Costs of Financial Distress

Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice. As we will see, financial distress is costly. Investors know that levered firms may fall into financial distress, and they worry about it. That worry is reflected

The Pecking Order of Financing Choices

The pecking-order theory starts with asymmetric information—a fancy term indicating that managers know more about their companies’ prospects, risks, and values than do outside investors. Managers obviously know more than investors. We can prove that by observing stock price changes caused by announcements by managers. For example, when a company announces an increased regular

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The After-Tax Weighted-Average Cost of Capital

We first addressed problems of valuation and capital budgeting in Chapters 5 and 6. In those early chapters, we said hardly a word about financing decisions. We separated investment from financing decisions. If the investment project was positive-NPV, we assumed that the firm would go ahead, without asking whether financing the project would add

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Valuing Businesses

On most workdays, the financial manager concentrates on valuing projects, arranging financ­ing, and helping to run the firm more effectively. The valuation of the business as a whole is left to investors and financial markets. But on some days, the financial manager has to take a stand on what an entire business is worth.

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Using WACC in Practice

1. Some Tricks of the Trade Sangria had just one asset and two sources of financing. A real company’s market-value balance sheet has many more entries, for example: Several questions immediately arise: How does the formula change when there are more than two sources of financing? Easy: There is one cost for each element.

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Adjusted Present Value

We now turn to an alternative way to take account of financing decisions. This is to calculate an adjusted present value or APV. The idea behind APV is to divide and conquer. Instead of capturing the effects of financing by adjusting the discount rate, APV makes a series of present value calculations. The first

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Calls Options, Puts Options, and Shares

Investors regularly trade options on common stocks.[1] For example, Table 20.1 reproduces quotes for options on the stock of Amazon.com. You can see that there are two types of options—calls and puts. We explain each in turn. 1. Call Options and Position Diagrams A call option gives its owner the right to buy stock

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Financial Alchemy with Options

Look now at Figure 20.4a, which shows the payoff if you buy Amazon stock at $900. You gain dollar-for-dollar if the stock price goes up and you lose dollar-for-dollar if it falls. That’s trite; it doesn’t take a genius to draw a 45-degree line. Look now at panel (b), which shows the payoffs from

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What Determines Option Values?

So far we have said nothing about how the market value of an option is determined. We do know what an option is worth when it matures, however. Consider, for instance, our earlier example of an option to buy Amazon stock at $900. If Amazon’s stock price is below $900 on the exercise date,

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A Simple Option-Valuation Model

1. Why Discounted Cash Flow Won’t Work for Options For many years, economists searched for a practical formula to value options until Fischer Black and Myron Scholes finally hit upon the solution. Later we will show you what they found, but first we should explain why the search was so difficult. Our standard procedure

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The Binomial Method for Valuing Options

The essential trick in pricing any option is to set up a package of investments in the stock and the loan that will exactly replicate the payoffs from the option. If we can price the stock and the loan, then we can also price the option. Equivalently, we can pretend that investors are risk-neutral,

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The Black-Scholes Formula for Valuing Options

Look back at Figure 21.1, which showed what happens to the distribution of possible Amazon stock price changes as we divide the option’s life into a larger and larger number of increas­ingly small subperiods. You can see that the distribution of price changes becomes increas­ingly smooth. If we continued to chop up the option’s

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Black-Scholes in Action

To illustrate the principles of option valuation, we focused on the example of Amazon’s options. But financial managers turn to the Black-Scholes model to estimate the value of a variety of different options. Here are four examples. 1. Executive Stock Options In fiscal year 2017, Larry Ellison, the CEO of Oracle Corporation, received a

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Option Values at a Glance

So far, our discussion of option values has assumed that investors hold the option until matu­rity. That is certainly the case with European options that cannot be exercised before maturity but may not be the case with American options that can be exercised at any time. Also, when we valued the Amazon call, we

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The Option Menagerie

Our focus in the past two chapters has been on plain-vanilla puts and calls or combina­tions of them. An understanding of these options and how they are valued will allow you to handle most of the option problems that you are likely to encounter in corporate finance. However, you may occasionally encounter some more

The Value of Follow-On Investment Opportunities

It is 1982 and the first personal computer has recently been launched. You are assistant to the chief financial officer (CFO) of Blitzen Computers, an established computer manufacturer casting a profit-hungry eye on the PC market. You are helping the CFO evaluate the proposed introduction of the Blitzen Mark I Micro. The Mark I’s

The Timing Option

The fact that a project has a positive NPV does not mean that you should go ahead today. It may be better to wait and see how the market develops. Suppose that you are contemplating a now-or-never opportunity to build a malted herring factory. In this case, you have an about-to-expire call option on

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The Abandonment Option

Expansion value is important. When investments turn out well, the quicker and easier the business can be expanded, the better. But suppose bad news arrives, and cash flows are far below expectations. In that case, it is useful to have the option to bail out and recover the value of the project’s plant, equipment,

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Flexible Production and Procurement

Flexible production means the ability to vary production inputs or outputs in response to fluc­tuating demand or prices. Take the case of CT (combustion-turbine) generating plants, which are designed to deliver short bursts of peak-load electrical power. CTs can’t match the thermal efficiency of coal or nuclear power plants, but CTs can be turned

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Investment in Pharmaceutical R&D

An investment in research and development (R&D) is really an investment in real options. When your research engineers invent a better mousetrap, they hand you an option to manufac­ture and sell it. New and improved mousetraps can be engineering triumphs but commercial failures. You will make the investment to manufacture and launch the better

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