Professional Documents
Culture Documents
Corporate FinanceOUpm006
KRISTEN
ID Number: 201300314
Course: MBA Specialization Financial Risk
Management cohort 3
Contents
PART 1........................................................................................................................ 1
1.1
2.
Profitability..................................................................................................................................13
(ii)
Leverage...................................................................................................................................15
(iii)
Liquidity...................................................................................................................................16
(iv)
Conclusion................................................................................................................................16
References............................................................................................................................................17
PART 1
Using examples, explain the concepts of '' Options''?
1.1 Definition of an OPTION contract
1 | Page
Calls
Buyers
Sellers
Puts
Bullish:
Bearish:
Bearish:
Bullish:
Have obligation
to sell stock
when stock price
is to fall
Have obligation
to buy stock
when stock price
is to rise
2 | Page
Call option
2. Definition of call option
A Call option is a contract between two parties to exchange a stock at a strike price by a
predetermined date. One party, the buyer of the call, has the right, but not an obligation, to buy
the stock at the strike price by the future date, while the other party, the seller of the call, has the
obligation to sell the stock to the buyer at the strike price if the buyer exercises the option.
Payoff means the gain or loss that a party will have when making a transaction.
Payoff of purchaser (buyer) = Max [0, spot price at expiration strike price]
Payoff of writer (seller) = - Max [0, strike price spot price at expiration]
A Simple understanding of a call option
Example 1:
2.1 From Buyer point of view
Today a call buyer acquires the right to pay $1,020 in six months for an index, but is not
obligated to do so.
a
Assumed that, after 6 months (at expiration) the spot price is $1,100.
Therefore the buyer will exercise its option as his payoff= Max [0, $1,100 - $1,020]
= $80
b What if the spot price is $900?
If the spot price is $900, the buys will have a payoff =$0, because he will not exercise the
option.
2.2 From Seller point of view
Using the above example a call seller is obligated to sell the index for $1,020 in six months, if
asked to do so.
a
Assumed that the option is executed in six months, where the spot price is $1,100.
If the spot price is $900, the seller will have a payoff =$0, because the buyer will not exercise the
option.
Call
Payoff
0
0
0
0
0
50
100
150
200
Future value
of premium
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
Call profit
-$95.68
-$95.68
-$95.68
-$95.68
-$95.68
-$45.68
$4.32
$54.32
$104.32
4 | Page
This table helps to assess the point (spot price) at which the buyer will make profit.
Price Index
This chart clearly shows that above $1000, the purchaser of the call option is making a
positive payoff.
The below diagram, shows the profit earned when premium is included in the calculation.
The purchaser will recover the premium when spot price is above $1020.
Price Index
5 | Page
A seller (writer) of a call option has an obligation toward the purchaser, if the latter intends to
exercise its position.
Payoff = -max [0 , strike price spot price at expiration]
Profit = payoff + future value of option premium
Example 3
A person entered in a call option in 6 months, at a strike price $1,000 with a premium of $93.81at
a risk-free rate 2%.
a
6 | Page
Price Index
Put Options
3. Definition of Put option
7 | Page
Example 4
Suppose a seller of put option has a strike price of $1000 for an index in 6 months.
a
=0
Thus, it is not worth to sell the index for $1000 when the latter worth is $1100.
b If the spot price is $900 in 6 months
Therefore the payoff of the seller
8 | Page
=0
Profit of the seller = 0- $75.68
=-$75.68 (loss)
Thus the seller will not exercise its position as it is incurring a Zero payoff and a loss.
b
Spot Price in
6 months
Put
Payoff
Future value
of premium
Put profit
9 | Page
800
850
900
950
1000
1050
1100
1150
1200
$200
$150
$100
$50
0
0
0
0
0
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
$124.32
$74.32
$24.32
-$25.68
-$75.68
-$75.68
-$75.68
-$75.68
-$75.68
The payoff will be zero because the seller will not exercise.
However the profit will equals to $75.68 which is the premium paid by the seller to the buyer.
Part 2
1
Ratio
1
Alpha
Return on Capital
employed
3000480
12000+5000
=
Profit before Interesttax
Capital Employed
Pre-tax on return on
equity
Profit before tax
Equity
=15%
2170
12000
2650
6600
=40.15%
29000
20600
50000
19200
=1.4 times
4
Gross profit
Turnover
x 100
3000
29000
Current ratio
current assets
= current liabilities
Closing inventory
holding
=2.6 times
5000
50000
=10.3%
5
50001000
6600+ 6400+6000+1000
=20%
=18%
Delta
=10%
2520
29000
4000
50000
=8.7%
=8%
11000
9200
15600
12400
= 1.20 : 1
= 1.26 : 1
5000
26000
x 365
8400
45000
x 365
12 | P a g e
closing inventory
Cost of sales
=70days
=68days
365days
8
Trade receivable
collection period
trade receivable
=
Credit sales
7200
50000
x 365days
x 365days
x
= 60 days
365 days
9
7200
26000
=53 days
x 365days
= 101 days
days
10 Leverage
Debts
= Equity + Debts
4800
29000
5200
12000+5200
11 Interest cover
NPBI
= Interest
2520
350
= 7.2 times
12 Dividend cover
NPA Tax
= Dividend per share
1870
500
=3.74 times
x 365days
= 69 days
=
6400+6000+1000
6600+ 6400+6000+1000
x 100
=30%
8500
45000
=67%
=
4000
600+ 750
= 3 times
=
2300
1400
=1.6 times
13 | P a g e
2
(i)
The ROCE of 20% Delta is more than 15% of the return of Alpha. This means that Delta is
efficiently using its Net Assets (Capital and Non-Current liabilities invested).
ROCE
35%
30%
0.15
25%
20%
15%
20%
10%
5%
0%
Alpha
Delta
The above statement can be supported by the company Net Asset Turnover, where Delta is
generating 2.6 times of its revenue from its net assets compared to Alpha which is only 1.4 times.
This means that $1 invested by Delta generates $2.6 of revenue compare to $1.4 for Alpha.
14 | P a g e
Return on Equity
60%
50%
40%
40.15%
30%
20%
10%
0%
0.18
Alpha
Delta
A major element of ROCE is to assess the carrying amount of the non-current assets. In this
given scenario, it can be found that Alpha held its own premises whereas Delta does not held its
own premises. Thus, Delta has to pay a rental fees compared to Alpha. In addition, Delta owned
plant is nearing the end of its useful life as it remains only 25% on its cost and it seems that Delta
is about replacing owned plant with leased plant. In the Alpha side, it has revalue its factory
which means the latter is at current value.
Another ratio that need due consideration is the Gross Profit Margin. It can be noted that Alpha
has slightly a better gross profit margin of 8.7% compare to Delta which is 8%. This might be
that Alpha is able to pass over cost on customer than Delta, or Alpha is purchasing goods at
lower price.
Profit Margin
18.00%
16.00%
14.00%
8%
12.00%
10.00%
8.00%
6.00%
0.09
4.00%
2.00%
0.00%
Alpha
Delta
15 | P a g e
The ROCE measures the overall efficiency of management, however, as Gamma Plc is
considering to buy the equity of one of the 2 companies, therefore, it would be useful to consider
the return on equity (ROE)- as this is what Gamma Plc is buying. ROE means how much profit
is available as dividend for each share held. ROE of Alpha is 18% which is worst compared to
Delta with a ROE of 40.15%. It can be noted that revaluation of Alphas factory is making its
ROE worst.
(ii)
Leverage
The leverage ratio of Delta is 67% which mean that 67% of its assets are financed by borrowing
fund compare to Alpha is only 30%.
Leverage
67%
70%
60%
50%
40%
0.3
30%
20%
10%
0%
Alpha
Delta
In addition, the interest cover of Delta is 3 times whereas Alpha is 7.2 times. The interest cover
explained how many times profit available can meet interest payment. Thus, Delta has fewer
profits to cover its interest payment compared to Alpha. This shows that Deltas profit is
16 | P a g e
vulnerable to any small change in the operating activity. For example, a small reduction in
revenue will reduce gross profit and eventually interest changes might not be covered.
Interest cover
12
10
8
6
4
7.2
2
0
Alpha
Delta
It is important to note that Alpha enjoys the government grant which is a risk less finance and
same is not available to Delta.
(iii)
Liquidity
Measuring the current ratio, both companies have a relatively low liquid ration of 1.20 and 1.26
for Alpha and Delta respectively. Delta seems to have a better Alpha, but is important to note that
Alpha has $1.2 million in the bank whereas Delta has $2.5 million as bank overdraft.
The working capital cycle of Alpha is 29 days whereas Delta is 52 days. This means it took 29
days of Alpha, for cash to flow in the business compared to Delta.
(iv)
Conclusion
Gamma investment will depend on its risk appetite. Delta is more profitable in terms of higher
revenue compared to Alpha, but, it is among the riskier of the 2 companies as it depends a lot on
external fund. Gamma should assess the long term objective of the 2 companies and their market
shares. Moreover, taking over a business having many debts might increase liquidity problem
therefore Gamma must assess where it will recover its initial investment in a short period and as
well as maximizing its wealth.
It is important to note that accounting information is always published with a delay. Thus,
accounts published after 5 months of the year end might not bear any relation to the companys
present situation.
17 | P a g e
Gamma plc has to see the credit rating of the 2 companies and assess their financial risk in the
following terms:
References
Books
Web Site:
1
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