winter2010_notes_part5

winter2010_notes_part5 - Introduction to Corporate...

Info iconThis preview shows pages 1–12. Sign up to view the full content.

View Full Document Right Arrow Icon
1-1 Introduction to Corporate Applications There are three corporate contexts in which options appear, explicitly or implicitly Capital structure (equity, debt, and warrants) Compensation Acquisitions
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
1-2 Equity, Debt and Warrants Firms often issue securities that have derivatives components For example, convertible debt is a bond coupled with a call option Even simple securities, such as ordinary debt and equity, can be viewed as derivatives
Background image of page 2
1-3 B Debt and Equity As Options Consider a firm that has nondividend- paying equity outstanding, and a single zero-coupon debt issue The time t values of the assets of the firm, the debt, and the equity are A t , B t , and E t , respectively The debt matures at time T and has maturity value
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
1-4 ) , 0 ( B A max E T T = B Debt and Equity As Options (cont’d) The value of the equity at time T is (16.1) This is the payoff to a call option with the assets of the firm as the underlying asset and as the strike price
Background image of page 4
1-5 ) , ( B A min B T T = ) , (0 ) (0, B A max A A B min A B T T T T T = + = Debt and Equity As Options (cont’d) The value of the debt is (16.2) or (16.3) This implies that the bondholders own the firm, but have written a call option to the equityholders Summing equations (16.1) and (16.2)—equity plus debt—gives the total value of the firm as A T
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
1-6 B Debt and Equity As Options (cont’d) Thus, we can compute the value of debt and equity prior to time T using option pricing, with the value of assets taking the place of the stock price and the face value of the debt taking the place of the strike price We can value the equity at time t as a call option on the assets of the firm with strike price . The value of the debt is then B t = A t E t
Background image of page 6
1-7 × + + × + = × + × = B t t t E t t t B E A r B E B r B E E r %Debt r %Equity r ) ( ) ( Leverage and the Required Return on Equity If assets have a positive beta, the expected return on equity will increase with leverage In general, the expected return on assets, r A , is a weighted average of the expected returns on debt, r B , and equity, r E This relationship requires that r B represent the expected return on debt, not the stated yield on debt
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
1-8 Equity r r r R A E % 1 ) ( ˆ ˆ + = t t A E E A r r r r Δ × + = ) ( Leverage and the Required Return on Equity (cont’d) If debt is risk-free, then r B = r , and we have Taking the elasticity of an option into account, the expected return on equity is where E t is computed as the price of an option and Δ is the delta of that option
Background image of page 8
1-9 Leverage and the Required Return on Equity (cont’d)
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
1-10 Conflicts Between Debt and Equity There are two decisions equityholders can make to reduce the value of debt Increase asset volatility (either by increasing the operating risk of existing assets or by “asset substitution”) Increase the size of payouts to shareholders (such as dividends and share repurchases)
Background image of page 10
1-11 Conflicts Between Debt and Equity (cont’d)
Background image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 12
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 04/13/2010 for the course FIN 823 taught by Professor Keweiho during the Spring '10 term at Ohio State.

Page1 / 53

winter2010_notes_part5 - Introduction to Corporate...

This preview shows document pages 1 - 12. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online