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Capital Structure, concluded

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Stock options usually do not involve the company on which the options are written ... Again: IBM is not directly involved in trading options on IBM stock ... – PowerPoint PPT presentation

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Title: Capital Structure, concluded


1
Capital Structure, concluded
  • March 5, 2004

2
Tradeoff Theory
  • So there are 2 major qualifications to MM taxes
    and bankruptcy costs
  • Leads to a tradeoff
  • Optimal capital structure
  • Consider a small increase in debt and decrease in
    equity
  • present value of increased bankruptcy cost
    present value of increase in tax shield at the
    optimum capital structure

3
Agency costs
  • So far weve assumed that (pre-tax) cash flow
    doesnt depend on capital structure. Maybe
    thats unrealistic
  • for a firm that has high bankruptcy risk, theres
    a conflict between debt and equity.
  • Management will accept negative NPV projects if
    most of the downside is born by bondholders
  • milking the assets -- the firm wont maintain
    the capital even if doing so is a positive-NPV
    project. Why benefit the creditors?

4
  • Agency costs suggest that replacing equity by
    debt will decrease the value of the firm
  • Covenants in the bond indenture are intended to
    decrease these costs

5
Free cash flow
  • if firms have lots of cash, they will waste it on
    perks.
  • If they have lots of debt, theyll have to run a
    tighter operation
  • This works in the opposite direction suggests
    that replacing equity by debt will be
    value-increasing

6
Unit V -- Derivatives
  • Derivatives securities with payoff that depend
    on (are derived from) the payoffs on other
    securities
  • Most important types options and futures

7
Options
  • Options traded on several exchanges (Chicago
    Board Options Exchange).
  • Also traded over-the-counter (customized hedging
    devices)
  • Financial engineering customized options
  • Options on stocks, bonds, foreign currencies,
    commodities, metals
  • Uses gambling and insurance (speculating and
    hedging)

8
  • Stock options usually do not involve the company
    on which the options are written
  • Think of them as a specialized kind of bet on the
    price of the stock.
  • option to buy is a call option to sell is a put.
  • Call long side has the right, but not the
    obligation, to buy the stock from the short side
    for a fixed price (the exercise price), on the
    exercise date
  • Because the long side has an option, not an
    obligation, the price (premium) of any option
    will be positive

9
Option terms
  • Either kind of option has a long side and a short
    side.
  • long side has the option
  • short side grants the option
  • Taking a short position in an option writing an
    option.
  • Exercise (strike) price exercise date
  • Purchase price premium
  • profit on a long position in an option payoff
    minus premium

10
Option payoffs
  • The holder (long side) of an option pays the
    premium the writer (short side) receives it.
  • The long position has the option to buy the stock
    from the writer for the exercise price
  • European option on the exercise date
  • American option on or before.
  • What is the value of the payoff? Max(stock price
    minus exercise price, 0)

11
Call
12
Put
13
options lingo
  • An option is in-the-money if its immediate
    exercise would yield a positive payoff
  • (at the money, out of the money)
  • Thus a call is in-the-money if the current stock
    price is greater than the exercise price.

14
Options trading
  • Again IBM is not directly involved in trading
    options on IBM stock
  • Prices determined by supply and demand. Markets
    are organized by specialists, just as with
    stocks.
  • If demand gt supply, the price will rise ...
  • Option clearing corporation organizes the
    transfer to shares of stock from writer to buyer.

15
Option strategies
  • Straddle simultaneous purchase of a put with a
    low exercise price and a call with a high
    exercise price
  • a bet on volatility

16
Straddle
17
Portfolio insurance
  • Buying a put with an exercise price below the
    current price
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