[Solution]Determine three methods of using stocks and options to create

Question 1 :Determine three methods of using stocks and options to create a risk-free hedge portfolio. Support your answer with examples of these methods being…

Question 1 :Determine three methods of using stocks and options to create a risk-free hedge portfolio. Support your answer with examples of these methods being used to create a risk-free hedge portfolio.Question 2 : What sources of capital should be included when you estimate weighted average cost of capital (WACC)? Why?Question 3 : Should the component costs of a company be figured on a before-tax or an after-tax basis? Why?Question 4 :From the scenario, create a unique hypothetical weighted average cost of capital (WACC) and rate of return. Recommend whether or not the company should expand, and defend your position.For question 4 you should use the scenario script which I have attached.I will only accept an original answer with zero plagiarized answer.The length of answer is 2 -3 pages.Thank youFIN534 Week 5 Scenario Script: The Weighted Average Cost of CapitalSlide Scene/InteractionNarration#1Scene 1Intro slideSlide2Scene 2FIN534_5_2_Joe-1:Hello, everyone. Ithas been awhile since we have seen eachother! Long time no see everyone. My job hasme out of the office more than usual, but Iwanted to stop by and congratulate you onsome fabulous work so far. You have beenasked to do a lot of calculating as part of ourfinancial analysis regarding our current state atTFC and the expansion project. I can see thatyour Strayer University education is payingoff. They are really preparing you for makinginformed business decisions.•½ banner in a break roomwith cake or goodies?•Joe there•Show Strayer banner•End of sceneWacc is pronounced like whackFIN534_5_2_Joe-2: I brought some snacksand refreshments; help yourself. They are inthe break-room. At TFC we encourage ouremployees to work out but that does not meanyou cannot have some snacks. It just meansyou will have to work out a little more at thegym later. (laughter)FIN534_5_2_Joe-3: Well, I have to go. Ihave a busy day – full of meetings, but before Ileave I would like you to continue yourfinancial analysis. First, I would like you to dosome research on financial options as we maybe interested in using some of our cash toinvest in those financial vehicles. Secondly, Iwould like you to determine our WACC, orweighted average cost of capital. Good luckand I’m excited to see the reports on my desk.Slide3Scene 3•Don in break room. Don’svoice is excitable andFIN534_5_2_Joe-4: Have a great day! Youare the best financial team in the world!FIN534_5_3_Don-1: Joe is the mostenergetic and positive-minded CEO on theplanet. He gave us some tall orders but, I amconfident you and Linda will complete themconvincing.••Go to next slidewith the highest standards.FIN534_5_3_Linda-1: Yes Don, we will.Our first task is to review what our financialoptions are in case we want to go down thatinvestment road in the future. I have alwayslearned that the more you are prepared aheadof time, the better the decision making is.FIN534_5_3_Don-2: I agree, Linda. That iswhy we have you and your Intern on thishighly visible project. We want to make surewe are going to make the best practicaldecision for TFC.I will leave you two now so you can startpreparing.Slide4Slide5Scene 4•Linda In conference roomwith a finance book in hand•Show Call Option, Strike(Exercise) Price and PutOption on a chart•Go to next slideScene 5••Linda In conference roomwith a finance book in handShow Call Option, StrikeFIN534_5_3_Linda-2: Let us meet in theconference room. I will meet you there. I wantto pick up some of my textbooks dealing withfinancial options.FIN534_5_4_Linda-1: Here we are back inwhat I am now calling the “FinancialManagement Room”. I was able to find sometext books on financial options. They are thepart of investing that I like to call “The GreatUnknown.”; because you are taking a chanceon how stock will react in the future. Anoption is basically an investor’s choice to buyor sell a particular security at a predeterminedprice in the future and within the certain timeperiod. For example, you may only haveninety days to have the option of buying ashare of stock at an already agreed upon price.Also, options are traded on an optionsexchange market just like stocks are tradedon a stock exchange market.FIN534_5_5_Linda-1: The two types ofoptions that we are going to look at are theCall Option and Put Option.FIN534_5_5_Linda-2: With a Call Option,the holder of the option is given the right to(Exercise) Price and PutOption on a chart•Go to next slidebuy a share of stock at a predetermined pricewithin a certain period. If the owner decides tobuy the share, then it is exercised. Thepredetermined price is called the strike orexercised price, because that is the agreedupon price and it is only carried out if theowner strikes a deal.FIN534_5_5_Linda-3: Let us look at anexample. If someone buys a call option fortwo dollars and it comes with the terms of astrike price of thirty dollars a share with anexpiration date of six months, the owner hassix months to buy a share of stock at thirtydollars. If the stock is currently selling fortwenty dollars, the owner would not exercisethat option as the strike price is greater thanthe trading price. However, if the trading pricegoes over thirty dollars, actually thirty twosince the owner paid two dollars for the option,then the owner has to decide if the optionshould be exercised. In our example, if thetrading price is forty dollars then the ownershould exercise the option as the share can bebought for thirty dollars. Whenever there is aprofit involved, meaning that the stock price isgreater than the exercised price, the option issaid to be “in-the-money.” In our example,the owner would be “in-the money.” When theowner is “out-of-the-money”, that is when theexercised price is greater than the currentprice; the owner would not want to go throughwith the transaction. Of course for eithertransaction, you need to also consider the priceyou paid for such an option.FIN534_5_5_Linda-4: Personally, I like tothink of the Call Option as the “High Rise”option, as the higher the share price goes thebetter as the owner is locked into a price.Keep in mind that most options come with anexpiration date, meaning that if the owner doesnot exercise it within a certain period of time,the option is no good.Slide6Scene 6•Linda In conference roomwith a finance book in hand•Show Call Option, Strike(Exercise) Price and PutOption on a chart•Go to next slideFIN534_5_6_Linda-1: The second type ofoption can be thought of as the exact oppositeof the Call Option. It is the Put Option. Thisoption gives the owner the right to sell a shareof stock at a predetermined price. An ownerwould most likely execute this when the priceof a share of stock falls below the exercisedprice, and of course the price paid for the putoption.FIN534_5_6_Linda-2:Let us look atanother example but this time with put options.If an investor buys a put option for one dollarat an exercised price of forty dollars and thestock is currently selling for fifty dollars, theinvestor would not exercise the option as theselling price is higher than the exercised price.In that case it would be better for the investorto sell a share of the company at fifty dollars ifthe owner has shares of it.FIN534_5_6_Linda-3:Now, let’s go backto our example. If the share price of the stockdrops to ten dollars a share, the investor canexercise the put option at the price of fortydollars. Even though the share price is onlyten dollars the investor would get forty dollars.Like the Call Option, the Put Option usuallycomes with an expiration date.FIN534_5_6_Linda-4:The difference withthe Put Option is the owner is taking a risk thatthe price of the stock will go down.FIN534_5_6_Linda-5:As you can see,futures trading has risk involved. The ownerof the option is taking a chance on what theprice will be in the future, whether higher orlower than when the option was purchased. Ifthe stock does not move in the direction youare hoping, then you stand the chance of losingmoney.(Phone rings)FIN534_5_6_Linda-6:be right over.Hello. Okay I will(Hangs up)FIN534_5_6_Linda-7:That was Don.He wants me to come by and pick up theinformation he has for our second task,calculating TFC’s weighted average cost ofcapital or WACC. In the meantime, can youdo some decision making on options so we canput it in our report to Joe? I will see you later.Slide7Scene 7Check Your Understanding:Linda would like you to completemake some determinations on calland put options. Please selected thebest choiceIf an investor purchases a call optionon a particular stock today, what isthe investor is hoping the stock pricewill do?a) Price will go up? – Correct! Theowner is hoping the price will go upas the call option provides for a fixedpurchase price. If the fixedpurchased price is less than the stockprice, the owner will have a gain onthe investment when executed.b) Price will stay the same? Nice try,but stock price volatility can providefor a gain or loss on an investmentc) Price will go down? Nice try, but ifthe price goes down the investor willnot be able to execute the option asthe option will cost more than whatthe open market is askingIf an investor purchases a put optionon a particular stock today, what isthe investor is hoping the stock pricewill do?a) Price will go down? – Correct!The owner is hoping the price will godown as the put option provides fora fixed selling price. If the fixedselling price is more than the stockprice, the owner will not lose asmuchb) Price will stay the same? Nice try,but stock price volatility can providefor a gain or loss on an investmentc) Price will go up? Nice try, but ifthe price goes up the investor will notbe able to execute the option asinvestors will be able to sell theirsecurities for more than what the putoption is worthSlide8Scene 8•Move into Linda’s office•WACC on slideWACC = wdrd(1-T) + wstdrstd(1-T)+wpsrps+wsrsWacc is pronounced like whack•Next slide•Is it possible to be pointing tothe formula when Linda isreading the formulacalculation?FIN534_5_8_Linda-1:Great work!While we are not too familiar with options atTFC, it is always good to increase yourknowledge base. This may be an investmentchoice for us later.FIN534_5_8_Linda-2:Now for oursecond task. The company wants us tocalculate TFC’s Weighted Cost of Capital,more commonly known as the WACC.FIN534_5_8_Linda-3:The WACCincludes many of the rates we have calculatedearlier. It is like bringing the pieces together ina puzzle.FIN534_5_8_Linda-4:calculate the WACC is:The formula toWeight of debt times coupon rate of debt timesone minus the tax rate plus weight of shortterm debt times interest rate on short term debttimes one minus the tax rate plus weight ofpreferred stock times required return onpreferred stock plus weight of common stocktimes required return on common stock.Slide9Scene 9 –Linda in her officeCost of debtFIN534_5_9_Linda-1:As we have donebefore, let us look at each component of theWACC.FIN534_5_9_Linda-2: The first componentis the r sub d, which is the Before-Tax Costof Long Term Debt. While there can be manydifferent ways to determine this debt, we willconsider it to be the coupon rate that we planon issuing for long term bonds. Previously, wedetermined that rate to be eight percent.FIN534_5_9_Linda-3: As the WACCsuggests, we have to make an adjustment forthe tax rate. This is because interest paid isdeductible on the income statement for TFC,so in essence we are saving on taxes beingpaid. Think of it this way, since interestexpense is deductible, TFC is already savingthe tax rate on its bonds, so the rate being paidis really one minus the tax rate. For us, we arepaying eight percent on our bonds and our taxrate is forty percent.FIN534_5_9_Linda-4: And the short termcomponent of cost of debt is handled the sameway. Let’s move back to the conference roomto meet up with Don.Slide10Scene 10•Don and Linda in conferenceroom, different part of room•Put factors on screen – rollthem out•Stock Price (Psub0) = Dsub 0times (1 plus dividend rate)all divided by (rate of returnminus the dividend rate)Next screen•FIN534_5_10_Don-1: Another component ofthe WACC is the required rate of return onpreferred stock. While TFC has never issuedpreferred stock, it is important to note shouldwe ever decide. Preferred Stock is differentthan Common Stock, as it usually pays a betterdividend than Common Stock and it is higherup on the order of being paid should acompany decide to liquidate assets. Todetermine the required rate on preferred stock,the dividend divided by the price per sharetimes one minus the flotation cost would beused. Flotation costs are those costs that arepaid by the company who issues stock, likeTFC, to an investment banking company, thecompany who would handle all of thetransactions for the new offering. These costsneed to be included in the calculation as theWACC is used to help determine the cost ofraising new capital. Any new stock wouldhave floatation costs included. For example, ifwe want to issue new shares of stock at onehundred dollars a share, and investmentbanking firm would handle the new issue forus. They would charge a fee. If they chargefive percent of the offering price, in this caseone hundred dollars, we would only get ninetyfive dollars for each share sold and the fivedollars would go to the investment bankingcompany for taking care of the new issue.Bottom line is it costs money to issue newshares,Slide11Slide12Scene 11•Cost of Debt•Next SlideScene 12••Show WACC againShow weights – as in gymweightsFIN534_5_11_Linda-1: The last componentis the required rate of return on commonstock or r sub s. For this component we usethe CAPM as our required rate of return forcommon stock. Typically, when doing aproject that involves an equity contribution, acompany would first look at using theirretained earnings. After they are used up, theywould look at selling stock. The main reasonis retained earnings do not have flotation costswhich will result in a lower overall cost ofequity for a company. Previously wecalculated our CAPM to be fifteen percent.FIN534_5_12_Linda-1: Now that we haveall the components to the WACC, we are stillmissing one critical piece. And that is, howare we going to raise the capital? We knowit will be through issuing bonds and sellingstock, but what percentage of each. Or betteryet, what weighted percentages will beassigned to each component? These are the”W’s” on our WACC formula.FIN534_5_12_Don-1: Linda that is anexcellent point. We have the components butthe weights come from what we at TFC feels isour optional capital structure and then keepthat in mind when we are trying to raise newcapital. While it is a work in progress, we feelthat our optimal capital structure is sixtypercent equity and forty percent debt. We alsodo not plan on issuing any preferred stock andall of our debt will be long term debt.FIN534_5_12_Linda-2: Well, now it istime to put all the pieces together.Slide13Scene 13Check Your Understanding – Fromthe information given in prior sceneswhat would TFC’s WACC be?WACC = wdrd(1-T) + wstdrstd(1-T)+wpsrps+wsrs.40*.08*.60 + .60*.15Answer = 10.92%If get wrong, good try but rememberWACC = wdrd(1-T) + wstdrstd(1-T)+wpsrps+wsrsAlso, with weights being .40 forbonds and .60 for stocks. There is noshort term debt or preferred stock•Slide14Scene 14•Linda in office roomFIN534_5_14_Linda-1: Great work. Theten and ninety-two hundredths percent tells uswhat the cost of raising new capital will be forour company. In order for us to proceed with aproject, we have to make sure the return will•Linda moves to another spotNext Slidebe at least ten and ninety-two hundredthspercent or we should not do the project. ThisWACC can be used to help us value ouroperations as it can be used as the discountfactor for future cash flows.FIN534_5_14_Linda-2: There are manyfactors and assumptions that went into derivingthe WACC. That is why it is important that weare confident in our analysis. We can also dosituational analysis here and consider adifferent optimal capital structure or requiredrates of return.FIN534_5_14_Linda-3: This was a lot ofwork and now it is time to work off those extracalories from our mini celebration by Joe. Letus go to the pool for a swim. But before we goto the pool, let’s stop by Don’s office to invitehim to the pool and to review what we coveredtoday.Slide15Scene 15•In Don’s office•Summary Slide – CAPM andValuing StocksFIN534_5_15_Don-1: You both did muchwork on this assignment. The two main areaswere financial options and the WACC. Whiledifferent, they both are needed for decisionmaking.FIN534_5_15_Don-2: We first looked atsome financial options and learned what theywere and when they should be exercised. Wethen learned that call options are bought inhopes that a company stock will go up whileput options are the opposite.FIN534_5_15_Don-3: The WACC isthought of as the cost of a project to acompany. Just like diversifying an investmentportfolio, a company should also look atdifferent options when raising capital. Thetwo common components are debt and equity.The optimal capital structure will assign apercent to each component which will be usedin calculating the WACC.FIN534_5_15_Don-4: Great work by thetwo of you. I already know your nextassignment. It has to do with cash flow. I willfill you in later. Now it is time to start burningoff those calories. (laughter)Slide16Scene 16•Closing slideClosing slide

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