FIN 6301 Unit III CS

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit III At the end of this unit, you should be able to:

2. Evaluate different financial options for corporate finance. 2.2 Develop strategic financial recommendations for a company based on comprehensive stock

and option analysis. 2.3 Present stock and option evaluations and recommendations.

Required Unit Resources Chapter 6: Risk and Return (ULO 2.2) Read from section 6-1 through section 6-10. The purpose of this chapter is to understand risk and return. First, we define investment returns and risk. Next, we illustrate probability ranges in normal probability distribution, determine mean, and standard deviation. Further we assess the impact of diversification and estimate a stock’s average return. We summarize conclusions from tests of market efficiency and contrast the Fama-French three-factor model and capital asset pricing model (CAPM). Finally, we identify ways that behavioral finance affects decisions and appraise retail trading, meme stocks, and cryptocurrencies. Chapter 7: Corporate Valuation, Stock Valuation, and Stock Market Equilibrium Rates (ULO 2.2) Read from section 7-1 through section 7-10. The purpose of this chapter is to understand corporate valuation, stock valuation, and stock market equilibrium rates. First, we will review the rights and privileges of common stockholders and classify and track stock. We further review a typical stock quote and contrast book, market, and intrinsic values of common stock. Next, we determine the value of constant growth, free cash flows, and utilize a multistage free cash flow valuation model. We identify a company’s value drivers. Finally, we discuss why stock prices are volatile, discuss the three valuation methods, and estimate the value of a preferred stock. Chapter 8: Financial Options and Applications in Corporate Finance (ULO 2.3) Read from section 8-1 through section 8-5. The purpose of this chapter is to understand financial options and applications in corporate finance. First, we define different features of options. Next, we illustrate and formulate the single-period binomial option pricing approach and utilize the multi-period binomial option pricing model. We also apply the Black- Scholes option pricing model (OPM). Finally, we determine the price of a put option and discuss applications of the option pricing in corporate finance.

Unit Lesson Lesson: Unlocking the Secrets of Finance: Navigating Risk, Valuation, and Options (ULOs 2.2 and 2.3) In the modern world, financial literacy is not just a luxury but a necessity. Whether you are considering buying a home, saving for retirement, or launching a startup, understanding the intricacies of risk, return, and options is pivotal. These concepts are not merely abstract ideas discussed in boardrooms; they influence your daily decisions, your future, and the economy's health. In this unit, we will embark on a journey through the world of investments, stock valuation, and financial options, aiming to arm you with knowledge and insights that will serve you throughout your life and career.

UNIT III STUDY GUIDE

Stocks and Options

FIN 6301, Corporate Finance 2

UNIT x STUDY GUIDE

Title

Understanding Risk and Return in Investments Every investment decision encompasses a delicate balance between risk and return. Think of it as a seesaw—on one end is the potential profit, while on the other sits the potential for loss. Understanding this balance is crucial for any investor aiming to navigate the financial world successfully. A tale that comes to mind is of the dot-com bubble in the late 1990s. Investors were pouring money into internet-based companies, expecting tremendous returns, only to face severe losses when the bubble burst (“Research Guides: Business Booms, Busts, & Bubbles,” n.d.) Defining Investment Returns and Risks

• Investment returns: These are the gains or losses made from an investment over a specified period. It could be in the form of capital gains or dividends. Remember, higher potential returns often come with higher risks.

• Investment risks: These risks refer to the likelihood of not getting your expected return, or even losing your initial investment. Factors contributing to these risks include market volatility, interest rate changes, and more.

Diving into Distributions: Normal Probability Distribution Visualizing data can be immensely helpful. Enter the bell curve or the normal probability distribution. It helps in picturing how returns on an investment are likely to pan out.

Figure 1: Normal distribution bell curve (Iamnee, n.d.) Within this curve, the mean signifies the average return, while the standard deviation represents the dispersion or volatility. The wider the curve, the higher the risk (Dahlquist & Knight, 2022).

FIN 6301, Corporate Finance 3

UNIT x STUDY GUIDE

Title

Diversification: Do Not Put All Your Eggs in One Basket You have probably heard this adage before. It is a strategy employed by investors to spread risks across various assets or sectors. By diversifying, they ensure that a poor-performing investment might be balanced out by another that is doing well. Think of it as a safety net; even if one rope breaks, others are there to hold the weight. Diversification does not guarantee against loss, but it can be a valuable tool to mitigate potential risks. Evaluating Market Efficiency Modern finance has posited that markets are efficient, meaning all available information is already reflected in stock prices. However, there are tests and models, such as the Fama-French three-factor model and capital asset pricing model (CAPM), that dive deeper into this idea, attempting to explain why certain stocks outperform others (Bartholdy & Peare, 2005). The Human Element: Behavioral Finance As logical as we would like to believe the financial market is, human emotions and biases often play a significant role. Behavioral finance studies how psychological factors affect investment decisions. It is how phenomena like meme stocks and the surge in cryptocurrencies can be explained. For instance, the meteoric rise of Bitcoin was fueled not just by its potential but also by the frenzy and fear of missing out (Bloomberg Professional Services, 2022). The Balancing Act Understanding risk and return is not just about numbers and graphs; it is about comprehending market dynamics, human psychology, and strategic planning. By diving deep into these areas, you will be better equipped to make informed investment decisions, ensuring a balance that aligns with your financial goals and risk tolerance.

Corporate and Stock Valuation: Navigating the Financial Landscape Imagine purchasing a house. Before deciding, you would assess its location, the state of repair, comparable prices in the area, future growth prospects of the neighborhood, and even its intrinsic value. Similarly, in the world of corporate finance, determining the true value of a company or its stocks requires a blend of analytical techniques, market perspectives, and a touch of intuition. Warren Buffett’s incredible success in the stock market, for instance, is largely attributed to his knack for valuation (Rotblut, 2021). Common Stockholders: Rights and Privileges Being a common stockholder is akin to holding a piece of a company’s future. With this ownership comes certain rights:

• Voting rights mean a voice in major company decisions.

• Dividend entitlement means a share in the company’s profits.

• Knowing these rights empowers investors and ensures companies uphold their responsibilities. Decoding Stock Quotes A stock quote is more than just a price. It is a summary of a stock’s financial health and performance. It provides details like trading volume, historical highs and lows, dividend yields, and more. Understanding these can offer invaluable insights into an investment’s potential (Lincoln, 2023). The Triad of Value: Book, Market, and Intrinsic Values

• Book value: This represents the value of the company according to its balance sheet, with assets and liabilities considered.

• Market value: This is the value as perceived by the stock market. It fluctuates based on demand and supply, among other factors.

FIN 6301, Corporate Finance 4

UNIT x STUDY GUIDE

Title

• Intrinsic value: Often seen as the true value, it is what an informed investor believes the company is genuinely worth, considering all qualitative and quantitative factors.

Delving into Cash Flows Cash flow is the lifeblood of a business. By evaluating constant growth free cash flows, investors can gain insights into a company’s profitability and growth potential. Further, utilizing a multistage free cash flow valuation model allows for more complex evaluations where growth rates might change over time. Drivers of Company Value Every company has specific factors that drive its value, from the uniqueness of its products/services to its operational efficiency, brand strength, and more. Recognizing these drivers can guide strategic decisions and enhance stockholder value. Stock Price Volatility: Navigating the Waves It is not unusual for stock prices to exhibit wild fluctuations. Various factors—from global economic events to company-specific news—contribute to this. Understanding the reasons behind such volatility can prepare investors for the tumultuous seas of stock trading. Three Valuation Methods and Preferred Stock The three primary valuation methods—discounted cash flow, comparable company analysis, and precedent transaction analysis—each offer a unique lens to assess value. Moreover, understanding preferred stocks, which often come with guaranteed dividends and seniority over common stocks, enriches an investor’s toolkit (Valentiam Group, n.d.). The Art and Science of Valuation While the methodologies are scientific and precise, valuation also requires an artful touch. It is about interpreting numbers, forecasting future trends, and sometimes, going with gut instincts. As we journey further, keep these lessons in mind, laying a solid foundation for astute financial decision-making.

Financial Options and Their Role in Corporate Finance Just as a traveler might consider multiple routes to a destination, in finance, options provide an avenue of possibilities. They grant the right, but not the obligation, to buy or sell an asset at a predetermined price. Understanding options is pivotal for anyone looking to optimize corporate finance strategies. Recalling the 2008 financial crisis, options and other derivatives played significant roles, emphasizing the importance of mastering their use (Schwert, 2011). At the heart of options lie certain core features as shown in Figure 2.

FIN 6301, Corporate Finance 5

UNIT x STUDY GUIDE

Title

Figure 2: Core features of options Binomial Option Pricing: Starting Simple The single-period binomial option pricing approach is akin to a fork in the road; there are two possible outcomes. This method uses potential future stock prices to derive an option’s present value. When we expand this to multiple periods, the routes multiply, leading to the multi-period binomial option pricing model, providing a more nuanced valuation (Tamplin, 2023). The Black-Scholes Model: A Deeper Dive Developed by Fischer Black, Myron Scholes, and Robert Merton, this model is pivotal in the world of finance for valuing European call and put options. It elegantly combines various factors, such as stock price, strike price, volatility, time, and interest rates, to compute an option's theoretical price. Its advent revolutionized trading and garnered a Nobel Prize in Economics (Choudhry, 2001). Delving into Put Options While call options focus on potential buying, put options revolve around selling. Their value can be determined using models like Black-Scholes, but understanding the inherent principles, such as how increasing stock volatility typically elevates put option prices, is essential. The Grand Picture: Options in Corporate Finance Options are not just about individual profits; they are instrumental in corporate finance. Companies use options for various reasons:

• Hedging risks: By holding options contrary to their assets, firms can offset potential losses.

• Employee incentives: Stock options can motivate employees, aligning their goals with company growth.

• Strategic acquisitions: Firms can acquire options to buy assets or stocks of other companies, positioning themselves for future expansions.

FIN 6301, Corporate Finance 6

UNIT x STUDY GUIDE

Title

The Versatile World of Financial Options In a constantly evolving financial landscape, options provide flexibility, potential profit avenues, and strategic tools for corporations. Their multifaceted nature—a blend of mathematics, strategy, and market intuition— makes them one of the most intriguing instruments in finance.

References Bartholdy, J., & Peare, P. (2005, February). Estimation of expected return: CAPM vs. Fama and French.

International Review of Financial Analysis, 14(4), 407–427. https://doi.org/10.1016/j.irfa.2004.10.009 Bloomberg Professional Services. (2022, April 6). Behavioural finance: In the age of Crypto, is the efficient

markets hypothesis still fit for purpose? Bloomberg Finance. https://www.bloomberg.com/professional/blog/webinar/behavioural-finance-in-the-age-of-crypto-is- the-efficient-markets-hypothesis-still-fit-for-purpose/

Cao, H. H., & Ou-Yang, H. (2009, January). Differences of opinion of public information and speculative

trading in stocks and options. Review of Financial Studies, 22(1), 299–335. https://libraryresources.columbiasouthern.edu/login?url=https://search.ebscohost.com/login.aspx?dire ct=true&db=bsu&AN=36291546&site=ehost-live&scope=site

Chan, K., Chung, Y. P., & Wai-Ming Fong. (2002). The informational role of stock and option value. Review of

Financial Studies, 15(4), 1049–1075. https://libraryresources.columbiasouthern.edu/login?url=https://search.ebscohost.com/login.aspx?dire ct=true&db=bsu&AN=11931289&site=ehost-live&scope=site

Choudhry, M. (2001). 44–Options II: Pricing and valuation. In The Bond & Money Markets(pp. 762–787.

Elsevier Ltd. https://doi.org/10.1016/b978-075064677-2.50052-8 Dahlquist, J., & Knight, R. (2022). 13.5Probability distributions. In Principles of finance. OpenStax.

https://openstax.org/books/principles-finance/pages/13-5-probability-distributions Iamnee. (n.d.). Normal distribution chart or Gaussian bell curve (ID 206717547) [Illustration]. Dreamstime.

https://www.dreamstime.com/normal-distribution-chart-gaussian-bell-curve-business-marketing- concepts-illustration-standard-deviation-isolated-image206717547

Lincoln, T. L. (2019, September 13). How to read a stock quote. In Investor’s handbook. Medium.

https://medium.com/the-investors-handbook/how-to-read-a-stock-quote-with-cheat-sheet- fb2ca9ff5ac3

Research guides: Business booms, busts, & bubbles: A resource guide on economic manias & crashes: Dot-

com & real estate bubbles. (n.d.). Library of Congress. https://guides.loc.gov/business-booms- busts/dot-com-real-estate

Rotblut, C. (2021, September 8). Investing the Warren Buffett way. Forbes.

https://www.forbes.com/sites/investor/2021/09/08/investing-the-warren-buffett-way/ Schwert, G. W. (2011, July 14). Stock volatility during the recent financial crisis. European Financial

Management, 17(5), 789–805. https://doi.org/10.1111/j.1468-036x.2011.00620.x Tamplin, T. (2023, September 4). Binomial option pricing model. Finance Strategists.

https://www.financestrategists.com/wealth-management/valuation/binomial-option-pricing-model/ Valentiam Group. (n.d.). Valuation methods: A guide. https://www.valentiam.com/newsandinsights/valuation-

methods

FIN 6301, Corporate Finance 7

UNIT x STUDY GUIDE

Title

Suggested Unit Resources Article: The Informational Role of Stock and Option Value (Optional) This article looks at the correlation between order flows and price movements in stocks and options (26 pages). Article: Differences of Opinion of Public Information and Speculative Trading in Stocks and Options (Optional) This article analyzes dynamics of stock and option trading volumes and the differences of opinion in relation to volume effects.