FINANCING WITH DERIVATIVES & RISK MANAGEMENT

GROUP FOUR
Gay Marie De Gracia Novah Mae Samar Jeil Canete Eunixia Gaye Labastida Rei Joyce Palad

FINANCING WITH DERIVATIVES What is a DERIVATIVE? A derivative is a financial instrument that derives its value from another asset or financial instrument. Securities containing OPTION features: 1. 2. 3. 4. Short-Term Options Convertible Securities Warrants Rights Offering

OPTION is a contract that gives the holder the right to purchase or sell an asset at specified price (exercise price) during a specified time period. CALL OPTION option to buy PUT OPTION option to sell Option Valuation Concepts a) Value of a call option at expiration b) Value of a call option prior to expiration c) Maximum Value of a call option d) Minimum Value of a call option = > = = Stock price Exercise Price Stock Price Exercise Price Stock price 0

EXAMPLE Suppose an investor is offered an opportunity to purchase a call option on one share of McKean Company. a) Options exercise price = P25.00; Stock price = P30.00; Options expiration date is TODAY. Value of option = P30 P25 Value of option = P5 **The investor is willing to pay P5.00 for the option. b) Options exercise price = P25.00; Stock price = P30.00; Option expires in SIX MONTHS. Value of option > P30 P25 Value of option > P5 **The investor is willing to pay more than P5 for the option because of the chance that the stock price will increase.

c) Options exercise price = P0.01; Stock price = P30.00; Option expires in SIX MONTHS. Value of option = P30 P0.01 Value of option = P29.99 **The investor is willing to pay as much as the stock price but not more than the stock price. Thus stock price is the maximum value of option. d) Options exercise price = P25.00; Stock price = 0.01; Option expires TODAY. Value of option = P0.01 P25 Value of option = P(24.99) **The investor is not willing to pay someone to take the option off his hands and could just allow the option to expire. Most likely, the investor is willing to pay NOTHING for the option under these conditions. Thus the minimum value of option is ZERO.

Variables Affecting Call Option Valuation 1) Relationship Between the Exercise Price and the Stock Price

**The higher the exercise price and given the stock price, the lower the call option value, all other things being equal. 2) Time Remaining Until Expiration Date **The longer the time remaining before the option expires, the higher the option value, all other things being equal. 3) Interest Rates **The higher the level of interest rates, the higher the call options value, all other things being equal. 4) Expected Stock Price Volatility **The greater the expected stock price volatility, the higher the call option value, all other things being equal. VALUATION MODEL

OPTIONS IN OTHER FORMS On BONDS On COMMON STOCKS Suppose a start-up firm raises equity capital and also borrows P7 million, due two years from now. Then, suppose further that the firm undertakes a risky project to develop new computer parts. In two years, the firm must decide whether or not to default on its debt repayment obligation. Consider this example in an options context. CONVERTIBLE SECURITIES It is an investment that can be changed into another form. The most common convertible securities are convertible bonds or convertible preferred stock, which can be changed into equity or common stock. A convertible security pays a periodic fixed amount as a coupon payment (in the case of convertible

bonds) or a preferred dividend (in the case of convertible preferred shares), and specifies the price at which it can be converted into common stock. Example Asheshe Corporation issues 2 million shares of convertible preferred stock at a price of $50 a share. After the sale the company receives gross proceeds of $100 million. In case of the Asheshe Corporation, each $50 preferred share can be exchanged for 2 shares of common stock at an issue price of $25 a share. Therefore, if all the preferred shares are converted, the company in effect will have 4 million new common shares. FEATURES OF CONVERTIBLE SHARES: Convertible securities are exchangeable for common stock at a stated CONVERTION PRICE Consider the $115 million, 25 year issue of 6 % convertible subordinated debentures sold by Well, Inc. This means that each $1000 debenture was convertible into common stock at $84 a share. After three years , the conversion price was reduced to $78. CONVERTION RATIO, determines the no. of common shares that can be obtained when a convertible security is exchanged. VALUATION OF CONVERTIBLE SHARES The actual market value of a convertible security depends on both the COMMON STOCK VALUE or CONVERSION VALUE, and the value of a fixed- income security, or STRAIGHT- BOND or INVESTMENT VALUE. Conversion Value - = Conversion ratio x Stock Price If convertible bond can be exchanged for 40 shares of common stock and the market price of the firms common stock is $20 per share. CONVERSION VALUE IS $800 (40x 20) Straight bond Value/ Investment value = Present value of interest annuity plus present value of expected principal repayment $61.25 [(1.09)^t] + $1000 [(1.09)^25] = $717.66 Market Value - It is usually somewhat above the higher of the conversion or the straight bond value. Conversion Premium= market value ---- straight bond value It allows investors to participate in any common stock appreciation while having some degree of downside protection because the straight bond value can represent a floor below which the market will not fall. CONVERTING CONVERTIBLE SHARES CONVERSION CAN OCCUR IN TWO WAYS: It may be voluntary on the part of the investor it can be effectively forced by the issuing company.

If a convertible security issue is ultimately exchanged for common stock, the number of common shares will increase and earnings per share will be reduced, all other things being equal. Companies are required (by Accounting Principles Board Opinion 15) to disclose this potential dilution by reporting both primary and fully diluted earnings per share. Primary earnings per share are computed based on the no. of shares outstanding plus the common stock equivalents Fully diluted earnings per share can be computed based on the assumption that all dilutive securities are converted into common shares.

WARRANT is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. are frequently issued in conjunction with an offering of debentures or preferred stock.

Features of Warrants Exercise Price price at which the holder can purchase common stock of the issuing company. Expiry Date the expiry date is the date on which trading in the warrant ceases and the right to exercise lapses. Holder of warrants do not have the rights of common stockholders, such as the right to vote for directors or receive dividends, until they exercise their warrants. Warrants are longer-dated options and are generally traded over-the-counter.

Reasons for Issuing Warrants Lower agency costs Permits a company to sell common stock at a price above the price prevailing at the time of original issue. Allow a company to sell common stock in the future without incurring significant issuance costs at the time of sale. Valuation of Warrants Formula Value of a warrant = (Common Stock Market Price per share-Exercise Price per share) x No. Of shares obtainable with each warrant

Comparison of Convertible Securities and Warrants Similarities: 1. Reduces agency costs 2. Deferred issuance of common stock at a price higher than the prevailing market rate. 3. Result in interest expense or preferred dividend savings for the issuing company, thereby easing potential cash flow problems. Differences: Convertible Securities No additional funds are received at the time convertibles are converted. The fixed-income security is exchanged for common stock and taken off the companys books. Potentially give the company more control than warrants over when the common stock is issued Warrants The company receives additional funds at the time warrants are exercised. The fixed-income security remains on the companys books after the exercise of warrants. Interest Rate Swap Is a contractual agreement between two parties(financial institutions or businesses) to make periodic payments to each other. RISK MANAGEMENT It is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. RISK is the possibility that the actual cash flows from an investment will be different from expected cash flows. It refers to the variability of possible future returns from an investment or any other business transaction. WHY MANAGE RISK? To reduce financial distress To assure that they will have adequate cash flows to make needed investments So that the focus of managements attention is properly placed on issues under managements control NONHEDGING RISK MANAGEMENT Acquisition of Additional information Diversification Insurance

Gaining control over the operating environment Limited use of firm-specific asset

One example of acquiring information is through test-market. What is test-market? It is presenting the product to panels of consumers for their evaluation. This tactic provides information to the company as it seeks to assess the probability of success of the new product. Diversification means reducing risk by investing in a variety of assets. Diversification within its core business Diversification into unrelated business Insurance is the equitable transfer of the risk of a loss, from one entity to another in exchange for payment. It is a form of risk management to hedge against the risk of a contingent, uncertain loss. Hedging Strategies For Risk Management Types of Financial Risk Price risk - Uncertainty about the future price of an asset Credit risk - Uncertainty over whether a counterparty or the party on the other side will honor the terms of the contract Interest rate risk - Uncertainty about the future interest rates and their impact on cash flows and the fair value of the financial instruments Foreign currency risk - Uncertainty about future Philippine peso cash flows stemming from assets and liabilities denominated in foreign currency. Hedge - Transaction that limits the risk associated with fluctuations in the price of a commodity, currency, or financial instrument. It is accomplished by taking offsetting positions in the ownership of an asset or security through the use of derivative securities, such as buying or selling a forward contract, futures contract, or an option to offset risk exposure in the cash payment. Forward Contract - An agreement to buy or sell an asset at some point in time in the future at a specified price agreed to at the time the contract is purchased or sold. Delivery price - specified price Spot price - current price of an asset Performance risk the risk that at maturity the party that has losses from the contract may fail to make the necessary payments to the party with gains from price movements in the contract Illustration Forward Contract On January 1, 2011, Simple Company expects to purchase 50,000 kilos of tobacco from ABC Company, a producer of tobacco, on January 31, 2012 at the prevailing market rate on such date.

Recent market factors indicate that the market price of tobacco per kilo is within the vicinity of P150. To protect itself from the variability of the market price of tobacco, Simple company entered into a forward contract with a speculator bank under the following terms: a) If the market price is more than P150, the excess is paid by the bank to Simple Company. b) If the market price is less than P150 the deficiency is paid by Simple Company to the bank. Futures Contract - A standardized contract, traded on an organized exchange, to buy or sell an asset at a specified future time at a specified price. Delivery price - specified price Spot price - current price of an asset Exchange procedures eliminate performance risk from the counterparty to the contract since it requires settlement between the buyer and the seller for gains and losses. Illustration Futures Contract Davao Company produces bottled apple juice. Apple juice concentrate is typically purchased and sold by pound. Davao Company uses 50,000 pounds of apple juice concentrate each month. On December 1, 2011, Davao Company entered into an apple juice concentrate futures contract to purchase 50,000 pounds of concentrate on February 1, 2012 at a fixed price of P50 per pound or P2,500,000. The contract means that if the price of the apple juice is more than P50 on February 1, 2012, Davao Company will receive a cash payment from the speculator equal to the difference. If the price is less than P50 on February 1, 2012, Davao Company will make cash payment to the speculator for the difference. Option - A contract that gives the holder the right to purchase or sell an asset at a specified price during a definite period at some point in time. Two types of option: 1. Call option on the part of the buyer 2. Put option on the part of the seller Illustration - Option On December 1, 2011, Aye projects a need for 100,000 units of raw material to be purchased at the middle of 2012. The raw material is selling at P50 per unit on December 1, 2011. Aye Company is concerned with the movement of prices of the raw material between December 31, 2011 and July 1, 2012. As a protection against the increase in the price of the raw material, Aye Company entered into a call option contract with a financial speculator by paying P50,000 for the option on December 1, 2011. The call option gives Aye Company the right to purchase 100,000 units of raw material at P50 per unit.