FFM Assignment

Finance and Financial Management Assignment

A Executive Summary

This report includes workings on 4 questions of Finance and Financial Management assignment

Question 1 was on Capital Expenditure Decision and Investment Criteria. It was answered with workings of NPV, IRR, and Payback Period of a drug project under consideration for capital budgeting decision. The assumptions made were specified and discussed. The resulting NPV of the project was subjected to Sensitivity Analysis on independent variables, findings interpreted and critical determinants of NPV were summarized.

Question 2 was on Interpretation of Price-Earnings Ratios. The given share prices and PE ratios were compared to understand company position and comparisons were made using PE ratios. Possible reasons for varying PE ratios between 2 retail chain companies were summarized and explained.

Question 3 was on Portfolio Management. From a given list of securities, a random selection was made on equally weighted basis to make a portfolio and analysis of individual and average monthly returns, standard deviation, covariance and correlation coefficients were calculated using formula and routine statistical models. Varying number of securities was chosen randomly to develop equally weighted portfolios of varying number of securities to study the affect of number of securities on the risk of the portfolio. Results were summarized and interpreted.

Question 4 was on Options Traded on Stock Market. Profit diagram was drawn for a call option, call premiums were explained, straddle diagram was drawn and explained and a comment was made on the contention that options are a zero sum game for the writer and investor options.

(Word Count 248)

1 Capital Expenditure Decisions and Investment Criteria : Bala Chemicals

Page 1 of 56


1.1 Capital budgeting decision of Bala Chemicals: Project’s Net Present Value, Internal Rate of Return, and Payback Period. Key assumptions and their implications on the analysis.

From the given financial details of the pharmaceutical division of Bala Chemicals which is ready to introduce a new pain killer designed to provide relief for muscle injuries incurred as a result of sporting activities, a product developed through a major research and testing programme, Income Statement (Table 1.1) and Cash Flow Statement (Table 1.2) were made and presented in the following pages. From these details, the Net Present Value (NPV) (Table 1.3), Internal Rate of Return (IRR) (Table 1.4) and Payback Period (Table 1.5) were calculated and presented in the following pages.

The Net Cash Flows were found to be £6.05 millions (year 1), £8.52 millions (year 2), £8.52 millions (year 3), £8.52 millions (year 4) and £10.62 millions (year 5) with an outlay of £13.85 millions at the beginning of the project (year 0) (Table 1.2).

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. A project with positive NPV can be accepted and with a negative NPV should be rejected (2)

The projects NPV was found to be £ 12.92 millions (Table 1.3) for the 5 years of product life and at a required rate of interest of 16%. This positive and high NPV value should support project acceptance decision.

Page 2 of 56


Page 3 of 56


Page 4 of 56


Page 5 of 56


Internal Rate of Return is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. The higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first (3).

The Internal Rate of Return (IRR) was found to be very high at 48.13% (Table 1.4) demonstrating the high potential of the project as it is 3 times the required rate of interest, 16%. This is very high IRR and indicates the growth potential of this project. This project could be accepted bases on its IRR

Payback is the he length of time required to recover the cost of an investment (4). It is calculated as [(cost of project) / (annual cash flows)]. All other things being equal, the better investment is the one with the shorter payback period. Payback ignores any benefits that occur after the payback period and, therefore, does not measure profitability and also ignores time value of money. The later limitation can be overcome by calculating discounted cash flows. With the given high IRR, the corresponding Payback Period was low at 19 months (1 year 7 months) on undiscounted cash flows and was at 29 months (2 years 5 months) on discounted cash flows (Table 1.5). The assumption made here was that the cash flows were distributed equally throughout the year.

The underlying key assumptions for the above analysis were specified and discussed below:

The basic assumptions inherently and unavoidably common to all NPV calculations are that 1) the benefits and costs can be identified, predicted and quantified in financial terms and 2) the appropriate discount rate for each period can be identified. Other assumptions include, 3) the discount rate is the actual or implied rate of interest on a financial instrument, commonly a bank account, 4) the discount rate is constant over time, 5) tax is not relevant, 6) risk is not relevant, or is included in the discount rate 7) inflation rates on prices of inputs and outputs are identical and constant. 8) Productivity growth over time is zero 9) no borrowings for this project, financed by equity 10) product will have a life time of 5 years (competitors are developing a better drug), 11) demand for the drug exists for the next 5 years at the forecasted figures 12) introduction of more effective products into market will render the current drug unprofitable to market and hence it should be withdrawn from market end of 5 years, 13) the increase in debtors as a

Page 6 of 56


result of introducing the product will just about be offset by the increase in creditors 14) only 25% of the unit sales expected in the subsequent year are to he held by the company.

An upward movement of costs considered (direct and fixed costs can reduce the NPV. Unforeseen inflation and other economical pressures could induce this movement. A sudden crash in the world economy may alter the discount rate and thus impacts NPV. A reduction in discount rate would increase the NPV while an increase in discount rate would tumble the NPV. Its varying nature could not support a proper calculation of NPV with assumptions. Tax may be relevant, a shift in taxes will alter cash flows and hence NPV. The discount rate may not cover unforeseen risk. Risk can arise from poor market demand, failure of product, consumer dissatisfaction and complaints, new competitors’ entry etc. Productivity growth may be significant that could affect the NPV positively or negatively. Borrowings may alter cash flows and affect the NPV. The drug under consideration either may last more than 5 years (increased NPV) due to delayed entry of competitors or shorter than 5 years (reduced NPV) due to early entry of competitors or other product related challenges. The increase in debtors as a result of introducing the product may not just about be offset by the increase in creditors. Increasing debtors and reducing creditors will show on the working capital cycle adversely. The forecasted 25% additional requirement may be less or more. If it is less, there would be loss of sales and it is more, there would be an increase in stock holding, increase in related costs, possible increase in debtors, pressure from creditors and unnecessary investment in stock, possible loss in revenues due to trade discounts to be given to drive the stock quickly out of factory premises.

Some of these assumptions were obvious due to lack of information. The above assumptions are justified as in their absence, the NPV calculation may becomes more complicated and also the resulting NPV may lead to the risk of opting for sub-optimal investment decisions.

The following costs were not considered in NPV calculation and analysis

£10 million expenditure incurred on the development of the product as it was a sunk cost (already incurred)

£0.3 million annual charge (book charge) toward the production facility as it is irrelevant

1.2 Use of sensitivity analysis and identification of critical determinants of the NPV of the proposed investment and interpretation of results.

Page 7 of 56


NPV analysis requires many assumptions and projections, all leading to one number, the NPV. If some of the projections are not correct then the NPV would be altered.

Sensitivity Analysis technique is used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions (5). It helps us to consider how NPV is affected by forecasts of key variables. It examines how changes in underlying assumptions affect NPV using a range of values for annual revenues, costs, etc. Each variable is examined at a time. It is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s).

Sensitivity Analysis was done for the Bala Chemicals (Pharmaceutical division) new drug project under consideration. The independent variables considered to affect the dependant variable (NPV) were 1) sales volume, 2) direct cost, 3) discount rate, 4) fixed cost and 5) working capital.The impact on NPV of a gradual decrease in sales volume was plotted in Graph 1.1 and presented below. It was found that 1% decrease in sales volume would bring down NPV by an absolute £0.25 millions (decreased by 1.95%). When the sales volume was decreased by 51.75%, the NPV of the project would become Zero.

Page 8 of 56


The impact on NPV of a gradual increase in direct cost was plotted in Graph 1.2 and presented below. It was found that 1% increase in direct cost would bring down NPV by an absolute £0.12 millions (decrease by 0.92%). When the direct cost was increased by 110%, the NPV of the project would become Zero.

Page 9 of 56


The impact on NPV of a gradual increase in discount rate was plotted in Graph 1.3 and presented below. It was found that 1% increase in discount rate would bring down NPV by an absolute £0.11 millions (decrease by 0.85%). When the direct cost was increased by 200.7%, the NPV of the project would become Zero.

Page 10 of 56


The impact on NPV of a gradual increase in fixed cost was plotted in Graph 1.4 and presented below. It was found that 1% increase in fixed cost would bring down NPV by an absolute £0.01 millions (decrease by 0.10%). When the direct cost was increased by 1233%, the NPV of the project would become Zero.

Page 11 of 56


The impact on NPV of a gradual increase in working capital was plotted in Graph 1.5 and presented below. It was found that 1% increase in fixed cost would bring down NPV by an absolute £0.01 millions (decrease by 0.07%). When the direct cost was increased by 1760%, the NPV of the project would become Zero.

Page 12 of 56


Page 13 of 56


From the above analysis it was observed that the highest influencing independent variable is decreasing Sales Volume (1.95%). The second set of influencing independent variables is having just half the impact of decreasing Sales Volume and includes increasing Direct Cost (0.92%) and Discount Rate (0.85%). e lowest influencing set of independent variables is increasing Fixed Cost (0.1%) and Working Capital (0.07%).

Hence, the impact of decreasing sales volumes, increasing direct cost and discount rate would alter NPV of the project under consideration significantly. Impact on NPV of a decrease in fixed cost and working capital on is relatively insignificant. A combined impact of 30% decrease in sales volume, 30% increase in fixed cost and discount rate would be a result in a reduction of £10.27 millions in NPV (79.49%)

Page 14 of 56


The graph 1.6 as presented below show the impact of all parameters on NPV.

Page 15 of 56

Graph 1.6 Sensitivity Analysis : Impact on NPV

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

-51.75 -40 -20 0 20 40 60% Change in Parameters

Absolut

e Chan

ge in N

PV

Sales Direct Cost Discount Rate Fixed Cost Working Capital


Page 16 of 56


2 Interpretation of Price-Earnings Ratios

2.1 Comparison of companies based on share prices

Share price is

determined primarily by book value, liquidation value and market value. The book value is simply what the company has paid for its assets with a provision for depreciation (inflation is not considered). Liquidation value is based on what the company could realize by selling its assets and repaying debts. It does not measure the value of a going concern. It ignores intangible assets, (patents, and brand name) and ignores that firms may be able to make profitable investments in the future because of their position in the industry (6). Market value is correct if Efficient Market Hypotheses applies, but managers might have withheld important information. Published reports can be misleading and fraught with dangers (Under-valuation of fixed assets, valuation of intangible assets etc.).

It is often not feasible to make any comparison between companies simply on the basis of the reported share prices.

If we can imagine the price of share is equal to the present value of future dividends and the evaluation is done by investor, it is purely a confidence of the investor in the company and its current returns, future prospects and anticipated future earnings. Customer confidence differs from company to company. Most of the times it is based on the past

Page 17 of 56

0%

25%

50%

75%

100%

0 1 2 3 4 10 20 50 100

Price Dividends


records. Companies with high dividend payout may shoot up their share prices, at least in the short run, while companies which did not pay dividends for investing back in to business may still maintain their share prices high if investor is confident about it growth and possible future earnings. In reality, the company which paid high dividends did not have a comparable future growth plan similar to that of the company which retained most of the earnings. Long term and wise investors will continue to hold stock of such companies.

Hence, a low share price may indicate either no dividends from the company because of its poor performance or because it invested back into business. Similarly, a high share price may indicate either high dividends being paid either along with a real growth or no growth plan in the company. A company which paid high dividends, hence, high share price, may not able to sustain its position if growth plans are not in place. Similarly, a company which did not pay dividends currently, may have a decline or less share price (in comparison to the company paying high dividends) for the time being but in a strong position if growth plans are in place (with reinvestment of free cash flows) to pay dividends in future.

And also as the time passes, the present value of dividend terms increases and the present value of the terminal price declines. Share of established companies are held by investors for cash flows from dividends. Such shares are also traded high

Although assets, aggregate equity value is same for two companies, the share price may be different. It may be because of one firm having fewer shares issued than the other. Those few shares might be issued even at higher par value and initial subscription price than the other company. Financing through retention could be another reason, as mentioned before, paid high dividends and issued more shares to fund its growth programmes.

Sometimes, company may consciously take up an action to increase the market share price, of course, which may not stand high at the same for a long time and if fails to gain investor confidence.

Page 18 of 56


Strong stock performance alone doesn't mean the management is of high quality.

There are several elements that could affect share prices; the accounting policies, pricing methods, the impact of enterprise objectives, the effects of competition, the influence of the prospect's perception, characteristics of product or service, enterprise resources and environmental influences (7), rumours of war, change in regulatory environment (business), political climate, interest rate variations, domestic factors, global factors, company profits, investor confidence, investor perception, supply and demand (8). There can be many more unknown factors contributing to a change in share price. It is a complex pattern of various dependent and independent variables impacting on the share price.

Based on this all information, it can be concluded that it is often not feasible to make any comparison between companies simply on the basis of the reported share prices.

2.2 Price-earnings ratios, used with caution, allow some comparisons to be made across companies.

Dividing the share price by earnings (Price-Earnings Ratio: PE Ratio) provides a basis for standardising share prices that otherwise can not be meaningfully compared. PE ratio is one of the market value measures. It shows how much an investor is willing to pay per pound of reported earnings (generally based on the last reported earnings). High PE means high projected earnings in the future. Generally, a high PE is associated with a low market capitalization rate. A low PE can be due to a low price (lack of investor confidence) or high earnings.

PE ratios allow some comparison to be made across companies, more meaningfully for companies in the same industry.

Page 19 of 56


Reviewing past PE ratios will disclose trends in companies. These can be compared across companies.

It is quite common to see a company which has almost no earnings will have an enormous P/E ratio (and a company which is making a loss has no P/E ratio). Generally, it is argued that stocks with low PE ratios are undervalued.

There needs to be a caution exercised in interpreting the PE ratios. Some times, market value measure may be difficult to compare across companies. It’s usually useful to compare the PE ratios of companies in the same industry only, or to the market in general, or against the company’s own historical PE. The earnings per share between firms arising from the differences in accounting methods will result in differences in reported price earning ratios. Also the different depreciation methods used may give rise to differences in PE ratios. Conservative depreciation policies with high charges would result in higher PE ratios than those firms using straight line depreciation. Temporary changes in earnings may affect reported price-earnings ratios however; they may not lead to a proportionate change in price. Negative transitory earnings may lead to higher price-earning ratios and vice-versa. Some firms with temporarily low earnings will be found to have high price-earning ratios. As a result, many of the companies with high recorded price-earning ratios are not growth firms at all but are firms suffering from transitory earnings set backs.

2.3 Possible reasons why the PE ratios of the companies listed below differ.

Page 20 of 56


Sainsbury and Tesco are supermarket chains in retail trade and basically a stable business. As a generic rule, stable businesses offer good dividends. The PE ratio for Sainsbury was the highest (almost 3.4 times that of Tesco).

The possible reasons for the difference in PE ratios between Sainsbury and Tesco might be

High retention of yearly profits by Tesco for growth (more outlets and diversification). Generally Tesco is more diversified than Sainsbury and in addition to retail, it covers finance and insurance. Reviewing the balance sheet of Tesco and Sainsbury it was learnt that Tesco retained £4,957 millions (2006) and £4,470millions (2005) while Sainsbury retained only £1,948millions (2006) and £1,692millions (2005). The net profit for Tesco was £1,576millions (2006) and £1,347millions (2005). The net profits for Sainsbury was only £58millions (2006) and £188millions (2005). The net profit figures and retained profits give more confidence to investor on the possible future earnings.

Page 21 of 56


The high PE ratio of Sainsbury might be due to their previous history of dividend payment. However, the Total Shareholder Return was higher than FTSE 100 index and also higher than Sainsbury over the last 5 yeas.

\

Tesco paid increasingly every year for the last 5 years (12.05p

(2002), 13.54p (2003), 15.05p (2004), 17.72p (2005), 17.52p (2005-1) and 20.20p (2006). Sainsbury paid (19.1p (2002), 23.7p (2003), 20.7p (2004), 3.5p (2005), 4.1p (2005-1) and 3.8p (2006), it was erratic.

The number of shares outstanding for Tesco was more than that of Sainsbury.

The high TSR explains the investor confidence in Tesco; the share price was close to Sainsbury (less only by £1.5 while the PE of Sainsbury is more than 3.4 times). This clearly shows investor perception of Tesco and confidence that it would certainly yield high earnings per share in future.

The diversification of Tesco also gives more confidence to investors.

Page 22 of 56


Earnings are of PE ratio are based on an accounting measure of earnings that is susceptible to forms of manipulation rendering the PE only as good as the quality of the underlying earnings number.

Other reasons for the high PE of Sainsbury might be the accounting procedures as it depends on accounting profits rather than the expected cash flows.

Investors of Sainsbury are willing to pay more per dollar of earnings in preference to Tesco.

In EPS we often ignore the capital that is required to generate the earnings (net income) in its calculation. The company which can generate same EPS using less equity is more efficient than the other. The Tesco is operating with a high equity and also offering high EPS. Tesco had opted for high gearing (£3,742millions (2006) and (£4,563millions (2005)) while Sainsbury went for a gearing of (£2,178 millions (2006) and (£1,793millions (2005)). Low gearing gives more confidence to investor.

Similarly, the PE ratio of Logical CMG was high 39.5% (1.4 times higher than Dicom) although its share price was lower 158p (against 242.5p of Dicom, less by 35%). It again shows the investor perception and confidence in Logical CMG that it would deliver better earnings per share in future.

Page 23 of 56

MonthlyDeviation from

Mean

Squared Deviation from

Mean

-0.0901 Minimum 0.0000

0.1304 Maximum 0.0132

Sum Sum0.9352 0.1266

Portfolio Average Monthly Returns

Portfolio Average Variance

0.0156 0.0021

Portfolio Standard Deviation

0.0459

A,B,C,D and E

Portfolio 1

1

Selected Portfolio Returns


3 Monthly Returns of Individual Securities and construction of Portfolio and its performance

3.1 Equally weighted Portfolio of five randomly chosen securities

An equally weighted portfolio was developed from five (0.2 each) randomly chosen securities from the given 20 securities. The returns for such portfolio for each month were calculated with average monthly return and its standard deviation in the table 3.1 and presented in next 3 pages.

As can be seen from the table 3.1, the monthly returns of the portfolio ranged from £-0.0901p to £0.1304 with an average of £0.0156 and a standard deviation of £0.0459.

Page 24 of 56


Page 25 of 56


Page 26 of 56


Page 27 of 56


3.2 Average returns over 60 months for the chosen individual securities and their respective standard deviation and comparison of these figures with that of the equally weighted portfolio developed using these five individual securities

Monthly returns, average monthly returns with standard deviation over 60 months for the chosen five individual securities were calculated and presented in the table 3.2 (in the next 3 pages).

Table 3.3 (after Table 3.2 in the following pages) shows the comparison of the above data for the chosen five individual securities with that of the developed equally weighted portfolio. The summaries are presented below;

Security D had registered the greatest variation (highest range (£0.6658) and a corresponding high standard deviation (£0.1083)) followed by security C at £0.5138 (range) and £0.957 (standard deviation). The lowest variation was given by security A (range at £0.2655 and standard deviation at £0.0595) followed by security E at £0.3408 (range) and £0.0739 (standard deviation). The variation in B was between the variation of the groups D and C (high) and A and E (low).

Page 28 of 56


Average monthly returns were the highest for security B (variation was average) followed by security A (variation was the lowest) while average monthly returns were the lowest for security E (variation towards lowest) followed by security C (variation towards highest). The average returns of security D were in between these extremes.

The performance of individual securities when compared with the performance of the chosen equally weighted portfolio of these five securities gives rise to the fundamental merits of the portfolio management.

Firstly, the range and standard deviation (risk) of the portfolio was significantly reduced to lower than the lowest risk (A) of the individual securities, a great risk management. The percentage reduction in various securities ranged from 23 to 58. The beauty of this reduction is that the highest % reduction in risk (58) was achieved in the security with highest individual risk (D). The same trend could be noticed for the next highest risk securities (C and B). Portfolio reduces risk exposure of the investor.

Secondly, the returns of the portfolio are reduced. However, it is still higher than the Lower (D) and Lowest (E). It was lower only to the Highest (B) and Higher (A). The change in monthly returns ranged from -57% (B) to 2,814% (E). Interestingly, it is an increase in comparison to 3 of the 5 securities (C, D and E) while it is a decrease in comparison to the other 2 (A and B). Surprisingly, the A and B were securities with individual risk rated Lowest and Average, respectively.

In conclusion, a portfolio may reduce the returns to some extent but definitely and significantly reduces the risk exposure of the investor.

These findings support the Portfolio Theory which states that “Combining securities in portfolios tends to result in the standard

Page 29 of 56


deviation of the portfolio return lower that of the weighted average of the standard deviations of the returns on the securities included in the portfolio”.

Page 30 of 56


Page 31 of 56


Page 32 of 56


Page 33 of 56


3.3 Covariance and Correlation Coefficient calculation for each pair of selected securities and calculation of standard deviation of portfolio using the relevant portfolio equation and comparison with the results obtained in 3.1

Covariance and Correlation Coefficients are calculated for each pair of selected securities and presented in the table 3.4 (in the next page).

The Standard Deviation of portfolio using the relevant portfolio equation has been calculated as below

It can be seen that the Standard Deviation for the Portfolio calculated using the relevant equation as above and calculated by step by step

Page 34 of 56


method in Table 3.1 (using Portfolio monthly returns deviation from monthly average, their squaring to know the variance, average variance and finally square root of average variance to find out Standard Deviation) are the same at £0.0459.

Page 35 of 56


Page 36 of 56


3.4 Choosing securities at random from equally weighted portfolios of 2, 4, 8, 12 and 20 securities determine the standard deviation of these portfolios and plot the standard deviations against the number of securities in the portfolios. Comment on your results and compare your results with those of the studies of naïve diversification.

Portfolios of 2 (Table 3.5), 4 (Table 3.6), 8 (Table 3.7), 12 (Table 3.8) and 20 (Table 3.9) were developed and presented in the following pages.

The impact of number of securities in a portfolio on its standard deviation is summarized in Table 3.9 and plotted in the graph (Fig 3.1). The graph was plotted for Standard Deviation of equally weighted Portfolios for different number of individual securities chosen randomly.

Page 37 of 56


It can be seen from the above Table 3.10 and Fig 3.1, as the number of the securities included into an equally weighted portfolio, the standard deviation (SD) of the portfolio has decreased. As the standard deviation of a portfolio is nothing but risk of the investment, the risk is considerably reduced as the number of individual securities increased in a portfolio. This is the essence of portfolio investment to reduce risk. After certain limit, additional increase in securities may produce either non-significant or minimal reduction in portfolio standard deviation (risk). Such minimum risk to be faced for a given portfolio (with reasonably good number of securities) denotes the undiversible risk. Hence, increasing number of securities in a portfolio reduces diversiable risk.

It can be seen that along with reduction in risk (SD), the average monthly returns also reduced as the number of individual securities increased in a equally weighted portfolio. This might be because of a lesser contribution of a each individual security in a portfolio with more number of securities in comparison to a portfolio with less number of securities. A high risk high risk individual security can affect more an equally weighted portfolio with a few number of securities rather than the portfolio with more number of securities.

The negative correlation between A and D, B and E, and C and E might have contributed to reduction in risk in portfolios where they were constituents. They also might compensate for some losses in monthly income.

The selection of the securities was purely at random and strictly not on any past, present or future information about the companies, not based on any financial understanding of their investments, decisions, management, not based on market trends, competition and many other factors which could either shoot up or trumpet the share prices in the future, in the present or in the past. The selection was not even done looking at the monthly averages. A purely random selection of such kind can be compared with a naïve diversification, choosing securities with no much information and expertise. Although, such naïve diversification was used to build a portfolio, it perfectly worked out to reduce the risk that would otherwise be faced with less number of the same securities. It supports the age-old adage “Don’t keep all your eggs in one basket”. A

Page 38 of 56


learned decision might further reduce risk and increase earnings from a professionally diversified portfolio.

Page 39 of 56


Page 40 of 56


Page 41 of 56


Page 42 of 56


4 Trading of Marks and Spencer’s Shares

4.1 Profit Diagram for a Call Option

The profit diagram for the call option with a 600p exercise price that expires in October was given in the next page.

The X-axis represents the stock price on the expiration day and Y-axis represents profits or losses on the expiration day. This diagram ignores any commissions that are to be paid as part of this call option.

The Call was made at an Exercise Price of 600p to be expired in October for a Call Price or Premium of 28.75p per share.

As the share price rises above the Exercise Price by the expiry of the call (October in this diagram), the premium paid on this call option will be slowly recovered by the investor. The Call Price paid (28.75p) will be recovered when the share price is rised to 628.75p by expiry of the call in which case the investor would just recover his cost (ignoring the discounting factors over the period on the initial outlay) and would not make any profit resulting in a state of Break-even.

Any further rise in share prices would start yielding profits to investor through this option as he should otherwise end up paying a higher price to acquire the same asset if he were not exercising this option. As seen in the diagram, the potential profit line is at 450 to X-axis, showing a strong relationship of Profits to Increasing Share Prices. It can be seen that for every 1p increase in the share price from Exercise Price the corresponding profit is also increased by 1p. For example, as shown in the diagram, when the share price rises to 700p from the exercise price of 600p (an increase of 100p) by the maturity of call then the profit for investor would rise from -28.75p (at Exercise Price) to 71.25p (an increase of 100p). These profits can be realized once the investor exercises this option and sells the shares in the shares in the market at the prevailing rates as shown in the diagram.

The call price denotes the maximum possible loss from this call. The investor may opt to get the option expired if the share price is trumpeting below 600p end of October thus minimising his ‘downside’ risk to a maximum of 28.75p per share (the call price). Thus, Share Prices below the Exercise Price were not shown many in the diagram as they have no greater impact on the loss beyond the share price.

Page 43 of 56


Page 44 of 56

Chart 1. Profit diagram for a call option of 600 pence exercise price expiring in October on Marks & Spencer's Shares

-40

-30

-20

-10

0

10

20

30

40

50

60

70

80

580 590 600 610 620 630 640 650 660 670 680 690 700

Share Price (pence)

Pro

fit

/ L

os

s

Call Price / Premium 28.75 p

Exercise Price 600p

Break-even Price 628.75p

Profit of 71.25p when share

price is 700p


Page 45 of 56

Oct Nov Dec600 28.75 34.25 37.25650 5.5 9.75 13

CallsShare Price

Exercise Price

618.5


4.2 December Calls Trading higher than the October Calls

From the given Call Option data, the October Calls are traded at 28.75p per share while December Calls are traded at 37.25p.

It is quite common that Calls for longer period are traded at high Call Price or Premiums than the Calls for shorter period. It can be seen from the calls values in the above table, December higher than November and November higher than October. The longer the period the higher the share option price.

The inherent provision of a Call Option is protecting investors from ‘Downside’ risk. If an investor has bought a Call Option, he would only and only exercise it when the share prices are at least equal or above the exercise price end of the period he had purchased the option for. In this scenario, he would either just recover his initial outlay (when the share price is just equal to Exercise Price + Share Premium) or make profits equal in pence of rise in share price from the Exercise Price. On the flip side, when the share price trumpeted below the Exercise Price, the investor would prefer not to exercise the option and have it expired. By doing so, the investor is limiting his losses, thus risk. Hence, the Call Option provides a much sought after provision by investors to limit ‘downside’ risk while keeping the option open for unlimited ‘upward’ profits in rising market.

The level of premiums being related to the length of period could be justifiable for the a few reasons. Firstly, the behaviour of all elements that could affect share prices can relatively be easily predictable in near future than for the further period. The uncertainty over a longer period could affect share prices either positively or negatively stronger than for shorter periods. As the investor is protected in call option against the downside risk, there is high probability that he would make additional profits (which can be unlimited) at a pre planned and prepared premium price. Hence, there are more chances of positive results and this justifies charging a high premium and also attractive to investor who can go for an additional risk expecting relatively higher returns. Secondly, a long period call option gives the investor some time to see the performance of the share in the market and he can take a suitable decision either to exercise the call or not having clearly seen and understood its performance, the additional premium is charged for this provision. Thirdly, the relative time value of money justifies high premium for longer periods (the December premium discounted back at 10% per annum (in monthly interest payments) to October would be 23.6p only).

Page 46 of 56


4.3 Diagram illustrating a straddle, using calls and puts expiring in November and an exercise price of 650.

The straddle diagram using calls (9.75p) and puts (40.5p) expiring in November at an exercise price of 650p is drawn and presented in the next page.

It was seen that when the straddle was opted at a total premium of 50.25p at a strike price of 650p, the break-even points were found on either side of share movements (at 599.75p on the downside and at 700.25p on the upward)

Page 47 of 56


Recovery of premium paid and subsequent profits were generated from movement in share price either on downside or on upward. The higher the variation from the strike prices the higher the profits from the straddle strategy.

Page 48 of 56

Chart 2. Straddle with calls and puts expiring in November at an exercise price of 650p for Marks & Spencer's Shares

-60

-40

-20

0

20

40

60

80

580 590 600 610 620 630 640 650 660 670 680 690 700 710 720

Share Price (pence)

Pro

fit

/ L

os

s

Call and Put Price / Premium 50.25p

Strike Price 600p Break-even

Price 700.25pBreak-even

Price 599.75p

Profit of 19.75p when share price is either 580p or 720p

Profit of 19.75p when share price is either 580p or 720p

Puts Calls

Payoff / Share Value at the expiry of straddle

Profit / Loss


Page 49 of 56


4.4 Explain why an investor might consider it worthwhile to invest in a straddle.

An investor might consider investing in a straddle worthwhile only when he believes share prices will significantly move but unsure as to which direction.

The main attraction to the investor is the essence of straddle where he makes profits when shares move either upward or downside. This option is better than a single strategy of either call or put when investor is unsure of the movement in shares but very confident it is going to happen. This gives him better option of limiting his loss to the extent of the premium he paid in establishing the straddle position. However, it entirely depends on the volatility in the future. Investor may consider straddle during periods of falling share prices or abrupt and quick rise in share prices.

Investor also considers straddle to minimize risk from significant movement of share prices in unexpected direction. Risk and reward and inextricably linked in straddles. On the flip side of it, straddle can even be risky to perform as well. For investor to make profits, the stock price must move significantly. A slight movement in share prices (less than the premium investor did outlay) may result in a loss to the investor. And also the premium for stocks that are expected to move significantly will be at a higher level. A high level premium stretches the break-even and comparatively reduces the payoff if the share prices move significantly. The short straddle is a very risky strategy an investor uses when he believes that a stock's price will not move up or down significantly. It is associated with unlimited amount of risk with a large move downside or upward.

In general, investor prefers straddle while dealing with a share whose movement is unpredictable as he could reduce risk (although this strategy is not just a risk-management strategy), gain insights into the performance of the share over a period (time leverage to decide whether to have this particular share in his portfolio) and get income streams which are otherwise not possible, more convenient and less expensive than wholesale purchase or sale of shares,

Page 50 of 56


4.5 Comment on the contention that options are a zero sum game for the writer and investor in options.

Zero Sum Game means a situation in which total gains equal total losses. The following diagram shows the Zero Sum Game in detail. It shows the four basic options positions, namely the call option (long and short) and the put option (again long and short). The net position of all these four positions is a Zero Sum Game.

The aggregate gains and losses will always net to zero. The most an option writer can make is the option premium which is paid by the option holder. Since the premium is paid by option holder and received by option writer, the break-even point occurs at the same share price point. A potential gain realized by option holder by end of the option maturity is just equal to the loss of born by the option writer for the altered share price.

Page 51 of 56

Chart 3. Options are a Zero Sum game for the writer and investor in options

-100

-80

-60

-40

-20

0

20

40

60

80

100

580 590 600 610 620 630 640 650 660 670 680 690 700

Share Price (pence)

Pro

fit

/ L

os

s

Call Price / Premium 20p paid by call holder

Exercise Price 600p

Break-even Price 620p

Loss of 80p when share price is 700p to call writer

Profit of 80p when share price is 700p to call holder

Call Price / Premium 20p received by call writer

Profit of 40p when share

price is 580p to put holder

Loss of 40p when share

price is 580p to put writer

Put Price / Premium 20p paid by put holder

Put Price / Premium 20p received by put writer


The demerit of this contention is its Ignorance of the commissions, taxes and with an assumption that all both buyer and seller will have the same ability to borrow and lend money in market at the same (risk free) interest, the options market is a zero sum game. The commissions may not be the same. Lower profits may demand a minimum slab which will increase the net percentage value of commission of the gross profit made. All earnings attract taxes; it can be significant if the profits are high. A loss in contrary may help to reduce some taxes otherwise are applicable on individual earnings. It is rather never true that both the lending and borrowing rates are same. Option investor takes the brunt of cost of capital and writer can invest his premium to generate additional cash flows.

Page 52 of 56


Having described the above exceptions, still this Zero Sum Game holds true to some extent and especially when the market is not perturbed by unprecedented and unpredicted rises and falls.

(Word Count 6,302)

Page 53 of 56


5 References

1 http://cyllene.uwa.edu.au/~dpannell/dp0405.htm

2 http://www.investopedia.com/terms/n/npv.asp

3 http://www.investopedia.com/terms/i/irr.asp

4 http://www.investopedia.com/terms/p/paybackperiod.asp

5 http://www.investopedia.com/terms/s/sensitivityanalysis.asp

6 http://pages.stern.nyu.edu/~kjohn/courses/session01.ppt#270,6,Valuing an Office Building

7 http://www.businessplans.org/Pricing.html

8 http://www.moneybiz.co.za/personal_finance/jse_6.asp

Page 54 of 56

http://www.moneybiz.co.za/personal_finance/jse_6.asp

http://www.businessplans.org/Pricing.html

http://www.investopedia.com/terms/s/sensitivityanalysis.asp

http://www.investopedia.com/terms/p/paybackperiod.asp

http://www.investopedia.com/terms/i/irr.asp

http://www.investopedia.com/terms/n/npv.asp

http://cyllene.uwa.edu.au/~dpannell/dp0405.htm


6 Appendix

Appendix I

Financial Statements of Tesco

Page 55 of 56


Appendix II

Financial Statements of Sainsbury

Page 56 of 56

Documents

FFM Assignment