15. Constant Normal Growth—The Gordon Model—Example Q: Atlas Motors is expected to grow at a constant rate of 6% a year into the indefinite future. It recently paid a dividends of $2.25 a share. The rate of return on stocks similar to Atlas is about 11%. What should a share of Atlas Motors sell for today? A: Example

19. Two Stage Growth—Example Q: Zylon Corporation’s stock is selling for $48 a share according to The Wall Street Journal. We’ve heard a rumor that the firm will make an exciting new product announcement next week. By studying the industry, we’ve concluded that this new product will support an overall company growth rate of 20% for about two years. After that, we feel growth will slow rapidly and level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company. The rate of return on stocks like Zylon is approximately 10%. Is Zylon a good buy at $48? A: We’ll estimate what we think Zylon should be worth given our expectations about growth. Example

20. Two Stage Growth—Example We’ll develop a schedule of expected dividend payments: Next, we’ll use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2, so: Example 6% $3.05 3 20% $2.88 2 20% $2.40 1 Growth Expected Dividend Year

21. Two Stage Growth—Example Then we take the present value of D 1 , D 2 and P 2 : Example Compare $67.57 to the listed price of $48.00. If we are correct in our assumptions, Zylon should be worth about $20 more than it is selling for in the market, so we should buy Zylon’s stock.

30. Preferred Stock—Example Q: Roman Industries’ $6 preferred originally sold for $50. Interest rates on similar issues are now 9%. What should Roman’s preferred sell for today? A: Just substitute the new market interest rate into the preferred stock valuation model to determine today’s price: Example

36. Figure 7-3: Basic Call Option Concepts If the option is selling for $1 and the stock’s price increased to $63 the option could be exercised and the stock immediately sold, resulting in a profit of $3 less the price of the option contract (a $2 profit on a $1 investment, or a 200% return). If the stock price doesn’t exceed $60 before the option expires, the $1 is lost (a 100% loss).

40. Figure 7-4: The Value of a Call Option

45. Option Example The following information refers to a three-month call option on the stock of Oxbow, Inc. Price of the underlying stock: $30 Strike price of the three-month call: $25 Market price of the option: $8 Q: What is the intrinsic value of the option? A: The intrinsic value represents by how much the option is in-the-money. Since the stock price is $30 and the call option’s strike price is $25, the option is in-the-money by $5, which is the intrinsic value. Q: What is the option’s time premium at this price? A: The time premium represents the difference between the market price of the option and the intrinsic value, or $8 - $5 = $3. Example

46. Option Example Q: If an investor writes and sells a covered call option, acquiring the covering stock now, how much has he invested? A: The premium ($8) that the writer receives for the option will offset some of the purchase price of the stock ($30), therefore the investor has invested $30 - $8 = $22. Q: What is the most the buyer of the call can lose? A: The buyer can lose, at most, 100% of his investment which is the purchase price of the option of $8. Q: What is the most the writer of a naked call option on this stock can lose? In theory since the stock price can rise to any price the writer can lose an infinite amount. However, a prudent writer would limit his losses by purchasing the stock once it started to rise in value. Example

47. Option Example Just before the option’s expiration Oxbow is selling for $32. Q: What is the profit or loss from buying the call? A: The buyer would exercise the option paying $25 for the stock and simultaneously selling the stock for $32, resulting in a gain of $7. However, this gain would be offset by the $8 premium paid for the option, resulting in an overall loss of $1. Q: What is the profit or loss from writing the call naked? A: A naked writer would have to buy the stock for $32 and sell it to the option owner for $25, resulting in a loss of $7. However, this loss would be offset by the premium received on the writing of the option of $8, resulting in an overall gain of $1. Q: What is the profit or loss from writing the call covered if the covering stock was acquired at the time the call was written? A: The call writer bought the stock for $30 and sold it for $25, resulting in a loss of $5, but the loss is offset by the $8 premium received for writing the option. The overall gain is $3. Example

49. Figure 7.5: Basic Put Option Concepts

50. Figure 7.6: The Value of a Put Option