Capital Structure, concluded

1
Capital Structure, concluded

• March 5, 2004

2
Tradeoff Theory

• So there are 2 major qualifications to MM taxes
  and bankruptcy costs
• Leads to a tradeoff
• Optimal capital structure
• Consider a small increase in debt and decrease in
  equity
• present value of increased bankruptcy cost
  present value of increase in tax shield at the
  optimum capital structure

3
Agency costs

• So far weve assumed that (pre-tax) cash flow
  doesnt depend on capital structure. Maybe
  thats unrealistic
• for a firm that has high bankruptcy risk, theres
  a conflict between debt and equity.
• Management will accept negative NPV projects if
  most of the downside is born by bondholders
• milking the assets -- the firm wont maintain
  the capital even if doing so is a positive-NPV
  project. Why benefit the creditors?

4

• Agency costs suggest that replacing equity by
  debt will decrease the value of the firm
• Covenants in the bond indenture are intended to
  decrease these costs

5
Free cash flow

• if firms have lots of cash, they will waste it on
  perks.
• If they have lots of debt, theyll have to run a
  tighter operation
• This works in the opposite direction suggests
  that replacing equity by debt will be
  value-increasing

6
Unit V -- Derivatives

• Derivatives securities with payoff that depend
  on (are derived from) the payoffs on other
  securities
• Most important types options and futures

7
Options

• Options traded on several exchanges (Chicago
  Board Options Exchange).
• Also traded over-the-counter (customized hedging
  devices)
• Financial engineering customized options
• Options on stocks, bonds, foreign currencies,
  commodities, metals
• Uses gambling and insurance (speculating and
  hedging)

8

• Stock options usually do not involve the company
  on which the options are written
• Think of them as a specialized kind of bet on the
  price of the stock.
• option to buy is a call option to sell is a put.
• Call long side has the right, but not the
  obligation, to buy the stock from the short side
  for a fixed price (the exercise price), on the
  exercise date
• Because the long side has an option, not an
  obligation, the price (premium) of any option
  will be positive

9
Option terms

• Either kind of option has a long side and a short
  side.
• long side has the option
• short side grants the option
• Taking a short position in an option writing an
  option.
• Exercise (strike) price exercise date
• Purchase price premium
• profit on a long position in an option payoff
  minus premium

10
Option payoffs

• The holder (long side) of an option pays the
  premium the writer (short side) receives it.
• The long position has the option to buy the stock
  from the writer for the exercise price
• European option on the exercise date
• American option on or before.
• What is the value of the payoff? Max(stock price
  minus exercise price, 0)

11
Call
12
Put
13
options lingo

• An option is in-the-money if its immediate
  exercise would yield a positive payoff
• (at the money, out of the money)
• Thus a call is in-the-money if the current stock
  price is greater than the exercise price.

14
Options trading

• Again IBM is not directly involved in trading
  options on IBM stock
• Prices determined by supply and demand. Markets
  are organized by specialists, just as with
  stocks.
• If demand gt supply, the price will rise ...
• Option clearing corporation organizes the
  transfer to shares of stock from writer to buyer.

15
Option strategies

• Straddle simultaneous purchase of a put with a
  low exercise price and a call with a high
  exercise price
• a bet on volatility

16
Straddle
17
Portfolio insurance

• Buying a put with an exercise price below the
  current price