1

Study Unit Six

Valuation Methods and Cost of Capital

6.1 Stock Valuation Methods ................................................................................................. 2

6.2 Cost of Capital -- Current ................................................................................................ 6
6.3 Cost of Capital -- New ..................................................................................................... 11
6.4 Options and Derivatives ................................................................................................... 14

This study unit is the third of five on corporate finance. The relative weight assigned to this major
topic in Part 2 of the exam is 20%. The five study units are
● Study Unit 4: Types of Securities
● Study Unit 5: Financial Markets and Financing
● Study Unit 6: Valuation Methods and Cost of Capital
● Study Unit 7: Working Capital Management
● Study Unit 8: Corporate Restructuring, International Trade, and Exchange Rates

This study unit discusses long-term financial management. Topics covered in this study unit include
● The constant growth dividend discount model
● Preferred stock valuation
● The components of cost of capital
● Calculating the weighted-average cost of capital (WACC)
● Marginal cost of capital
● Hedging
● Options
● Forward contracts
● Futures contracts
● Swaps

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2 SU 6: Valuation Methods and Cost of Capital

6.1 Stock Valuation Methods

Stock Valuation
The method of valuing a bond shown in Study Unit 4, Subunit 1, can also be used for preferred stock.
● If the preferred dividend rate is less than what is prevalent in the market, then the preferred stock
will sell at less than its par value.

● A dividend rate higher than the market average (based on a similar risk level) will result in the
preferred stock selling at a premium.

● The discount rate used would normally be higher than that used for a bond valuation because a
preferred stock is slightly more risky than a bond but has few additional advantages (other than the
advantage that preferred dividends are sometimes taxed at lower tax rates than bond interest).

Common stocks can be valued in the same way, but the return is based on earnings per share rather
than dividend level. Also, with common stocks, the future returns are pure estimates, so there is
usually a heavy risk premium incorporated into the calculation.
● For example, if a bond could be sold at its face value based on an 8% interest rate, a similar
preferred stock might necessitate a 10% return because of the increased risk.
■ At the same time, a common stock might have to be valued on an assumed return of 20%.
Because investors in common stock fear the risk of never getting future returns, a high risk
premium must be used to calculate the common stock’s value.

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 SU 6: Valuation Methods and Cost of Capital 3

The Constant Growth Dividend Discount Model

The constant growth dividend discount model (also known as the dividend growth model) is a
method of arriving at the value of a stock by using expected (next) dividends per share and
discounting them back to present value. The formula is as follows:

● This method is used when dividends are expected to grow at a constant rate. If the value
obtained using this formula is greater than the stock’s current fair market value, then the stock is
considered to be undervalued (meaning it is worth more than its fair market value).
■ The expected dividend is calculated using the growth rate of the company.

t
Expected dividend = Last annual dividend paid × (1 + Growth rate)
t = time (years, months, periods, etc.)

Example 6-1 Dividend Growth Model -- Value of Stock Currently

A company recently paid an annual dividend of $10. Dividends have grown steadily at a rate of 5% and
are expected to continue indefinitely. Investors require a 12% rate of return (cost of capital) for similar
investments. The value of this stock can be calculated as follows:

Example 6-2 Dividend Growth Model -- Value of Stock in 4 Years

A company recently paid an annual dividend of $10. Starting next year, it will implement a 5% yearly
dividend growth policy. Investors require a 12% return. The value of this stock in 4 years can be calculated
as follows:

4
Step 1: Dividend at the end of 4 years = $12.16 ($10 × 1.05)

$12.16 × (1.05)
Step 2: = $182.40
.12 – .05

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4 SU 6: Valuation Methods and Cost of Capital

Common Stock with Variable Dividend Growth

Dividends do not always grow at a constant rate. This can make stock valuation more difficult. Many
companies experience a two-stage growth.
● In the initial phase, growth can be very rapid and unstable.
● In the second phase, growth slows down and stabilizes.

In these situations, the two-stage dividend discount model can be used to effectively calculate the
stock value. This calculation requires three steps:
1. Calculate and sum the present value of dividends in the period of high growth.
2. Calculate the present value of the stock based on the period of steady growth, discounting the
value back to Year 1.
3. Sum the totals calculated in Step 1 and Step 2.

Example 6-3 Dividend Growth Model -- Variable Growth

Rapido Company expects to pay an annual dividend of $5 at the end of this year. Annual growth is
expected to be at 20% for the next 2 years, after which growth is expected to stabilize at 8%. Investors
require a 12% rate of return (cost of capital) for similar stock.

Step 1: Calculate and sum the present value of dividends in the period of high growth.

End of
Year Dividend PV Factor at 12% PV of Dividend
1 $5.00 .893 $ 4.47
2 $5 × (1 + .20) = $6.00 .797 4.78
3 $6 × (1 + .20) = $7.20 .712 5.13
Total PV of Dividends $14.38

Step 2: Calculate the present value of the stock based on the period of steady growth and discount it back
to Year 1. This is done using the constant growth dividend discount model. The end of Year 4 dividend is
$7.78, calculated by taking the end of Year 3 dividend and multiplying it by 1 plus the Year 4 rate [$7.20 ×
(1 + .08)].

Dividend per share $7.78

= = $194.50
Discount rate – Dividend growth rate .12 – .08

Then discount the value back to Year 1, using the present value factor from the Year 3 row in the Present
Value table above.

$194.50 × .712 = $138.48

Step 3: Sum the totals calculated in Step 1 and Step 2.

$14.38 + $138.48 = $152.86

Based on the two-stage dividend discount model, $152.86 is an appropriate value for this stock, given the
projected dividends per share and cost of capital.

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 SU 6: Valuation Methods and Cost of Capital 5

Preferred Stock Valuation

Preferred stock usually pays a fixed dividend. This formula also can be used when dividends on
common stock are not expected to grow. The value of the stock can be calculated as follows:

Example 6-4 Preferred Stock Valuation

Several years ago, a company issued preferred stock that pays a fixed dividend each year of $12.
Investors require a 15% rate of return (cost of capital) for similar preferred stock. The value of this stock
can be calculated as follows:

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6 SU 6: Valuation Methods and Cost of Capital

6.2 Cost of Capital -- Current

Investors provide funds to corporations with the understanding that management will deploy those
funds in such a way that the investor will ultimately receive a return.
● If management does not generate the investors’ required rate of return, the investors will take
their funds out of the corporation and redirect them to more profitable ventures.
■ For this reason, the investors’ required rate of return (also called their opportunity cost of
capital) in turn becomes the firm’s cost of capital.

A firm’s cost of capital is typically used to discount the future cash flows of long-term projects, since
investments with a return higher than the cost of capital will increase the value of the firm, i.e.,
shareholders’ wealth. (The cost of capital is not used in connection with working capital because
short-term needs are met with short-term funds.)

Component Costs of Capital

As described in Study Unit 4, Subunits 1 and 2, a firm’s financing structure consists of three
components: long-term debt, preferred equity, and common equity (retained earnings are treated as
part of common equity in this analysis for reasons provided on the following page).

Figure 6-1

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 SU 6: Valuation Methods and Cost of Capital 7

The rate of return demanded by holders of each is the component cost for that form of capital.
● The component cost of debt is the after-tax interest rate on the debt (interest payments are tax-
deductible by the firm):

Effective rate × (1.0 – Marginal tax rate)

● The component cost of preferred stock is computed using the dividend yield ratio:

Cash dividend on preferred stock ÷ Market price of preferred stock

● The component cost of common stock is also computed using the dividend yield ratio:

Cash dividend on common stock ÷ Market price of common stock

● In theory, the component cost of retained earnings is the same as that for common stock.
If the firm has no profitable use for retained earnings, it should be distributed to the common
shareholders in the form of dividends so they can find their own investments. However, the cost of
retained earnings normally is lower than the cost of common stock because of issuance costs.

Providers of equity capital are exposed to more risk than are lenders because
● The firm is not legally obligated to pay them a return.
● In case of liquidation, equity investors trail creditors in priority.

To compensate for this higher level of risk, equity investors demand a higher return, making equity
financing more expensive than debt.

CMA candidates will need to be able to determine the weighted-average cost of capital
(WACC) and how it is applied in capital structure decisions. On the CMA exam, you will be
expected to calculate WACC and the marginal cost of capital (discussed in Subunit 6.3)
and demonstrate that you understand how they will affect investment decisions for a
business.

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8 SU 6: Valuation Methods and Cost of Capital

Weighted-Average Cost of Capital

Corporate management usually designates a target capital structure for the firm, i.e., the
proportions that each component of capital should comprise in the overall combination. An example
might be 10% debt, 20% preferred stock, and 70% common stock.

Figure 6-2

A firm’s weighted-average cost of capital (WACC) is a single, composite rate of return on its
combined components of capital. The weights are based on the components’ respective market
values, not book values, because market value provides the best information about investors’
expectations.

Example 6-5 Weighted-Average Cost of Capital

The following excerpt is from a firm’s most recent balance sheet:

Carrying
Component Amount Proportions
11.4% Bonds Payable $ 2,200,000 10.00%
11.5% Preferred Stock 4,600,000 20.91%
Common Stock 14,000,000 63.64%
Retained Earnings 1,200,000 5.45%
Totals $22,000,000 100.00%

-- Continued on next page --

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 SU 6: Valuation Methods and Cost of Capital 9

Example 6-5 -- Continued

In order to calculate its WACC, the firm must first determine the component costs of long-term debt and
preferred equity. The company has historically provided a 16% return on common equity. The firm is in a
35% marginal tax bracket. Assume that the market price of the preferred stock is the same as the book
value.

Component cost of long-term debt = Effective rate × (1.0 – Marginal tax rate)
= 11.4% × (1.0 – .35)
= 7.41%
Component cost of preferred equity = Cash dividend ÷ Market price of stock
= ($4,600,000 × 11.5%) ÷ $4,600,000
= 11.5%

The firm can now determine its WACC by multiplying the cost of each component of capital by the
proportion of total market value represented by that component.

(1) (2) (3) (2) × (3)

Market Component Weighted
Component Value Weight Cost Cost
11.4% Bonds Payable $ 2,200,000 10.00% × 7.41% = 0.7410%
11.5% Preferred Stock 4,600,000* 20.91% × 11.5% = 2.4047%
Common Stock 14,000,000 63.64% × 16.0% = 10.1824%
Retained Earnings 1,200,000 5.45% × 16.0% = 0.8720%
Totals $22,000,000 100.00% 14.2001%

*The par value of the preferred stock is assumed to be equal to the market value.

Generally, the component cost of retained earnings is considered to be the same as that for common
stock.

The firm will invest in projects that have an expected return that is greater than 14.2001% (firm’s WACC).
These projects will generate additional free cash flow and will create positive net present value for the
shareholders.

Example 6-6 WACC -- No Preferred Stock

A firm provides the following information:

Capital used to generate profits

50% debt, 50% equity $1,200
Cost of equity 15%
Cost of debt 5%
Corporate tax rate 40%

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10 SU 6: Valuation Methods and Cost of Capital

Standard financial theory provides a model for the optimal capital structure of every firm. This
model holds that shareholder wealth-maximization results from minimizing the weighted-average
cost of capital. Thus, the focus of management should not be on maximizing earnings per share
(EPS can be increased by taking on more debt, but debt increases risk).

The relevant relationships are depicted below:

Figure 6-3

NOTE: Ordinarily, firms cannot identify this optimal point precisely. Thus, they should attempt to find
an optimal range for the capital structure.

Impact of Income Taxes on Capital Structure and Capital Decisions

Taxes are an important consideration because they can be anywhere from 25% to 50% of income.

Interest is a tax-deductible expense of the debtor company, but dividends are not deductible. Thus,
a company needing capital would prefer to issue bonds rather than stock because the interest would
be deductible. As a result, the issuer would prefer to issue debt because the interest is deductible, but
the investor would prefer stock because interest on debt is fully taxable while the return on stock is
only partially taxable or taxable at special low rates. Similarly, a corporation may be reluctant to issue
common stock because it does not want to share control of the company, but the investor may prefer
stock because of the favorable tax treatment.

Multinational corporations frequently derive income from several countries. The government of each
country in which a corporation does business may enact statutes imposing one or more types of
tax on the corporation, so any capital decision affecting multiple countries must consider the tax
provisions of each nation.

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 SU 6: Valuation Methods and Cost of Capital 11

6.3 Cost of Capital -- New

Marginal Cost of Capital

While internally generated capital provides a supply of needed capital, a firm cannot rely solely on
retained earnings to fund new projects.
● Retained earnings alone are rarely sufficient to fund all of a corporation’s long-term needs.

● Maintaining the firm’s optimal capital structure may require the issuance of new securities at some
point.

The marginal cost of capital (MCC) is the weighted-average cost to the firm of the next dollar of new
capital raised after existing internal sources are exhausted.
● Each additional dollar raised becomes increasingly expensive as investors demand higher returns
to compensate for increased risk.

Example 6-7 Marginal Cost of Capital

A company has determined that it requires $4,000,000 of new funding to fulfill its plans. Retained earnings
of $1,200,000 are insufficient, and the firm wants to maintain its capital structure of 10% long-term debt,
20% preferred stock, and 70% common stock (which includes retained earnings). The cost of raising the
$2,800,000 shortfall between retained earnings and funding needs will be at some rate above the current
WACC.

Figure 6-4

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12 SU 6: Valuation Methods and Cost of Capital

Cost of New Capital

The cost of new capital (also called external capital) is the ratio of what the firm must pay to what the
firm gets.
● Because of interest rate fluctuations, the cost of new debt will rarely be the historical, or
embedded, rate. Also, if the firm’s debt load is already considerable, new debtholders will demand
a higher interest rate to compensate for the increased risk. The cost of new debt is calculated as
follows:

Annual interest ÷ Net issue proceeds

■ As tax rates rise, the deductibility of interest makes debt a more attractive financing option.

● All new issues of equity securities involve the payment of flotation costs, which reduce the
proceeds received, thereby raising the cost of capital. The cost of new preferred stock is
calculated as follows:

Next dividend ÷ Net issue proceeds

● The cost of new common stock is commonly calculated using the dividend growth model (also
known as the discounted cash flow method), which anticipates that common shareholders will
demand steadily increasing dividends over time (while assuming that the dividend payout ratio will
remain constant). The cost of new common stock is calculated as follows:

(Next dividend ÷ Net issue proceeds) + Dividend growth rate

■ An issue of new common stock is used mostly by young, growing companies. Mature firms
rarely issue new common stock to the general public because of the issue costs involved and
the depressing influence a new issue can have on the stock’s price.

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 SU 6: Valuation Methods and Cost of Capital 13

Example 6-8 Cost of New Capital

A company’s current capital structure is 10% debt, 20% preferred stock, 40% common stock, and 30%
retained earnings.

A company has determined that it requires $4,000,000 of new funding to fulfill its plans. Retained earnings
are sufficient to cover 30% of the firm’s new capital needs ($1,200,000 ÷ $4,000,000). The rest must come
from the other three components of capital.

The company can issue new debt at a cost of 12.6%. The firm can also sell $100 par value preferred
stock that pays a 14% dividend and has $5-per-share flotation costs. The $1,200,000 balance of retained
earnings will be used, and the remainder will come from an issue of common stock. The new common
stock will pay an $8 dividend that is expected to grow 2% annually. The company’s common stock is
currently trading at $55 per share, and the new issue will have $3-per-share flotation costs.

Cost of new long-term debt = 12.6% (given)

Cost of new preferred stock = Next dividend ÷ Net issue proceeds
= $14 ÷ ($100 – $5)
= 14.7%
Cost of new common stock = (Next dividend ÷ Net issue proceeds) + Dividend growth rate
= [$8 ÷ ($55 – $3)] + 2%
= 15.4% + 2%
= 17.4%
Cost of retained earnings = ($8 ÷ $55) + 2% = 16.55%*

*The component cost of retained earnings is the same as that for common stock (discussed in
Subunit 6.2).

If the company maintains its current capital structure, the weighted-average cost of capital for this round of
capital formation is calculated as follows:

Cost of Weighted
Component Weight Capital Cost
New long-term debt 10% × 12.6% = 1.26%
New preferred stock 20% × 14.7% = 2.94%
New common stock 40% × 17.4% = 6.96%
Retained earnings 30% × 16.6% = 4.98%
Total 16.14%

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14 SU 6: Valuation Methods and Cost of Capital

6.4 Options and Derivatives

A derivative instrument is an investment transaction in which the parties’ gain or loss is derived
from some other economic event, for example, the price of a given stock, a foreign currency
exchange rate, or the price of a certain commodity.
● One party enters into the transaction to speculate (incur risk), and the other enters into it to hedge
(avoid risk).

Derivatives are a type of financial instrument, along with cash, accounts receivable, notes receivable,
bonds, preferred shares, common shares, etc. Derivatives are not, however, claims on business
assets, such as those represented by equity securities.

Hedging
Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse
price movements.

A person who would like to sell an asset in the future has a long position in the asset because (s)he
benefits from a rise in value of the asset.

Example 6-9 Long Position

An investor buys 100 shares of Collerup Corporation stock. The investor now has a long position in
Collerup Corporation. In financial market terminology, it is called “long Collerup.”

To protect against a decline in value, the owner can enter into a short hedge, i.e., obtain an
instrument whose value will rise if the asset’s value falls.
● EXAMPLE: A soybean farmer hopes that the price of soybeans will rise by the time her crop is
ready to go to market. The farmer is thus long in soybeans. To protect against the possibility that
the price will fall in the meantime, she can obtain a short hedge. This arrangement is a cash-flow
hedge because the intent of the transaction is to avoid risks attributable to future cash flows.

A person who would like to buy an asset in the future has a short position in the asset because
(s)he benefits from a fall in value of the asset.
● Typically, the entity with the short position must borrow the asset from an entity that owns it before
the “short sale” occurs.

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 SU 6: Valuation Methods and Cost of Capital 15

Example 6-10 Short Position

Money Management Fund A believes that the share price of Collerup Corporation will decrease (perhaps
due to a future poor earnings announcement). Fund A therefore borrows a block of Collerup shares from
Fund B, which Fund A then sells on the appropriate stock exchange. Fund A is selling short because the
fund can replace the borrowed shares later when the share value falls.
● If the price of Collerup decreases, Fund A can repurchase the shares at the lower price and return
them to Fund B, making a profit.
● If Fund A guessed wrong and the share price of Collerup remains the same or increases, then, to fulfill
its obligation to return the borrowed shares to Fund B, Fund A must purchase the shares on the stock
exchange (at the higher price), incurring a loss.

To protect against a rise in value, the party can enter into a long hedge, i.e., obtain an instrument
whose value will rise if the asset’s value rises.
● EXAMPLE: An agricultural wholesaler hopes that the price of soybeans will fall by the time farmers
bring their harvests to the warehouse. The wholesaler is thus short in soybeans. To protect against
the possibility that the price will rise in the meantime, the wholesaler can obtain a long hedge.

A fair-value hedge is an instrument that hedges the exposure to changes in fair value of an asset or
liability.

A natural hedge relies on normal operations to mitigate risk. It does not involve sophisticated
financial products.
● For example, financing a purchase of long-lived equipment over the same period as the life of the
equipment is a form of hedge.

Options
Options are the most common form of derivative.
● A party who buys an option has bought the right to demand that the counterparty (the seller or
“writer” of the option) perform some action on or before a specified future date.
● The exercise of an option is always at the discretion of the option holder (the buyer) who has, in
effect, bought the right to exercise the option or not. The seller of an option has no choice; (s)he
must perform if the holder chooses to exercise.

An option has an expiration date after which it can no longer be exercised.

Determining the correct price for an option is a complex calculation.

● The exercise price (or strike price) is the price at which the owner can purchase or sell the asset
underlying the option contract.
● The option price, also called option premium, is the amount the buyer pays to the seller to
acquire an option. Option price is always based on supply and demand.
■ Intrinsic value is the value of the option if it was exercised immediately.
■ Time value is the amount of money an option costs in excess of the intrinsic value.

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16 SU 6: Valuation Methods and Cost of Capital

Options can be classified by their underlying assets.

● A stock option is an option whose underlying asset is a traded stock.

● An index option is an option whose underlying asset is a market index. If exercised, settlement is
made by cash since delivery of the underlying is impossible.

● Long-term equity anticipation securities (LEAPS) are examples of long-term stock options or index
options, with expiration dates up to 3 years away.

● Foreign currency options give the holder the right to buy a specific foreign currency at a
designated exchange rate.

Option Terminology
“In-the-money” means that the option has a positive intrinsic value. Thus, if it were exercised
immediately, there would be value.

“Out-of-the-money” means the option has no intrinsic value. Thus, if it were exercised immediately,
there would be no value.

“At-the-money” means the option’s exercise price (or strike price) is identical to the price of the
underlying stock.

Call Options
A call option gives the buyer (holder) the right to purchase (i.e., the right to “call” for) the underlying
asset (stock, currency, commodity, etc.) at a fixed price.

Option is . . . Price Relationship Decision

In-the-money Price of underlying > Exercise price Exercise option at a bargain price

Out-of-the-money Price of underlying < Exercise price Option is not worth exercising

A call option represents a long position to the holder because the holder benefits from a price
increase.
● The seller (writer) of a call option hopes the price of the underlying will remain below the exercise
price because (s)he must make the underlying available to the holder at the strike price, regardless
of how much the seller must pay to obtain it. The seller of a call option is thus taking a short
position.

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 SU 6: Valuation Methods and Cost of Capital 17

The buyer’s gain (loss) necessarily mirrors the seller’s loss (gain). The amount of gain and loss on a
call option can be calculated as follows:

Buyer/holder (long position)

Units of underlying × (Excess of market price over exercise price – Option price)

Seller/writer (short position)

Units of underlying × (Option price – Excess of market price over exercise price)

Example 6-11 In-the-Money Call Option

Tapworth Co. bought call options giving it the right to buy 100 shares of PanGlobal Corp. stock in 30 days
at $100 per share. Smith Co. sold these options to Tapworth for $3 per share. On Day 30, PanGlobal stock
is trading at $105 and Tapworth exercises all of its options (since the options give Tapworth the right to
buy PanGlobal stock at a better-than-market price). Tapworth’s and Smith’s respective gains and losses
on the transaction can be calculated as follows:

Buyer’s gain (loss) = 100 call options × [($105 – $100) – $3] = $200 gain
Seller’s gain (loss) = 100 call options × [$3 – ($105 – $100)] = $(200) loss

Example 6-12 Out-of-the-Money Call Option

Following from Example 6-11, on Day 30, PanGlobal stock is trading at $97 and Tapworth’s options are
worthless (since having the right to buy PanGlobal at $100 gives Tapworth no advantage over buying
on the open market). Tapworth’s and Smith’s respective gains and losses on the transaction can be
calculated as follows:

Buyer’s gain (loss) = 100 call options × ($0 – $3) = $(300) loss
Seller’s gain (loss) = 100 call options × ($3 – $0) = $300 gain

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18 SU 6: Valuation Methods and Cost of Capital

The relationship between the buyer and seller of a call option is depicted in the following diagram:

Figure 6-5

Put Options
A put option gives the buyer (holder) the right to sell (i.e., the right to “put” onto the market) the
underlying asset (stock, currency, commodity, etc.) at a fixed price.

Option is . . . Price Relationship Decision

In-the-money Price of underlying < Exercise price Exercise option

Out-of-the-money Price of underlying > Exercise price Option is not worth exercising

A put option represents a short position to the holder because the holder benefits from a price
decrease.
● The seller (writer) of a put option hopes the price of the underlying investment will remain above
the exercise price, since (s)he must buy from the holder at the strike price, regardless of the fact
that the same underlying can be obtained for less in the open market. The seller of a put option is
thus taking a long position.

The buyer’s gain (loss) necessarily mirrors the seller’s loss (gain). The amount of gain and loss on a
put option can be calculated as follows:
Buyer/holder (short position)
Units of underlying × (Excess of exercise price over market price – Option price)

Seller/writer (long position)

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 SU 6: Valuation Methods and Cost of Capital 19

Units of underlying × (Option price – Excess of exercise price over market price)

Example 6-13 In-the-Money Put Option

Tapworth Co. bought put options giving it the right to sell 100 shares of PanGlobal Corp. stock in 30 days
at $100 per share. Smith Co. sold these options to Tapworth for $3 per share. On Day 30, PanGlobal
stock is trading at $92 and Tapworth exercises all of its options (since the options give Tapworth the right
to sell PanGlobal stock at a price higher than the one prevailing in the market). Tapworth’s and Smith’s
respective gains and losses on the transaction can be calculated as follows:

Buyer’s gain (loss) = 100 put options × [($100 – $92) – $3] = $500 gain
Seller’s gain (loss) = 100 put options × [$3 – ($100 – $92)] = $(500) loss

Example 6-14 Out-of-the-Money Put Option

Following from Example 6-13, on Day 30, PanGlobal stock is trading at $104 and Tapworth’s options are
worthless (since having options to sell PanGlobal at $100 gives Tapworth no advantage over selling on the
open market). Tapworth’s and Smith’s respective gains and losses on the transaction can be calculated as
follows:

Buyer’s gain (loss) = 100 put options × ($0 – $3) = $(300) loss
Seller’s gain (loss) = 100 put options × ($3 – $0) = $300 gain

The relationship between a buyer and seller of a put option is depicted in the following diagram:

Figure 6-6

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20 SU 6: Valuation Methods and Cost of Capital

Valuing an Option
The two most well-known models for valuing options are the Black-Scholes formula for call options
and the binomial method. The equations themselves are extremely complex and beyond the scope
of an accounting text, but some general statements can be made about the factors that affect the
outcomes.
● Exercise price. In general, the buyer of a call option benefits from a low exercise price. Likewise,
the buyer of a put option generally benefits from a high exercise price.
■ Thus, an increase in the exercise price of an option results in a decrease in the value of a call
option and an increase in the value of a put option.

● Price of underlying. As the price of the underlying increases, the value of a call option also will
increase; the exercise price is more and more of a bargain with each additional dollar in the price
of the underlying.
■ By the same token, the value of a put option will decrease as the price of the underlying
increases since there is no advantage in selling at a lower-than-market price.

● Interest rates. Buying a call option is like buying the underlying on credit. The purchase of the
option is a form of down payment. If the option is exercised in a period of rising interest rates, the
exercise price is paid in inflated dollars, making it more attractive for the option holder.
■ A rise in interest rates will therefore result in a rise in the value of a call option and a fall in the
value of a put option.

● Time until expiration. The more time that passes, the riskier any investment is.

■ Thus, an increase in the term of an option (both calls and puts) will result in an increase in the
value of the option.

● Volatility of price of underlying. The price of an asset can drop no lower than zero. Thus, there
is a natural limit to the potential downside loss for either party to an option transaction. On the
upside, however, there is much greater flexibility. Thus, parties to an option transaction will prefer
volatility.
■ An increase in the volatility of the price of the underlying will result in an increase in the value of
the option (both calls and puts).

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 SU 6: Valuation Methods and Cost of Capital 21

These factors and their effects can be summarized as follows:

Value of call Value of put

Increase in
option will option will

Exercise price of option Decrease Increase

Price of underlying Increase Decrease

Interest rates Increase Decrease

Time until expiration Increase Increase

Volatility of price of underlying Increase Increase

Forward Contracts
One method of mitigating risk is the simple forward contract. The two parties agree that, at a set
future date, one of them will perform and the other will pay a specified amount for the performance.
● A common example is that of a retailer and a wholesaler who agree in September on the prices
and quantities of merchandise that will be shipped to the retailer’s stores in time for the winter
holiday season. The retailer has locked in a price and a source of supply, and the wholesaler has
locked in a price and a customer.

The party that has contracted to buy the underlying at a future date has taken a long position, and the
party that has contracted to deliver the underlying has taken a short position. The payoff structure is
similar to that for options:
● If the market price of the underlying on the delivery date is higher than the contractual price, the
party that has taken the long position benefits, since (s)he has locked in a lower price.

● If the market price of the underlying on the delivery date is lower than the contractual price, the
party that has taken the short position benefits, since (s)he is entitled to receive higher payment for
the underlying than the amount currently prevailing in the market.

Note the significant difference between a forward contract and an option: In a contract, both parties
must meet their contractual obligations, i.e., to deliver merchandise and to pay. Neither has the
choice of nonperformance. With an option, only one party has to perform. The holder (buyer) of the
option has the option of either performing or not performing.

A forward contract is appropriate for a retailer and a wholesaler who are exchanging very specific
merchandise and can take the time to address all the facets of the contract.
● Traders in undifferentiated commodities, such as grains, metals, fossil fuels, and foreign
currencies, often do not have this luxury. The trading process of these products is eased by the
use of futures contracts.

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22 SU 6: Valuation Methods and Cost of Capital

Futures Contracts
A futures contract is a commitment to buy or sell an asset at a fixed price during a specific future
month; unlike with a forward contract, the counterparty is unknown.

Futures contracts are actively traded on futures exchanges.

● Because futures contracts are for delivery during a given month, not a specific day, they are more
flexible arrangements than forward contracts.

● The clearinghouse randomly matches sellers who will deliver during a given month with buyers
who are seeking delivery during the same month.

Because futures contracts are actively traded, the result is a liquid market in futures that permits
buyers and sellers to net out their positions.
● For example, a party who has sold a contract can net out his or her position by buying a futures
contract. In contrast, a person holding a forward contract does not enjoy this liquidity.

Another distinguishing feature of futures contracts is that their prices are marked to market every
day at the close of the day to each person’s account. Thus, the market price is posted at the close of
business each day.
● A mark-to-market provision minimizes a futures contract’s chance of default because profits and
losses on the contracts must be received or paid each day through a clearinghouse.

● This requirement of daily settlement minimizes default and is necessary because futures contracts
are sold on margin (i.e., they are highly leveraged).

Another difference is that a party to a forward contract typically expects actual delivery; futures
contracts are generally used as financial tools to offset the risks of changing economic conditions.
Thus, the two parties simply exchange the difference between the contracted price and the market
price prior to the expiration date.
● This is why a trader who does not want to accidentally have to settle in a certain month buys a
future for the following month.

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 SU 6: Valuation Methods and Cost of Capital 23

Example 6-15 Hedge of a Futures Contract

On August 1, Year 1, a firm wishes to hedge 120,000 Brazilian reals that it is contractually due to receive
on November 7, Year 1. The spot rate on August 1, Year 1, is 3 USD/BRL. The firm sells a 100,000
December Year 1 Brazilian real futures contract at 2.8 USD/BRL. On November 1, Year 1, the company
buys a 100,000 December Year 1 Brazilian real futures contract at 2.9 USD/BRL. The company then
translates 120,000 reals into U.S. dollars by selling 120,000 reals on the spot market, which is trading at
2.92 USD/BRL.

(2.8 USD/BRL – 2.9 USD/BRL) × 100,000 BRL = $ (10,000)

120,000 BRL × 2.92 USD/BRL = $350,400
Net proceeds = $340,400
Effective exchange rate = 340,400 USD ÷ 120,000 BRL = 2.84

NOTE: The spot rate is the number of units of a foreign currency that can be received today in exchange
for a single unit of the domestic currency.

Swaps
Swaps are contracts by which the parties exchange cash flows.
● Interest rate swaps are agreements to exchange interest payments based on one interest
structure for payments based on another structure. These agreements are highly customized.
■ For example, a firm that has fixed debt service charges may enter into a swap with a
counterparty that agrees to supply the first party with interest payments based on a floating rate
that more closely tracks the first party’s revenues.

● Currency swaps are agreements to exchange cash flows denominated in one currency for cash
flows denominated in another.
■ For example, a U.S. firm with revenues in euros has to pay suppliers and workers in dollars, not
euros. To minimize exchange-rate risk, it might agree to exchange euros for dollars held by a
firm that needs euros.
■ The exchange rate will be an average of the rates expected over the life of the agreement.

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