Question 1
You are a financial manager that wants to know projected cash flows next year for decision-making purposes. Below is some financial statement information that is loosely based on General Electric (symbol: GE) for the year ended December 31, 2014:
Income Statement (in millions $)
Year Ended December 31, 2014
|
Sales
Cost of Sales
|
148,600
83,900
|
|
Gross Income
|
64,700
|
|
Selling, General, Administrative Expenses
|
28,700
|
|
Depreciation Expenses
|
9,300
|
|
Operating Income (EBIT)
|
26,700
|
|
Interest Expense
|
9,500
|
|
Pre-tax Income
|
17,200
|
|
Tax
|
1,800
|
|
Net Income
|
15,400
|
Balance Sheet (in millions $)
Year Ended December 31, 2014
|
Cash
Net Receivables Inventory
|
138,100 257,100 17,700
|
Accounts Payable
Short Term Debt
Other Current Liabilities
|
31,200 101,700 75,500
|
|
Current Assets
|
412,900
|
Current Liabilities
|
208,400
|
|
Net Property, Plant, Equipment
|
72,700
|
Long Term Debt
|
200,400
|
|
Goodwill and Intangibles
|
90,700
|
|
|
|
Other Long Term Assets
|
72,000
|
Other Long Term Liabilities
|
111,300
|
|
|
|
Total Liabilities
|
520,100
|
|
|
|
Total Stockholders' Equity
|
128,200
|
|
Total Assets
|
648,300
|
Total Liabilities and Equity
|
648,300
|
Assume the following: (1) net property, plant, and equipment for the year ended December 31, 2013 was $68,900 (in millions); (2) long-term debt for the year ended December 31, 2013 was $221,700 (in millions); (3) goodwill and intangibles, other long-term assets, short-term debt, other current liabilities, and other long term liabilities will remain unchanged next year.
a) Construct a pro-forma income statement for next year based on the assumption that sales will grow by 2.0 percent next year. Be clear about your work and assumptions.
b) Construct a pro-forma balance sheet for next year. Assume that the firm will buy another $16,000M in property, plant, and equipment. Also assume that a dividend of $13,000M will be paid out next year. If total assets are greater than total liabilities plus equity, correct this imbalance (i.e. the net funding need) by adding to long-term debt. If total assets are less than total liabilities plus equity, correct this imbalance by retiring long-term debt. Be clear about your work and assumptions and report how much you add to or subtract from long-term debt.
c) What is the projected free cash flow (FCF) for December 31, 2015? Use the following equation to solve for FCF:
FCF = OCF -Capex - ΔNWC,
where OCF = Net Income + interset + Depreciation. Make sure to show the individual numbers used in this equation. The free cash flows are the cash flows available for distribution to the firm's investors (stockholders and bondholders).
d) The free cash flow is the cash available to pay out to your investors (i.e. your bondholders and stockholders). According to your pro-formas, how much do you plan to pay your investors in 2015 (this will be the sum of interest and dividend payments)? By how much does this exceed the free cash flow you calculated in part (c)?
e) Suppose that debt markets are not available to cover the net funding need calculated in part (b). Instead, you announce a reduction in capital expenditures in 2014 by this corresponding amount. The public believes this will reduce your long-term competitive position and thus revises its expectation of your long-term regular dividend growth rate downward. Specifically, the public originally thought the dividend growth rate was 6.5 percent, but because of this announcement, it now believes the growth rate is 6.0 percent.
What is the change in the stock price of GE due to this announcement? Assume that the public values GE equity as a growing perpetuity with a $9.2B regular dividend payout next year. Also assume GE's equity beta is 1.35, a risk-free rate of 3 percent, and a market risk premium of 6 percent. GE has 10B shares outstanding.
Question 2
Suppose you want to create a "Condor Spread" option strategy based on GE call options. The butterfly spread will involve the following:
- Buying a call option with strike price $23
- Selling a call option with strike price $24
- Selling a call option with strike price $25
- Buying a call option with strike price $26
You want all of these options to have the same maturity of approximately 3 months.
a) Go to Yahoo! Finance and search for General Electric (symbol: GE), then click on "Options" on the left side of the screen, then select "December 18, 2015" in the dropdown box below the stock price to obtain a list of GE options with approximately three months to expiration.
The "Ask" price is the price at which you can buy an option while the "Bid" price is the price at which you can sell an option.
Report the bid and ask prices for each of the four call options described above. Also report the date, time, and stock price when you retrieved these options prices.
b) Like in class, provide the payoff function for each range of strike prices in which the stock price in could land in 3 months. (The stock price can land in five ranges: ???? < 23, 23 < ???? < 24, 24 < ???? < 25, 25 < ???? < 26, ???? > 26.)
c) Graph the payoff of the option strategy as a function of ????.
d) How much will this condor spread cost? Remember to use the bid price when you sell a call option, and the ask price when you buy a call option. You receive money when you sell an option and pay money when you buy an option.
e) What kind of price movements are we betting on with this strategy? (no calculations needed for this question)
f) Suppose you buy a GE call option that has a strike price equal to $23 and expiration on December 18, 2015. Because the strike price is less than the current stock price, this option is considered "in-the-money".
Report the strike price of this call option, the ask price, and the current price of GE stock.
Suppose you immediately exercise this call option. What is your payoff? Why do you think the payoff is less than the (ask) price at which you bought this option?
Question 3
You are the sole bondholder in a firm that will be liquidated next year. Your main concern is that you will not be paid back the $50M you are owed at that time. The current market value of the firm is $60M, although it is unknown what the market value will be next year.
a) Provide the payoff diagram for the bondholder with the final market value of the firm on the x- axis.
b) The financial manager of the firm currently has to make one of two choices:
- Do Nothing: under this choice, the market value of the firm will be equal to either $50M or $70M next year, with equal probability.
- Take A Huge Risk: under this choice, the market value of the firm will be equal to either $150M or zero next year with equal probability.
Assume that the bondholders and shareholders have to maintain their positions until firm liquidation next year. What is the expected payoff to bondholders and shareholders next year under each choice? If the manager is acting in the best interests of the shareholders, which choice would he make? Assume this choice is made for the rest of the problem.
c) The financial manager, acting in the shareholders' best interests, takes the huge risk, much to the detriment of you, the bondholder. If you were to completely protect yourself against the state of the world where the firm does not pay you back, would you buy a (call or put) option on the final market value of the assets of the firm, and at what strike price?
d) This option you purchase has a price of $20M. You decide to borrow the $20M, in order to pay for the option, at a 10% interest rate. The loan plus interest must be repaid in one year. What is your total expected payoff (bond + option - loan repayment) in one year? Would you be better off purchasing the option?
Firms that go bankrupt are typically unable to fully repay all bondholders. A bondholder can protect himself from this event by purchasing a "Credit Default Swap", an agreement in which he pays a third counterparty a fee (or a sequence of fees over time) and, in exchange, the third counterparty will repay the bondholder what he is owed in the event that the firm goes bankrupt and cannot repay what the bondholder is owed (you also hand over the bond to that third counterparty). "Credit Default Swaps" are, in essence, the option that you purchased in part (c).