ActSc371_Lecture 26_Chapter 23 cont'd(Ross)

ActSc371_Lecture 26_Chapter 23 cont'd(Ross) - ActSc 371...

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Lecture 27 Sections 23.9-23.13: Options and Corporate Finance – Basic Concepts Rules(Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1
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23.9 Stocks and Bonds as Options Much of corporate financial theory can be presented in terms of options. Three topics in which implicit options play an important role: Stocks and bonds as options. Capital structure decisions as options. Capital budgeting decisions as options.
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Example ABC Company has issued debt to help finance a new venture. The firms cash flows next year are forecasted below. Interest and principal on the debt next year will be $800. If either of the first two scenarios occur, the bondholders will be paid in full. The extra cash flow goes to the shareholders. But, if either of the last two scenarios occurs, the bondholders will not be paid in full. Instead, they will ABC’s Cash Flow Schedule V. Succ. Mod. Succ . Mod. Unsucc. Fail Cash flow before interest and principal $1,000 $850 $700 $550 Interest and Principal 800 800 700 550 Cash flow to shareholders $200 $50 $0 $0
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23.9 Stocks and Bonds as Options Levered Equity is a Call Option Stock can be viewed as call option on the firm. What is the underlying asset? The firm itself! View bondholders as owning the firm. Bondholders have a written call against the firm with an exercise price of $800. Shareholders have call option on the firm with an exercise price of $800. If at the maturity of their debt, the assets of the firm are greater in value than the debt, the shareholders have an in-the-money call, they will pay the bondholders, and “call in” the assets of the firm. If at the maturity of the debt the shareholders have an out-of- the-money call, they will not pay the bondholders ( i.e., the shareholders will declare bankruptcy), and let the call expire.
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0 Cash Flow to Firm ($ Cash Flow to Shareholders ($) B u y a c l 800 Cash Flow to Shareholders as a Function of the Cash Flow to the Firm
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23.9 Stocks and Bonds as Options Levered Equity is a Put Option. A bit more confusing than looking at it from a call option perspective. Shareholders: Own the firm. Owe $800 in interest and principal to the bondholders. Because of the risk of default: shareholders own a put option on the firm with an exercise or $800. The group of bondholders is the seller of the put. If at the maturity of their debt, the assets of the firm are less in
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This note was uploaded on 12/16/2011 for the course ACSTC 371 taught by Professor Lisaporth during the Fall '11 term at Waterloo.

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ActSc371_Lecture 26_Chapter 23 cont'd(Ross) - ActSc 371...

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