Financial Management of Mcdonalds Company - Case Study Example

9 Define each of the following terms: a. Option; call option; put option Option – Risk is always part of business. And in the world of investing, managing risk is essential. Thus, instruments like options are designed in order to minimize the impact of risk. As Arthur Keown in his book Financial Management: Principles and Applications, this is how he coined it: “an option, or option contract, gives its owner the right to buy or sell a fixed number of shares of stock at a specified price over a limited time period (2005, 746).” Call option – “Right to buy an asset at a specified exercise price on or before the exercise date (Brealey 2004, 722).” A call option offers its owner to buy an asset for the hope of making a gain or not, when the price of the asset or a stock—the stock price—is greater than the exercise price for a limited period. This will enable the owner to buy stocks at a price (exercise price) which is higher or smaller than the stock price at the time of expiration of the contract.” Put option – “Right to sell an asset at a specified exercise price on or before the exercise date (Brealey 2004, 725).” When the call option gives the owner a right to buy, the put option gives the owner a right to sell. At the time of expiration, if the price of the stock is lower than the exercise price, the owner has the advantage to make profits by buying the stock and selling it at the exercise price. b. Exercise value; strike price The exercise or striking price is “the price at which the stock or asset may be purchased from the writer in the case of a call or sold to the writer in the case of a put (Keown 2005, 747).” c. Black-Scholes Option Pricing Model Black-Scholes formula “showed that even when share prices are changing continuously, [one] can still replicate the option by a series of levered investments in the stock.” (9-3) Describe the effect on a call option’s price caused by an increased in each of the following factors: (1) stock price, (2) strike price, (3) time to expiration, (4) risk-free rate, and variance of stock return. An increase in the stock price, with everything else remaining the same, will result in an increase in the call option’s value; as call value = stock price – exercise price. An increase in strike price, with everything else remaining the same, will result in a decrease in the value of the call option. When time to expiration increases, the call option’s value increases too; the longer the option is dated, the more chances it offers as the stock price changes. If the interest rate increases, the value of a call option will increase too. If the variance of the stock return increases, which means the volatility of the stock price increases, the value of a call option will increase too. (9-4) The current price of a stock is $33, and the annual risk-free rate is 6%. A call option with a strike price of $32 and 1 year until expiration has a current value of $6.56. What is the value of a put option written on the stock with the same strike price and expiration date as the call option? INPUTS     OUTPUTS   Standard deviation (annual) 0.402   PV (Exercise Price) 30.18868 Maturity (in years) 1   d1 0.422494 Risk-free rate (effective annual rate) 0.06   d2 0.020494 Stock price 33   N(d1) 0.663668 Exercise price 32   N(d2) 0.508175       B/S call value 6.559893       B/S put value 3.748573 The put option has a price of 3.748573 at a strike price of 32, current price of 33, risk-free rate of 6%, expiration of 1 year—when it is the same as a call option valued at 6.56. (9-5) Use the Black-Scholes model to find the price for a call option with the following inputs: (1) current stock price is $30, (2) strike price is $35, (3) time to expiration is 4 months, (4) annualized risk-free rate is 5%, and (5) variance stock return is 0.25 INPUTS     OUTPUTS   Standard deviation (annual) 0.25   PV (Exercise Price) 34.43539 Maturity (in years) 0.333333   d1 -0.883142 Risk-free rate (effective annual rate) 0.05   d2 -1.02748 Stock price 30   N(d1) 0.18858 Exercise price 35   N(d2) 0.152097       B/S call value 0.419862       B/S put value 4.855248 Call option value = 0.419862 according to Black-Scholes Model. (10-7) Shi Importers’ balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shi faces a 40% tax rate and the following data: rd = 6%, rps = 5.8%, and rs = 12%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common stock, what is Shi’s WACC? WACC = [(debt/value * (1-tax rate* rd)) + (preferred stock/value * rps) + (common stock/value * rs) = (.30 * (1-.4) * .06) + (.05 * .058) + (.65 * .12) = 0.0108 + .0029 + 0.078 = 0.0917 or 9.17% (10-12) Spencer supplies’ stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share this year and to pay a year end-end dividend of $3.60. a. If investors require a 9% return, what rate of growth must be expected for Spencer? Rate of return = (dividend in year 1/price year 0) + growth rate; Therefore: growth rate = rate of return – (dividend in year 1/price year 0); g = .09 – (3.60/60); g = .09 - .06; g = .03 or 3% growth rate in order to get a return of 9% b. If Spencer reinvests earnings in projects with average returns equal to the stock’s expected rate of return, what will be next year’s EPS? (Hint: g= ROE (Retention ratio). Retention ratio = (earnings-dividend)/earnings; retention ratio = (5.40-3.60)/5.40 Retention ratio = 0.33 or 33% Therefore: growth = ROE * retention ratio; Growth = .09 * .33; growth = 0.0297 EPS year 1 = EPS year 0 * (1 + growth rate); EPS year 1 = 5.40 * (1+.0297); EPS year 1 = 5.56038 Bibliography Brealey, R., Myers, S., Marcus, A. (2004). Fundamentals of Corporate Finance, (International Edition). Philippines: Mc-Graw Hill Education (Asia). Jensen, M., Murphy, K. J. and E. Wruck (2004). Remuneration: Where we’ve Been, How We Got to Here, What are the Problems, and How to Fix Them. Available from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=561305#PaperDownload. [Accessed 12 May, 2008] Keown, A. J., Martin, J. D., Petty, J. W., Scott, Jr., D. F. (2005) Financial Management: Principles and Applications. New Jersey: Pearson Education, Inc. Read More