Valuing Real Options

In this chapter, we have presented several examples of important real options. In each case, we used the option-pricing methods developed in Chapter 21, as if the real options were traded calls or puts. Was it right to value the real options as if they were traded? Also we said next to nothing about

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Yields on Corporate Debt

The year 2017 was not a happy one for telecom operator, Frontier Communications. Its share price fell by 85% over the year, and its 11% bonds maturing in 2025 were trading at 79% of face value, where they offered a yield to maturity of 15.8%. A naive investor who compared this figure with the

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Valuing the Option to Default

The difference between a corporate bond and a comparable Treasury bond is that the com­pany has the option to default whereas the government supposedly doesn’t.[1] That default option is valuable. If you don’t believe us, think about whether (other things equal) you would prefer to be a shareholder in a company with limited liability

Bond Ratings and the Probability of Default

Banks and other financial institutions not only want to know the value of the loans that they have made, but they also need to know the risk that they are incurring. Some rely on the judgments of specialized bond rating services. Others have developed their own models for measuring the probability that the borrower

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Predicting the Probability of Default

1. Statistical Models of Default If you apply for a credit card or a bank loan, you will probably be asked to complete a ques­tionnaire that provides details about your job, home, and financial health. This information is then used to calculate an overall credit score.[1] If you do not make the grade on the

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Long-Term Bonds

1. Bond Terms Applied Materials (AMAT) supplies equipment and software for the manufacture of semi­conductors. In 2011, AMAT issued 30-year bonds to help finance an acquisition. The bond was a plain-vanilla issue; in other words, it was pretty well standard in every way. To give you some feel for the bond contract (and for

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Convertible Securities and Some Unusual Bonds

Unlike the common or garden bond, a convertible security can change its spots. It starts life as a bond (or preferred stock) but subsequently may turn into common stock. For example, in March 2017, Tesla issued $850 million of 2.375% convertible senior notes due in 2022. Each bond can be converted at any time

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Bank Loans

Bonds are generally long-term loans and more often than not are issued publicly by the bor­rowing company. It is now time to look at shorter-term debt. This is not usually issued pub­licly and is largely supplied by banks. Whereas the typical bond issue has a maturity of 10 years, the bank loan is generally

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Commercial Paper and Medium-Term Notes

1. Commercial Paper Banks borrow money from one group of firms or individuals and relend the money to another group. They make their profit by charging the borrowers a higher rate of interest than they offer the lender. Sometimes it is convenient to have a bank in the middle. It saves the lenders the

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What Is a Lease?

Leases come in many forms, but in all cases the lessee (user) promises to make a series of payments to the lessor (owner). The lease contract specifies the monthly or semiannual pay­ments, with the first payment usually due as soon as the contract is signed. The payments are generally level, but their time pattern

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Why Lease?

You hear many suggestions about why companies should lease equipment rather than buy it. Let us look at some sensible reasons and then at four more dubious ones. 1. Sensible Reasons for Leasing Short-Term Leases Are Convenient Suppose you want the use of a car for a week. You could buy one and sell

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Operating Leases

Remember our discussion of equivalent annual costs in Chapter 6? We defined the equivalent annual cost of, say, a machine as the annual rental payment sufficient to cover the present value of all the costs of owning and operating it. In Chapter 6’s examples, the rental payments were hypothetical—just a way of converting a

Valuing Financial Leases

For operating leases, the decision centers on “lease versus buy.” For financial leases, the deci­sion amounts to “lease versus borrow.” Financial leases extend over most of the economic life of the leased equipment. They are not cancelable. The lease payments are fixed obligations equivalent to debt service. Financial leases make sense when the company

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When Do Financial Leases Pay?

We have examined the value of a lease from the viewpoint of the lessee. The lessor’s criterion is simply the reverse. As long as lessor and lessee are in the same tax bracket, every cash out­flow to the lessee is an inflow to the lessor, and vice versa. In our numerical example, the bus

Leveraged Leases

Big-ticket leases are usually leveraged leases. The structure of a leveraged lease is summa­rized in Figure 25.1. In this example, the leasing company (or a syndicate of several leasing companies) sets up a special-purpose entity (SPE) to buy and lease a commercial aircraft. The SPE raises up to 80% of the cost of the

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I Part Eight: Risk Management

ife is punctuated by unforeseen and unforeseeable shocks. Wars, banking and currency crises, political upheavals, pandemics, and natural catastrophes such as earthquakes and floods can all cause severe economic disruption. For example, if you want to make your hair stand on end, look at Table 26.1, which lists some of the greatest macroeconomic disasters

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Why Manage Risk?

Financial transactions undertaken solely to reduce risk do not add value in perfect and effi­cient markets. Why not? There are two basic reasons. Reason 1: Hedging is a zero-sum game. A corporation that insures or hedges a risk does not eliminate it. It simply passes the risk to someone else. For example, suppose that

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Insurance for Managing Risk

Most businesses buy insurance against a variety of hazards—the risk that their plants will be damaged by fire; that their ships, planes, or vehicles will be involved in accidents; that the firm will be held liable for environmental damage; and so on. When a firm takes out insurance, it is simply transferring the risk

Reducing Risk with Options

Managers regularly buy options on currencies, inter­est rates, and commodities to limit downside risk. Consider, for example, the problem faced by the Mexican government. A hefty portion of its revenue comes from Pemex, the state-owned oil company. So, when oil prices fall, the government may be compelled to reduce its planned spending. The government’s

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Forward and Futures Contracts

Hedging involves taking on one risk to offset another. It potentially removes all uncertainty, eliminating the chance of both happy and unhappy surprises. We explain shortly how to set up a hedge, but first we give some examples and describe some tools that are specially designed for hedging. These are forwards, futures, and swaps.