FIN 401 Lecture Notes - Lecture 4: Option Style, South Dakota Highway 45, Cengage Learning

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18 Apr 2016

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Chapter 4: option pricing models: the binomial model. 4. (two-period binomial model) in a recombining tree, if the underlying first moves up and then down, it will be at the same price as in the case when it first moves down and then up. In a non-recombining tree, the underlying will not be at the same price in those two cases. A recombining tree will have far fewer possible prices of the underlying. For a recombining tree of n time steps, there will be n + 1 possible final prices. For a non-recombining tree of n time steps, there will be 2 n possible final prices. That spread is an indication of the volatility. It is easy to see that if we increase u and/or decrease d, we increase the volatility. (extending the binomial model to n periods) if the up and down parameters were not adjusted, the stock would have unreasonable volatility.

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You have just completed your undergraduate degree, and one of your favorite courses was "Today's Entrepreneurs." In fact, you enjoyed it so much you have decided you want to "be your own boss." While you were in the program, your grandfather died and left you $300,000 to do with as you please. You are not an inventor, and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is three years. After three years you will sell off your investment and go on to something else. You have narrowed your selection down to two choices; (1) Franchise L: Lisa's Soups, Salads, & Stuff and (2) Franchise S: Sam's Fabulous Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the three-year period.

Franchise L's cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise S's cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: you could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds without the franchises' directly competing against one another. Here are the net cash flows (in thousands of dollars):

	Expected
	net cash flows
Year	Franchise S	Franchise L
0	($100)	($100)
1	70	10
2	50	60
3	20	80

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.

You also have made subjective risk assessments of each franchise, and concluded that both franchises have risk characteristics that require a return of 10 percent. You must now determine whether one or both of the projects should be accepted.

In order to do so please answer the following questions fully. Make sure to show a time line, the formula to be used, the steps taken to solve the problem (calculator or excel) and the final numerical answer when appropriate.

Questions:

Define the term net present value (NPV).

What is each franchise's NPV? Make sure to show the formula, steps and final answer.

Based on your answer which franchise would you select? Why?

Would your answer be different if the projects are independent or mutually exclusive? Why or why not?

Would the NPVs change, and therefore your answer, if the cost of capital changed? Why or why not?

Internal Rate of Return (IRR) â you may use a financial calculator or excel. (Worth 8 points)

What is the logic/idea behind the IRR method?

Calculate the IRR for each project. Make sure to show the formula, calculator or excel steps and final answer.

According to IRR, which franchise should be accepted if they are independent? Mutually exclusive? Why?

Would the franchises' IRRs change if the cost of capital changed? Why or why not?

Define the term modified IRR (MIRR).

Find the MIRRs for Franchise L and S. Make sure to show the formula, steps and final answer.

What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR's advantages and disadvantages vis-a-vis the NPV?

What is the rationale for the payback method?

Calculate the payback period for each franchise. Make sure to show the formula, steps and final answer.

Calculate the discounted payback period for each franchise. Make sure to show the formula, steps and final answer.

According to the payback criterion, which franchise or franchises should be accepted if the firm's maximum acceptable payback is 2 years, and if Franchise L and S are independent? If they are mutually exclusive? Why?

What is the difference between the regular and discounted payback periods? Make sure to mention the advantage and disadvantage of each.

Based on the results obtained and everything that you have described above, which franchise would you ultimately choose if the projects are mutually exclusive? Explain in detail your decision and why you chose the model you did to make your final decision.

Can you tell me What does this article tell us about the bond markets performance and the interest rate environment?

Long-Term Government Bonds Shine as Fed Goes Slow

Pimco, Vanguard funds with focus on long-term debt beat out other bond funds in the 1st quarter

For investors, one of the best bets of 2016 has been a wager via U.S. Treasurys on falling interest rates.

A Pimco long-term government-bond fund was the best performer among bond funds in the first quarter. Above, Pimco offices in Newport Beach, Calif. PHOTO: MIKE BLAKE/REUTERS

The $460 million Pimco Extended Duration Fund posted a total return of 11.8% in the first quarter, making it the best performer among 2,015 U.S.-based bond mutual funds, according to data from Morningstar. Total return reflects price gains plus periodic payments.

The runner-up was $1.3 billion Vanguard Extended Duration Treasury Index Fund, which returned 11.7% during the quarter, according to Morningstar.

Both funds posted their best returns since the last quarter of 2014 and have extended those gains in the early days of the second quarter. Duration refers to a fundâs exposure to interest-rate risk, meaning its prices will rise more when rates fall and fall more when rates rise.

Analysts have warned repeatedly that bets on duration are risky, given the long decline in interest rates over recent years. The gains are striking at a time when stocks and other riskier assets have rebounded from an early-year selloff that at one point left the Dow industrials down 10%. The Dow fell 20.55 points, or 0.1%, on Monday, but is up 0.8% for the year.

While safer securities such as U.S. Treasurys and German bunds tend to decline in price when stocks and low-rated corporate bonds rally, many analysts say the simultaneous rise of safer and riskier assets this spring is tied to the unexpectedly slow pace of policy tightening by the Federal Reserve, along with signs the global economy continues its slow healing.

MORE IN MARKETS

A Measure of Stock-Market âFearâ Just Hit an All-Time High

Spreads Point to Growing Stress in Japanese Government Bond Market

By One Measure, U.S. Rates Are Already Negative

At the same time, many investors are concerned that the rally in stocks, bonds and commodities off Feb. 11 lows may have gone too far too fast.

âWe are still stuck in low growth,ââ Jack Flaherty,portfolio manager at money manager GAM, which has over $119 billion in global assets under management. âIt may be time to lighten up a bit and pauseâ on purchases of riskier assets, he said.

The uncertainty is why many investors are buying long-term U.S. government bonds, even though analysts have warned that slim yields leave bondholders vulnerable to potentially large capital losses if interest rates do rise.

The average U.S. equity mutual fund posted a total return of minus-0.4% between January and March, according to Morningstar. The average return for all U.S.-based bond funds tracked by Morningstar was 2.1% for the period. Quarter-end data for all funds are typically finalized in the early days of the following period.

âIt has been a good start for bond funds,ââ said Jeff Tjornehoj, head of Americas research at Lipper. That performance âmay be hard to repeat this quarter.â

Stock funds on average returned 4.4% in the fourth quarter last year, according to Morningstar. Bond funds posted a negative 0.1% return in the final quarter of 2015.

U.S. Treasury bonds overall have posted a total return of 3.6% this year through Friday, according to data from Barclays. U.S. bonds sold by lower-rated firms, or junk bonds, have returned 3.8% over the same period. S&P 500 has returned 0.8%, according to FactSet.

The Vanguard fund passively tracks an index of long-term Treasury bonds. The fund âwill tend to have extreme resultsâboth on the up and down sideââ given its focus on buying government bonds with very long-term maturity, said a representative of Vanguard in a written statement.

The Pimco fund is actively managed by three fund managers at Pacific Investment Management Co.: Stephen Rodosky, Michael Cudzil and Josh Thimons. A representative at Pimco declined to comment.

The Pimco fund attracted $19.7 million of new cash between January and February, topping the $11.9 million it obtained for the whole year of 2015, according to the latest data from fund tracker Lipper.

The Vanguard fund attracted $20.4 million of new cash during the first two months of the year, after suffering a net withdrawal of $115.7 million in 2015, according to Lipper.

The Vanguard fund posted a loss of 20.9% in 2013, according to Morningstar, when worries about the Fed reducing bond purchases rattled the bond market. The Pimco fund lost 21.2% that year.

But U.S. bond yields have largely been on a downward trend since the financial crisis. The two funds both posted an annualized return of about 17% on average over the past five years through Friday, according to Morningstar.

Assignment Please read the instructions carefully. You need to write 6 sentences for each article which includes what i have given in instructions.

Instructions

For the two articles below:

Write a few sentences explaining how the article is relevant to Verizon or Sprint Mobile. How and why would you expect it to affect stock prices, and whether they were affected in the way you expected (do this in terms of expected future earnings). Because traders buy or sell stocks immediately as new information becomes available, stock prices respond rapidly. Be sure to include the date of the article. You should be able to distinguish whether the news was relevant to only one of your stocks, your industry, or the whole market by noting the relative price changes - if only one of your stocks went up while the market was down, the news affected only your stock; if both your stocks moved differently from the market, the news probably affected your industry as a whole; if your stocks moved in tandem with the market, the news probably broadly affected the whole economy. You should also be able to explain why the news affected just one company, the industry, or the whole market. The articles selected should be balanced chronologically and topically.

Below are stock prices from Nov 16^th through 19th

Verizon Communications Inc. VZ (U.S.: NYSE)							Sprint Corp. S (U.S.: NYSE)
		Time	close	S&P 500			Time			Close	S&P 500
NOV	16	4:03PM EST	45.04	1.49	16	4:00PM EST.		4.21	1.49
	17	4:00	45.08	-0.13%	17	4:03		4.4	-0.13%
	18	4:05	45.38	1.62%	18	4:00		3.99	1.62%
	19	4:00	45.76	-0.11%	19	4:00		4.05	-0.11%
	20					20

1.Sprint Promotion Sends Investors Running

The carrier should be more focused on improving profitability and free-cash-flow generation.

Updated Nov. 19, 2015 1:15 p.m. ET

Sprint (S: NYSE)
By Evercore ISI ($3.99, Nov. 19, 2015)After days of hinting at a âbig announcement,â Sprint released new pricing plans which offer a 50% discount to plans from T-Mobile US, Verizon Communications and AT&T -- while also covering up to $650 of switching costs.

If a 50% discount from Sprint (ticker: S) sounds familiar, thatâs because it is essentially the same as the companyâs earlier âcut your bill in halfâ promotion -- though, notably, this time it extends to T-Mobile ( TMUS ) customers as well as those from Verizon ( VZ ) and AT&T ( T). And, while this may drive some uptick in subscriber attraction, we note: 1) we believe the most cost-sensitive subscribers likely took advantage of this offer the first time around; 2) we do not agree with Sprintâs contention that transitioning subscribers are likely to opt for higher data plans versus the discounted offerings; and 3) the offer comes at a time when Sprint should be more focused on improving profitability and free-cash-flow generation (and is somewhat contradictory to other recent initiatives such as increasing unlimited pricing by $10 and attempting to cut $2.5 billion in annual costs from its budget). It is this last point -- on the impact to profitability -- that appears to have upset investors the most, sending Sprint shares down 9.3% Wednesday.

Prior to (and on) Sprintâs fiscal-second-quarter call, the company announced that it would seek to cut $2.5 billion in costs. We saw these costs cuts, along with Sprintâs decision to not participate in the 600 megahertz (MHz) auction, to use off-balance-sheet financing, and raise its unlimited pricing by $10, as evidence that Sprint was attempting to improve its cash flow position. However, as part of this current promotion, Sprint is offering up to $650 in reimbursements for early termination fees (ETFs) and other fees (provided you turn your phone in). Because we believe that the most cost-sensitive subscribers may have already taken advantage of this offer the first time around, the corresponding increase in subscriber traction may not be enough to offset the negative implications to profitability and free cash flow.

Sprint sees potential upside from more data, same price. The emphasis of the promotion is to cut your bill in half. Despite this, Sprint believes subscribers are likely to opt for the same nominal value plans, but twice the data. We do not agree. If Sprintâs intention was to see customers double their data, the pitch should have been âdouble your data,â not âtake 50% off.â

Customers can trial the offer for 28 days. If they are not satisfied, and have purchased a device through Sprint, they can return the device with no restocking fee. Importantly, the offer is for activations from Nov. 20 through Jan. 6 and the promotional pricing will run for 24 months. While the offer is available to new Sprint customers, current Sprint subscribers can get a free [Apple (AAPL)] iPad with one year of free service, if they sign a two-year contract. Sprint expects the iPad offer to reduce churn (as customers with more devices become âstickierâ).

Based on our last published model, our discounted-cash-flow-driven year-end 2016 price target is $4. [We rate Sprint at Hold.]

-- Jonathan Schildkraut
-- Justin Ages

The companies mentioned in Hot Research are subjects of research reports issued recently by investment firms. Their opinions in no way represent those of Barrons.com or Dow Jones & Company, Inc. Some of the reportsâ issuers have provided, or hope to provide, investment-banking or other services to the companies being analyzed. Share prices at the time the report was issued and the date of the report are in parentheses.

7:39 am ET
Nov 19, 2015

2.The Morning Download: Ford CEO Says

Steve Rosenbush

CONNECT

Good morning. Ford Motor Co. CEO Mark Fields says that wireless updates for vehicle software have more or less arrived. Thatâs going to lead to big changes in the way people build and use cars, which are bound to adopt more characteristics of mobile phones. CIO Journalâs Rachael King has the story.

Ford launched Sync Connect with the 2017 Ford Escape at the LA Auto Show this week. The platform lets drivers unlock or start the vehicles from their smartphones. âSync Connect will serve as the platform to offer over-the-air updates allowing us to go beyond the infotainment system such as updating other parts of the vehicle like the engine or driver-assist technologies,â said Mr. Fields, speaking at a press event Wednesday in San Francisco.

Wireless updates mean that phones donât have to be brought into the shop or replaced every time that the operating system is brought up to date, or that a security patch is available. And of course, they facilitate the use of apps and the development of ecosystems. Now, the automobile, which until now has more or less remained the same during its long life cycle, is about to become much more dynamic.

Macquarie taps Barclays BCS -4.34% IT Executive as CIO. Justin Raoul Moffitt, an 18-year IT veteran with Barclays, steps in as CIO at Macquarie starting in February 2016, a company spokesman said.

Verizon Communications Inc. VZ (U.S.: NYSE)							Sprint Corp. S (U.S.: NYSE)
		Time	close	S&P 500			Time			Close	S&P 500
NOV	16	4:03PM EST	45.04	1.49	16	4:00PM EST.		4.21	1.49
	17	4:00	45.08	-0.13%	17	4:03		4.4	-0.13%
	18	4:05	45.38	1.62%	18	4:00		3.99	1.62%
	19	4:00	45.76	-0.11%	19	4:00		4.05	-0.11%
	20	4:00	45.39	0.38	20	4:00		3.83	0.38
	21					21

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FIN 401 Lecture Notes - Lecture 4: Option Style, South Dakota Highway 45, Cengage Learning

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