The Ten-Day MBA 4th Ed.

by Steven A. Silbiger

  Stock options work in the same way as in the real estate deal discussed. An option is “the right” to buy or sell a stock:

  at a stated price—the strike price

  by a certain date—the expiration date

  at a cost for the privilege—the option premium

  Options to purchase stocks are called calls. (“Call” in the stock to buy.) Rights to sell a stock to somebody else are called puts. (“Put” it to somebody else for sale.) The values of call and put options move in opposite directions. If a stock price rises, then the value of a call option to buy it, at a fixed price, increases. If a stock’s price falls, its call value decreases. Conversely, the value of a put option increases when the underlying stock price falls and decreases when the stock price increases.

  On the Chicago Board Options Exchange (CBOE), the oldest and largest exchange, traders buy and sell options on blocks of one hundred shares of stocks in the same way as Mr. Quick bought an option on real estate. Buyers of stock options buy the right to the appreciation (calls) or depreciation (puts) of a stock for a period of time. Sellers, called option writers, of covered options sell to buyers the rights on the stocks that they own. If an option writer sells an option on a stock not owned, the options are called naked options. They are not covered.

  There are two types of option valuations, theoretical and market value. The theoretical value is the difference between the underlying stock’s market price and the option’s strike price. For example, a call option to buy Coca-Cola at $40 when the market price of the stock is $45 would have a theoretical price of $5. However, options are written for extended periods of time. Therefore, the market value is the sum of the theoretical value plus a premium for the chance of profitable price movements until the expiration date. As the date of expiration approaches, there is less time for profits, so the premium erodes. On the expiration date, the option is settled for cash based on the optioned security’s market value. The market value equals the theoretical value because there is no longer a premium for future gains.

  THE WAY OPTION VALUES FLUCTUATE

  Option Valuations. In 1973, Fisher Black and Myron Scholes published a model that became the industry standard for option valuations throughout the world. In the Black-Scholes Option Pricing Model, an option’s calculated value is determined by five factors:

  Time until expiration—The longer the optioned time, the more chance of a desired price movement. That’s the time premium.

  The difference between the current stock price and the strike price—The closer the strike price is to the current price the more probable it is that current price movements can meet or exceed it by the expiration date.

  The price volatility of the stock—The more volatile the price movement of a stock, the more likely that a price movement could jump near the strike price.

  The market rate of interest on short-term government securities—If the cost of financing the transaction is high, then the option price has to be higher to cover the handling costs of the transaction.

  Dividend payments on the stock—Option owners do not collect the dividends on the underlying stock, but the stock price that influences the option price is affected.

  One can calculate the approximate prices of calls and puts by placing these five inputs into a simple computer spreadsheet. Because everybody uses some form of the Black-Scholes model, the prices produced by these models are close to the market price. That is in sharp contrast to common stock valuations, in which investment analysts use thousands of methods to determine their own “correct” value.

  A Call Option Example. Optimistic stock options traders buy calls to purchase stock if they believe the underlying stock will increase in the near term. For example, let’s call our options trader Billy Peligro. On June 15, 2011, Billy saw Wal-Mart stores common stock quoted at $54 per share in the Wall Street Journal. The call right to purchase one share of Wal-Mart by September at $55 traded at $2.69. Billy bet that Wal-Mart would trade significantly above $55 by September (SEP), and he paid $2.69 for the chance. If the option expired on the day of purchase in June, the option purchase price of $55 would have been “out of the money,” by one dollar, and the option would be worthless. The value of a $55 call option of Wal-Mart graphically looks like a hockey stick. It varies with the stock price.

  But is $2.69 the correct price? Plugging the five factors of Wal-Mart’s common stock and the particulars about the option into the Black-Scholes black-box spreadsheet, the outcome for your author was a $2.66 price. Pretty close!

  THE VALUE OF A WAL-MART SEP $55 CALL OPTION

  THE VALUE OF A WAL-MART SEP $55 PUT OPTION

  Put Option Example. Let’s look at the opposite situation, a pessimistic Billy Peligro. He bought a put option to sell Wal-Mart at $55 for settlement in September when the market price was $54 in June. That was one dollar “in the money” because he had the right to sell at $55 when the market was at $54. The market price (or “fair value”) for the option was $2.75 on June 15, 2011. One dollar of the value was “in the money” (or “intrinsic value”) and the other $1.75 was the premium for three months to make more money. If the stock fell further, Mr. Peligro had the right to sell a share of Wal-Mart stock at $55, no matter how low it might have gone. Checking Black-Scholes for reasonableness, the $2.75 market value was close to the modeled value of the put. The put’s graph of possible values is the call’s hockey stick in reverse.

  Options Strategies and Hedging. Options are highly risky investments, but their risk can be reduced by hedging. Hedging is buying an option to offset a possible decline in value in an owned investment. Like other options, it can be taken on many types of assets. Suppose that a risk-adverse investor, Mr. Scared E. Cat, owned the same share of Wal-Mart stock trading at $54, but because of the downside risk, he wanted to protect himself from a steep decline. The investor could have bought a three-month put option at a $50 strike price for $1 in June 2011. The put would have ensured that he could have sold his Wal-Mart share for at least $50 in the next three months. The person who wrote the option believed that there was little risk of that happening and was happy to take the $1 premium, hoping it would have no value to Mr. Cat.

  If Wal-Mart fell to $40, the put option that cost only one dollar would be worth $10 at expiration. The put writer would be obligated to pay up. For Mr. Cat, the option’s $10 gain would partially offset the $14 loss in the value of the stock from $54 to $40. That is why many people view the options market as a way to shift risk from one investor to another.

  Option traders and portfolio managers use many options strategies in addition to simple hedges. Sophisticated investors combine options and stocks in many ways, using spreads, butterflies, condors, straddles, and boxes.

  In addition to put options, an investor can short a stock if he or she would like to bet that a stock’s value will decline. In this transaction, you borrow the stock to sell it, with the hope of repurchasing it later at a lower price. And just as with options, short selling can be part of a hedging strategy.

  MORE ON DERIVATIVES

  Derivatives are financial instruments that base their value on the value of other assets or variables. In addition to options already discussed, the most common derivatives are called futures and swaps. The underlying assets on which the derivatives are valued include stocks, commodities, currencies, and interest rates. They can also include other non-tradable items such as creditworthiness or even weather. When the underlying asset’s value changes, the derivative’s value changes in lockstep. As with the options described on Wal-Mart stock, investors can either hedge a risk or speculate on changes in asset values.

  Derivatives called futures are contracts to buy commodities (such as gold, oil, or grain) or financial assets (such as the S&P 500 stock index) on a settlement date in the future. The contract can be settled on that date with either cash or the delivery of the commodity, depending on the contract. As the value of the underlying asset changes, the value of the future changes. Future
s can be very risky because they are highly leveraged. Depending on the futures contract, investors can control 20 times the value of the asset with a margin account that is marked-to-market on a daily basis. If the asset’s value moves down, the investor must supply more margin cash that day.

  Using a derivative called a swap, a financial institution insures or “swaps” the risk of value changes of an asset with an investor or institution for a negotiated fee. Interest rate increases and bond payment defaults are the most common risks insured by swaps. Swap purchasers do not necessarily need to own the underlying asset involved; they may just be speculating that negative events will occur.

  The financial crash in 2008 was caused by the collapse of real estate prices, but the derivatives made the crisis a meltdown. Large institutions, including insurance giant AIG, sold credit default swaps (CDS) to investors that insured bundles of residential mortgage debt, called collateralized mortgage obligations (CMO), against the risk of default. When the likelihood of higher-than-expected defaults increased, swap values increased to cover the losses, and AIG owed swap purchasers hundreds of billions of dollars. AIG thought the probability of high mortgage default was remote when it sold the CDSs, so it charged very little for the swap insurance contracts. Investors who believed the opposite eagerly bought the inexpensive CDSs. Ultimately the government had to take over AIG in 2008. Now everyone knows the term “toxic mortgage.”

  FINANCIAL MANAGEMENT

  How a company funds itself and maximizes the return on money raised from its shareholders or debt holders is the essence of financial management. MBAs who choose to go into financial management perform two major functions:

  Business Investment Decisions—What assets should the firm own? In what projects should the business invest?

  Financing Decisions—How should those investments be paid for?

  BUSINESS INVESTMENT DECISIONS

  There are many investments that a company can make. It is a financial manager’s job to help the management team evaluate investments, rank them, and suggest choices. The MBA term for such activity is capital budgeting.

  In the quantitative analysis chapter, the Quaker Oats example described the techniques used to decide whether to invest in new cereal filling equipment. Quaker managers used discounted cash flows to calculate the net present value (NPV) of the project. In the marketing chapter, the decision to launch a new coffee brand was evaluated by a simpler measure, the payback period. Some investments, however, defy financial analysis. Charitable donations, for example, provide intangible benefits that financial managers alone cannot evaluate.

  Investment decisions fall into one of three basic decision categories:

  Accept or Reject a Single Investment Proposal

  Choose One Competing Investment over Another

  Capital Rationing—With a limited investment pool, capital rationing tells which projects among many should be chosen.

  Each corporation uses its own criteria to ration its limited resources. The major tools that MBAs use are:

  Payback Period

  Net Present Value

  Payback Period Method. Many companies believe that the best way to judge investments is to calculate the amount of time it takes to recover their investments:

  Payback = Number of Years to Recover Initial Investment

  Analysts can easily calculate paybacks and make simple accept-or-reject decisions based on a required payback period. Those projects that come close to the mark are accepted, and those falling short are rejected. For example, the managers of a small company may believe that all energy- and laborsaving devices should have a maximum three-year payback, and that all new equipment should “pay back” in eight years, whereas research projects should pay back in ten years. Those requirements are based on management’s judgment, experience, and level of risk aversion.

  By accepting projects with longer paybacks, management accepts more risk. The further out an investment’s payback, the more uncertain and risky it is. The concept is similar to the measure bond investors use, duration. The longer it takes an investor to recover half of his or her bond investment, the riskier it is.

  Payback period criteria are desirable because they are easy to calculate, use, and understand. However, they ignore the timing of cash flows, and accordingly, the time value of money. Projects with vastly different cash flows can have the same payback period. For example, a research project that repays a $100,000 investment evenly in $33,333 installments over three years has the same three-year payback as the single $100,000 return received at the end of three years.

  Another shortcoming of using payback is that it ignores the cash flows received after the payback. What if the $100,000 research project with a three-year payback continued to churn out a stream of royalties forever as a result of a new invention? Clearly it would be worth much more than a project that had a onetime payout of $100,000 in the third year of the invention’s life.

  Net Present Value Methods. The same method used for valuing the cash flows of bonds and stocks is also used to value projects. It is the most accurate and most theoretically correct method.

  The further in the future a dollar is received, the greater the uncertainty that it will be received (risk) and the greater the loss of opportunity to use those funds (opportunity costs). Accordingly, cash flows received in the future will be discounted more steeply depending on the riskiness of the project.

  NPV = Cash to Be Received × (1 + Discount Rate) − Number of Periods

  (as calculated in tables in the appendix or by using business calculators and computers)

  The ways in which a corporation wishes to fund itself are “financing” decisions independent of “investment” decisions. A glaring non-MBA mistake in evaluating projects is to use a discount factor equal to the cost of borrowing or cost of capital for the corporation as a whole. The individual projects that businesses may want to invest in are not as stable. Accordingly, financial managers must use a discount rate commensurate with the risk of the particular project. “Value” for the corporation as a whole is created by using the correct rate, but also choosing projects with returns above the corporation’s cost of capital.

  In the Quaker Oats factory example from the QA chapter, the cash flows looked as follows:

  10% DISCOUNT

  The NPV method says that the project returned $32,343 in excess of the required rate of return for a project with that level of risk. Projects that have NPVs of $0 are also acceptable because they return the required rate. Those below zero are flatly rejected.

  NPV has many advantages. It is flexible in making calculations that are useful in comparing different projects.

  Riskiness of Projects. In calculating the NPV an analyst can use different discount rates. For example, if he or she considered the profits from Quaker Oats’ new oatmeal filling equipment more risky, a 15 percent or 20 percent discount rate would value the project at $21,019 or $11,217 respectively.

  Unequal Lives of Projects. An analyst does have the ability to value cash over many years by using different discount factors based on the risk-adjusted discount rate. The Quaker project could be compared with many other projects with cash flows of one year, ten years, or unlimited. The discount factor can be used to discount all cash flows to their present value for comparison.

  Scale Differences in the Size of Projects’ Cash Flows. The ability of the NPV method to discount cash at different amounts yields a “net” present value that is comparable among different-sized projects. The discount factor also values the cash flow at any time in the future.

  Since capital needs to be rationed, what is an MBA to do if he or she needs to choose? NPV tells you the best projects, but not the best group of projects. The profitability index (PI) can be of help. The PI divides the NPV of the future cash flows by the initial investment. For example, the Quaker project has an index of 1.317.

  In situations where money is unlimited, all PIs above 1.00 would be accepted. All projects with a ret
urn over the risk-adjusted rate are attractive. With constrained resources, only the investment opportunities with the highest PI are chosen so that the group of investments may yield the highest NPV for the shareholders.

  In those cases, it is up to the MBA analyst to try different combinations of the best projects using NPVs and PIs as guides to get the highest possible NPV for the entire group.

  BUSINESS FINANCING DECISIONS

  A large number of MBAs devote their lives to finding the financing for the capital needs of businesses. The goal of corporate finance is to raise sufficient capital at the least cost for the level of risk that management is willing to live with. The risk is that a business will not be able to service its debt and will be forced into bankruptcy.

  There are five basic ways of financing a company’s needs:

  Receive Credit from Suppliers

  Obtain Lease Financing

  Obtain Bank Loans

  Issue Bonds

  Issue Stock

  Supplier Credit. Supplier credit is the easiest way that companies obtain financing. Companies buy goods and services and have anywhere from seven days to a year to pay their bills. When companies need more credit from suppliers, financial managers negotiate longer credit terms or larger credit lines. Cash managers can also stretch their payables to vendors by paying them late. In the case of Borders Books in 2011, vendors refused to extend them additional credit. The combination of creditors and debt holders forced the company into bankruptcy.

  Lease Financing. Instead of buying equipment, many companies choose to lease equipment. This is a form of financing. Automobiles, computers, and heavy machinery can be financed for short periods or for longer periods. If the lease is for a shorter period, it is called an operating lease. At the end of the lease the property is still useful and is returned to the finance company. This is the case with two-year car leases.