Corporate Finance Final Exam – October 16th
Module 1 – Corporate Claims
CH 20.6 Options and Corporate Finance
Think of equity as an option, the payoff to equity looks exactly the same as the payoff of a
call option. The strike price is equal to the fair value of debt.
Debt can also be represented using options; they own the firm and have sold a call option. If
If the value of the firm exceeds the required debt payment, the call will be exercised; the
debt holders will therefore receive the strike price (the required debt payment) and “give
up” the firm. If the value of the firm does not exceed the required debt payment, the call
will be worthless, the firm will declare bankruptcy, and the debt holders will be entitled to
the firm’s assets.
Another way to view corporate debt is to see it as a portfolio of risk-free debt and a short
position in a put option:
Risky debt = risk-free debt – put option on firm assets
Risk free debt = risky debt + put option on firm assets
Such a put option is called a credit default swap.
Module 1 – Law of one Price
CH 3.4 Arbitrage and the Law of One Price
Arbitrage: buying and selling “equivalent” (generating the same payoffs) goods to take
advantage of price differences, without taking any risk.
A competitive market in which there are no arbitrage opportunities is called a “normal
market”.
The Law of One Price: if equivalent investment opportunities trade simultaneously in
different competitive markets, then they must trade for the same price in all markets. In
other words, the Law of One Price means no arbitrage.
The Law of One Price allows us to determine the value of stocks, bonds, and other
securities, based on their cash flows, and validates the optimality of the NPV decision rule in
identifying projects and investments that create value.
The Law of One Price is used for pricing and other arguments all the time
- Two securities that generate the same pay-off must cost the same
• Modigliani-Miller
• Multiples
• DCF
• Option pricing / put-call parity
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,CH 3.5 No-Arbitrage and Security Prices
(financial) security = an investment opportunity that trades in a financial market
How to determine the price of securities:
1. Identify the cash flows that will be paid by the security
2. Determine the “do-it-yourself” cost of replicating those cash flows on your own; that
is, the present value of the securities cash flows
If this PV is equal to the price of the security, there is no arbitrage opportunity
The NPV of trading a security in a normal market is 0, because cost and benefit are equal.
In a normal market, financial transactions are not sources of value.
Portfolio = collection of securities
A loss of information can be a result of loss of liquidity. If markets are illiquid, market prices
are not reliable anymore.
Value additivity: if C is equivalent to A and B, therefore the price of C must equal the price
of the portfolio (A + B).
By value additivity, to maximize the value of the entire firm, managers should make decision
that maximizes NPV. The NPV of the decision represents its contribution to the overall value
of the firm. Explanation: The cash flows of the firm are equal to the total cash flows of all
projects and investments within the firm.
Module 1 – Options – A primer
CH 20.1 Option basics, CH 20.2 Option Payoffs at Expiration, CH 20.3 Put-Call parity
Purchasing a stock and a put, or a bond and a call both provide the same payoff, hence they
must have the same price (Law of One Price).
Stock + Put = PV of Strike price (K) (of a bond) + Call price
Left side of the equation is the cost of buying the stock and a put (with strike price K). Right
side of the equation is the cost of buying a zero-coupon bond with FV of K and a call option
(with strike price K).
The price of zero-coupon bond is the present value of the future value.
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,Put-call parity: relationship between the value of the stock, the bond, and call and put
options.
Options and capital structure
Basically, equity investors hold a call option with the strike price of the debt on the firm
Convertible bonds
(5 is FV of bond)
Most optimal to convert when the conversion value is bigger than the redemption value.
When conversion percentage (to how many shares in percentage of total shares it is
converted) * firm value (V) > redemption value. With this equation, it is also possible to
calculate at which specific firm value this is. If there is also debt, first deduct the debt from
firm value, as convertible shareholders have no rights on this money anyways. Therefore:
(V-Debt) * Conversion redemption > redemption value.
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, Module 2 – Capital Structure Stylized Facts
Firms can finance themselves through retained earnings (internal financing) and
Selling securities in the market (external financing).
Internal financing biggest source of financing for firms
External financing firms with less developed market rely less on this
Net external funds = sum of D and E
Internal funds = total investment – net external funds
Facts
- Sources of financing vary over time and overt business cycle
- Borrowing debt is less cyclical
- Equity issues can be a bit more volatile, and can increase when stock market returns
have been high for some period of time
- SEO = seasonal equity offering
- Net debt = debt – excess cash = negative debt
- Excess cash = cash – operational cash
Capital structure also depends heavily on the industry
- High leverage industries: Utilities, transportation, paper
- Low leverage industries: biotech, software/internet, hardware
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