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Unformatted text preview: ftertax savings Lease payment Tax benefit Net cash flows –$27,000 9,180 –$17,820 Year 1 $7,920 –$27,000 9,180 –$9,900 Year 2 $7,920 –$27,000 9,180 –$9,900 Year 3 $7,920 –$27,000 9,180 –$9,900 Year 4 $7,920 –$27,000 9,180 –$9,900 Year 5 $7,920 $7,920 The amount the company borrows and the repayment schedule are irrelevant since the company maintains a target debt-equity ratio. So, the cash flows from buying the machine will be: Cash flows from purchasing: Aftertax cost savings = $20,000(1 – .34) Aftertax cost savings = $13,200 And the deprecation tax shield will be: Depreciation tax shield = ($150,000 / 5)(.34) Depreciation tax shield = $10,200 Year 0 Aftertax savings Purchase Dep. tax shield Net cash flows –150,000 –$150,000 10,200 $23,400 10,200 $23,400 10,200 $23,400 10,200 $23,400 10,200 $23,400 Year 1 $13,200 Year 2 $13,200 Year 3 $13,200 Year 4 $13,200 Year 5 $13,200 Now we can calculate the incremental cash flows from leasing versus buying by subtracting the net cash flows from buying from the net cash flows from leasing. The incremental cash flows from leasing are: Year 0 $132,180 Year 1 –$33,300 Year 2 –$33,300 Year 3 –$33,300 Year 4 –$33,300 Year 5 –$15,480 Lease – Buy The aftertax discount rate is: Aftertax discount rate = .10(1 – .34) Aftertax discount rate = .0660 or 6.60% So, the NAL of leasing is: NAL = $132,180 – $33,300(PVIFA6.60%,4) – $15,480 / 1.0665 NAL = $7,114.14 Since the NAL is positive, the company should lease the equipment. 435 b. As long as the company maintains its target debt-equity ratio, the answer does not depend upon the form of financing used for the direct purchase. A financial lease will displace debt regardless of the form of financing. The amount of displaced debt is the PV of the incremental cash flows from year one through five. PV = $33,300(PVIFA6.60%,4) + $15,480 / 1.06605 PV = $125,065.86 c. 436 CHAPTER 22 OPTIONS AND CORPORATE FINANCE
Answers to Concept Questions 1. A call option confers the right, without the obligation, to buy an asset at a given price on or before a given date. A put option confers the right, without the obligation, to sell an asset at a given price on or before a given date. You would buy a call option if you expect the price of the asset to increase. You would buy a put option if you expect the price of the asset to decrease. A call option has unlimited potential profit, while a put option has limited potential profit; the underlying asset’s price cannot be less than zero. a. b. c. d. The buyer of a call option pays money for the right to buy.... The buyer of a put option pays money for the right to sell.... The seller of a call option receives money for the obligation to sell.... The seller of a put option receives money for the obligation to buy.... 2. 3. An American option can be exercised on any date up to and including the expiration date. A European option can only be exercised on the expiration date. Since an American option gives its owner the right to exercise on any date up to and including the expiration date, it must be worth at least as much as a European option, if not more. The intrinsic value of a call is Max[S – E, 0]. The intrinsic value of a put is Max[E – S, 0]. The intrinsic value of an option is the value at expiration. The call is selling for less than its intrinsic value; an arbitrage opportunity exists. Buy the call for $10, exercise the call by paying $35 in return for a share of stock, and sell the stock for $50. You’ve made a riskless $5 profit. The prices of both the call and the put option should increase. The higher level of downside risk still results in an option price of zero, but the upside potential is greater since there is a higher probability that the asset will finish in the money. False. The value of a call option depends on the total variance of the underlying asset, not just the systematic variance. The call option will sell for more since it provides an unlimited profit opportunity, while the potential profit from the put is limited (the stock price cannot fall below zero). The value of a call option will increase, and the value of a put option will decrease. 4. 5. 6. 7. 8. 9. 10. The reason they don’t show up is that the U.S. government uses cash accounting; i.e., only actual cash inflows and outflows are counted, not contingent cash flows. From a political perspective, they would make the deficit larger, so that is another reason not to count them! Whether they should be included depends on whether we feel cash accounting is appropriate or not, but these contingent liabilities should be measured and reported. They currently are not, at least not in a systematic fashion. 11. Increasing the time to expiration increases the value of an option. The reason is that the option gives the holder the right to buy or sell. The longer the holder has that right, the more time there is for the option to increase (or decrease in the case of a put) in value. For example, imagine an out-of-themoney option that is about to expire. Because the opti...
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