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A call option is an asset that gives the owner the right but not the obligation to buy some other underlying asset for a set price, on or up to a set date. For example, consider a call option on Disney stock that gives the owner the right to purchase one share of Disney stock for $30 per share, on or up to next June 15. (Actually, options are usually sold in blocks covering 100 shares. For expository purposes, however, we will describe an option on only a single share.) The underlying asset would be one share of Disney stock. The prespecified price, known as the “strike price,” would be $30 per share. The expiration date would be June 15. The Disney option might cost $3 initially. If on the expiration date, June 15, the market price of Disney stock stood at $35, the call option owner would exercise the option and buy a share of Disney stock for $30. The new share owner could then turn around and sell the share for $35 in the marketplace, realizing a terminal payoff from the option of $5. The terminal payoff is $5, so the profit net of the $3 initial option price is $2. Suppose, alternatively, that the market price of Disney stock on June 15 were $29. It would not be profitable to exercise the call option and thereby purchase for $30 what is elsewhere available for $29. In such a case, the option owner would choose not to exercise, and the call would expire worthless. It is the right not to execute the transaction that is the major difference between options and forwards. The long party in a forward contract must buy the goods upon expiration whether it is advantageous to do so or not. By contrast, call option owners do not have to buy the underlying asset if they choose not to. At expiration, a call option should be exercised if and only if the market price exceeds the strike price. When the market price is above the strike price, the call option is said to be “in the money.” When the market price is less than the strike price, the call is “out of the money.” When the market price equals the strike price, the option is “at the money.” An option that is out of the money, or even at the money, at expiration will expire unexercised and worthless. An option‟s payoff is defined as the maximum amount of money the option owner would receive at expiration, if she totally liquidated her position. If the option expires out of the money, the payoff is zero. If the option expires in the money, the payoff is the amount of money received from exercising the call option and then selling the stock in the open market. For example, if the strike price is $30 and the terminal stock price is $20, the payoff would be zero, since the option would be out of the money and should not be exercised. If the terminal stock price were $40, the payoff would be $10, since the option should be exercised, allowing the owner to buy the stock for $30, and then sell that stock for $40 in the open market. Mathematically, the payoff is the maximum of zero or the stock price minus the strike price. The payoff ignores the initial price that was paid for the option. Payoff treats the initial price as a sunk cost, and measures only what the option owner might subsequently receive. The payoff minus the initial price is known as the option profit. The option payoff is the same for all owners of the option, regardless of what they each initially paid for it. Profit, however, depends on what was initially paid and therefore differs from one investor to another. A payoff diagram is a valuable analytical device for understanding options. A payoff diagram graphs the payoff of an option as a function of the underlying asset‟s spot price at expiration. Exhibit 15.1 depicts the payoff diagram for the Disney call option with a strike price of $40. The payoff diagram is a picture of the option. It tells you when you will receive money and when you will not. It helps to visualize how the contract will perform, and whether the option is appropriate for any particular application.
Exhibit 15.1 Call option payoff diagram. The payoff diagram is flat and equal to zero in the entire range where the option is out of the money—that is, where the stock price is less than the strike price. This means that someone who buys an option might lose his entire investment in that option. You may pay $3 for the option and lose 100% of that $3 by the expiration date. On the brighter side, the payoff diagram confirms that the most you can lose in an option is the initial premium, the $3 you paid for it. Unlike futures or forwards, an option will never call upon you to make additional payments at a later date. Initially, you pay for the option, perhaps $3. From then on you can only receive cash inflows. Note that the payoff diagram begins to rise at the point where the stock price equals the strike price. The payoff is dollar for dollar greater than zero for every dollar that the stock price exceeds the strike price. Thus we see that a call option rises in value as the underlying asset rises in price. For this reason, some people refer to call options as bullish instruments. Hedging with a Call Option Consider the trucking company whose rates are regulated, yet costs fluctuate with market prices. The chief raw material purchased by the company is diesel fuel. If fuel prices rise, the trucking company will suffer losses, and may in fact be put out of business. As we saw earlier, the company can guarantee a fixed price for fuel by going long in a future or a forward. Another strategy would be to buy a diesel fuel call option contract. The strike price of the call option would lock in the highest price that the company will have to pay for fuel. If fuel prices should drop below the strike price, the company would be under no obligation to exercise the option. It would simply buy fuel at the low market price. If, however, fuel prices rise above the strike price, the company would exercise the option and buy fuel at the relatively low strike price. The added flexibility of the option over the futures strategy comes at a cost. When the company buys the call option, it must pay a price or “premium.” The call option is essentially an oil price insurance contract for the firm, insuring that fuel prices will not exceed the strike price. If fuel prices
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Table of Contents Title Page Copyri
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Chapter 6 - Planning Capital Expend
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For Further Reading Part IV - Manag
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Successful Postmerger Implementatio
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This book is printed on acid-free p
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Syllabus How Chapter Topics in This
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Some of these experts are full-time
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About the Contributors Richard T. B
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Advances in Quantitative Analysis o
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enterprise development. Dr. Zachara
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The left side shows Nutrimin‟s in
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Gail, let‟s go over this balance
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Gail, do you have any questions abo
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11. Not all expenses are cash outfl
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Financial Statements: Who Uses Them
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profitability to keep investing for
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Financial Accounting Standards It i
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Downloadable Resources for this cha
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Next, we explain each of these thre
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liquidity. Or, more simply, achievi
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If these ratios are seriously defic
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The debt-to-equity ratio is evaluat
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year 1 to year 3. The net effect wa
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to rate of return on the equity. Th
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Other types of comparisons of finan
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income/sales), asset turnover (sale
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successful businesspeople should ha
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More than a decade ago, a special c
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companies is used for illustration.
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The identification of nonrecurring
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The Dow Chemical single-step income
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is a pretax measure, but income fro
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Sources: Companies‟ annual report
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Exhibit 3.11 Examples of discontinu
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amortization purposes, the Company
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Examples of nonrecurring items disc
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During Fiscal 2006, inventory quant
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The nonrecurring items of Boston Sc
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The disclosure presented earlier in
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gains or losses that appear as part
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ecurring as for Kimberly-Clark, the
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Summarizing Nonrecurring Items and
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This example of using the SEB works
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Exhibit 3.27 Other income (expense)
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Source: Pfizer, Inc., annual report
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Exhibit 3.30 Acquisitions note: Pfi
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Source: Pfizer, Inc., annual report
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Exhibit 3.33 Cost-reduction initiat
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Exhibit 3.36 Share-based payment no
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The Pfizer Worksheet Analysis: Down
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Some Further Points on the Pfizer W
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• It is common to treat items as
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FedEx Corporation (2007) First Sola
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1 The American Institute of Certifi
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28 These alternative translation me
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If you need some instruction in Exc
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To solve using Excel, open your Exc
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As you can see from the previous ex
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C6 = 5 • Now enter the “=” si
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Ordinary Annuity An ordinary annuit
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To confirm that the number of payme
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The FV of this first payment into t
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Exhibit 4.15 Finding the future val
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Exhibit 4.18 Finding the present va
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From Exhibit 4.20, we see that as t
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Exhibit 4.22 Amortization schedule
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Exhibit 4.25 Regular cash flows wit
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Internet Links For Further Reading
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Investors who are risk averse will
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considering the risk of a single as
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Portfolio Risk Stand-alone risk is
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In spite of unique or diversifiable
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If a particular stock is highly sus
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The formula tells us that, to begin
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for the entire market of stocks sin
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The dividend per share for preferre
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If you are able to determine the cu
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Debt finance is the lower-cost meth
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We don‟t observe many firms whose
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Capital Structure in Practice Finan
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are able to observe regularities in
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dividends and capital gains. We wil
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where EBIT is earnings before inter
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Since long-term debt holders have a
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accept more investment projects. Re
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A beer company is considering build
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accounts receivable, and tabulates
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profit by the tax rate determines t
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Accounting profit often mixes varia
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The concept that future cash flows
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Like project A, project C also cost
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The after-tax interest rate is the
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equal mix of debt and equity, its d
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The payback period rule stipulates
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The IRR rule is appealing in that i
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complete with its real options is g
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What does it matter that one invest
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Exhibit 7.3 Time line in dollars an
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There are a number of countries in
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eturn of 10% on its investments in
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Exhibit 7.12 Summary of exchange ra
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and so will the value of the liabil
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Source: CIA, World Factbook, availa
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Exhibit 7.18 Net present value of c
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equired interest payments to be pai
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So if the assistant treasurer was r
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This theory is far from perfect, as
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The Consulting Firm Jennifer, Jean,
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part by a statute, the Uniform Limi
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formation in Delaware (or any state
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purpose of requiring qualification.
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Phil‟s death may terminate the bu
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the transfer. This means that if Br
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These rules extend to tort liabilit
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In the absence of a meeting, stockh
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A more detailed discussion on the b
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Partnerships If possible, the resul
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associated with this arrangement ar
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Partnerships are also not separate
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For most start-up businesses, howev
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form, even at the risk of some unli
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likely that our consultants will be
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Thus, the corporation and LLC, with
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It is not possible to fully describ
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usiness corporation for all purpose
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a cash-basis taxpayer to be taxed a
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The Tax Reform Act of 1986 substant
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limit is the product of the value o
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he would have spent anyway. In fact
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protect Brad from the scenario of h
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paying for the privilege. If the st
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The second tax scenario attaches to
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include that nullity in his taxable
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then the capital gain to be taxed h
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Most relevant to Morris is Section
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To begin with, the ESOP will have t
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general partner of a limited partne
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small businesses) is also subject t
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oth Lisa and Brad would be free to
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Assume that a limited liability com
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corporations, and had been audited
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There is plenty of blame from the c
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• An important study about top ma
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• The federal government made at
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$79.7 million for other services, a
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Budgets offer a variety of benefits
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determine the impact of specific pr
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Exhibit 11.2 Budget variance report
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udget, we just add more to it next
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income statement. The financial bud
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For a manufacturing company, cost o
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C&G‟s Gift Shop has a policy to m
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Meeting cash obligations as they co
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was unusually low, say, due to the
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A fixed budget, sometimes called a
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A large part of the budget selling
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• Centralized resource allocation
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Merewitz, Leonard, and Stephen H. S
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This chapter starts with a discussi
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Interestingly the numbers for quart
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Exhibit 12.4 Scenarion analysis.
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Pitfalls Although this analytic tec
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Exhibit 12.6 Variable cost element
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Variable Cost as a Function of Outp
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If scenario 2 yields a lower profit
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Microsoft certainly does not price
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If it is determined that dumping ha
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Leaving government agencies and not
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transaction processing. Each proces
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Exhibit 13.3 E-commerce transaction
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To summarize the analysis, the busi
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Capacity costs are probably the mos
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which it was, but for the inventory
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They called this strategic cost man
Page 371 and 372: A closer study, however, revealed s
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Page 375 and 376: The last type of plan is called a d
Page 377 and 378: The Business Plan We will progress
Page 379 and 380: Hook the Reader That means having t
Page 381 and 382: Industry The goal of this section i
Page 383 and 384: upscale suburban client who wants p
Page 385 and 386: Company and Product Description Com
Page 387 and 388: Exhibit 14.8 shows the competitive
Page 389 and 390: Exhibit 14.9a Advertising schedule.
Page 391 and 392: Scope of Operations What is the pro
Page 393 and 394: Development Time Line A development
Page 395 and 396: By law, most organization types req
Page 397 and 398: As mentioned in the development pla
Page 399 and 400: that can be depreciated, you should
Page 401 and 402: 1 Special thanks to Matt Feczko, Mi
Page 405 and 406: For better or worse, the business e
Page 407 and 408: Leeson bet and lost. Japanese stock
Page 409 and 410: Between February and April 1994, Da
Page 411 and 412: LTCM could be picky when it came to
Page 413 and 414: An investor who wished to invest in
Page 415 and 416: Similarly, the swaps market has rev
Page 417 and 418: speculator would suffer losses equa
Page 419 and 420: American manufacturer will suffer l
Page 421: The ease with which futures facilit
Page 425 and 426: Exhibit 15.2 Payoff diagram for a w
Page 427 and 428: Notice that the put option payoff r
Page 429 and 430: Bank, owns a large block of NASDAQ
Page 431 and 432: can be tailored so that the money r
Page 433 and 434: Finally, the last step is to choose
Page 435: 3 Fischer Black, who co-invented th
Page 439 and 440: not include assets that the firm ha
Page 441 and 442: Thus, a business valuation will usu
Page 443 and 444: Negative • Acme is highly depende
Page 445 and 446: Exhibit 16.3 Acme Manufacturing, In
Page 447 and 448: Profitability ratios reflect the re
Page 449 and 450: When we talk about the value of a b
Page 451 and 452: This example illustrates that with
Page 453 and 454: Income Approach: Discounted Cash Fl
Page 455 and 456: Exhibit 16.5 Acme Manufacturing, In
Page 457 and 458: Victoria explains that the second p
Page 459 and 460: Victoria analyzes Acme‟s audited
Page 461 and 462: In summary, the discounted cash flo
Page 463 and 464: Adjustment for Illiquidity As previ
Page 465 and 466: 51% position sells for a higher pri
Page 467 and 468: examples. The proper application of
Page 471 and 472: The subject of this chapter is grow
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Finally, an acquisition can be effe
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M&A activity has been the focus of
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companies continue to make the same
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equals was taking on a distinctive
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Anatomy of a Successful Acquirer: T
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employees kept their original jobs
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where ΔCF t is the incremental cas
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where it‟s ultimately buried. Suc
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The following example summarizes th
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make sure that you are at least awa
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acquisition, there is no immediate
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its vascular business, which was so
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While all employees should be part
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makes strategic and financial sense
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Bhagat, Sanjai, Ming Dong, David Hi
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The 2008 financial crisis underscor
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Source: Plunkett’s Outsourcing &
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To summarize: Trends • Large numb
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Companies are becoming increasingly
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What steps should a company follow
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• Results of meetings with vendor
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• Breach of contract and remedies
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Assuming the project or service rev
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The answer is: profits. The company
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19 Information Technology and You D
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People‟s lives have been turned u
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its self-contained rechargeable bat
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Random-Access Memory (RAM) Random-a
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On laptop computers and PDAs, the s
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Operating System An operating syste
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the spreadsheet software together w
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Exhibit 19.5 Pro forma sales and in
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Database Software A database is a c
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Internet e-mail addresses often con
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Personal Finance Software There are
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There are several different approac
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One of the major attractions of the
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While not a new version of the Web
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industrial revolution, and has occu
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Dummies Inc. has a series of books
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organization. This chapter is desig
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As technology has evolved, the term
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While the software mentioned earlie
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Most of the focus of the investor c
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Data Access and OLAP Before the lat
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Exhibit 20.5 illustrates a differen
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Productivity Tools Workers expect t
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Client-server technology is based o
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Today, most programmers write in C+
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Exhibit 20.6 is a model of a typica
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No treatment of relational database
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Online analytical processing (OLAP)
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server) and the rest on the users
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the other operational departments w
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The world of business has changed d
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Chaffey, Dave, E-Commerce and E-Com
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According to the results of the sur
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understand the financial situation
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MBA graduates who are hoping to ent
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Summary Financial services opportun
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Let‟s begin with the “I left it
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MBA student: “Well, I go to [Grea
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Aiming for Your Goals For career ch
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Networking is generally regarded as
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Let‟s begin with some key assumpt
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like, or moving ahead in the compan
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Accrual accounting: An accounting m
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Cash flow: Cash that is spent or re
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Distribution channel: A chain of in
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Goodwill: As it relates to valuatio
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Management’s discussion and analy
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Ordinary annuity: An annuity that p
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Securities and Exchange Commission
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Vertical merger: A merger in which
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about activity-based costing progre
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Application systems ARPAnet Arthur
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Bell Labs Benefit measurement Beta
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goal orientation legal and contract
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segment information note share-base
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process of purpose of real world us
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uy/build decision capital budget in
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written resume Careers in corporate
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Cell Center for Research in Securit
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Compensation and ownership Competit
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Corporate culture Corporate debt in
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profit planning from an internal pe
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Data Data access and OLAP Database
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Askin Capital Management Barings Ba
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market approach publicly traded gui
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Electronic data interchange (EDI) E
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Extensible markup language (XML) Ex
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short term liquidity users and uses
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Fourth generation programming (4GL)
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Going private Going private transac
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Hypertext links Hypertext markup la
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Information technology and the firm
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International Accounting Standards
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Last-in-first out (LIFO) vs. curren
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Long call option payoff Longer-term
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Market risks Market size and struct
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Motivation to outsource Multiple IR
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Nonrecurring items defined disclosu
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Operational complexity Operational
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Outsourcing metrics Overhead Over-t
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Personal end game Personal expense
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Price competition Price decreases P
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Projected cash flow statements Proj
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Relevant range Relevant range assum
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Risk sharing Risk transfer Risk vs.
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Short call option payoff Short part
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Spot price Spreadsheet software Spr
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Summarizing nonrecurring items and
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acquisition the business dividends
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Timmon‟s Model of Opportunity Rec
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U.S. immigration quotas U.S. Intern
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discounting with discount rate form
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